It is useful to be able to visualize what funding retirement is all about. Rows and columns of numbers on a spreadsheet are a great tool, but sometimes a picture is worth a thousand columns.
This article provides an overview of three ways to visualize what's going on when you think comprehensively about all of your financial assets for retirement.
[Source: Advisor Perspectives, www.advisorperspectives.com/commentaries...]
The bucket brigade is proving to be a popular picture of retirement funding. This visual construct segments retirement assets according to the time when they will be needed, or into "safety" in the traditional sense (nominal price volatility). Both mean about the same thing in this way of thinking.
The basic idea is that long-term assets (mostly "risky" stocks) are held for needs more than 10 years (or so) out; medium-term assets ("safe" bonds) are held for the 5-10 year range; and cash ("risk-free") is used to supply directly the money needed in retirement.
The buckets are filled or replenished downstream, from long-term to short-term, which is to say from riskier to safer.
In the most common representation, three buckets are employed:
Bucket 1 contains cash and cash equivalents. This bucket is the direct supplier of income to the retiree.
Judging from comments on Seeking Alpha, most retirees maintain a certain amount of readily available cash in their checking accounts, money market funds, CDs, etc. This money (or part of it) is often considered to be an emergency fund. I have seen commenters state they keep anywhere from a few months to 5 years' of expenses in cash. The most typical amount is probably 1-2 years' worth.
The target for Bucket 1 may be a percentage of assets; or it may be pegged to how many months or years it is supposed to cover expenses; or it may consist of a length of time for expense coverage plus an emergency fund.
In the example shown in the diagram, if Bucket 1 contains 5% of all assets, and you withdraw 4% of your assets per year, the bucket lasts just over a year. However, as depicted, cash spills down from Bucket 2 into Bucket 1. The cascade can come from the yield on bonds in Bucket 2 and/or the deliberate selling of assets in Bucket 2 to replenish Bucket 1. Bucket 1 is kept at or near its designated level all of the time to promote good sleep. So it always contains around 5% of total assets.
Note that since the return on cash is near-zero these days, the more kept in cash, the lower the overall return of the entire asset mix.
Bucket 2 contains fixed income assets, mostly bonds. In the sources that I consulted, the "fixed-income-equivalents" of Social Security, pensions, and annuities were not specifically mentioned as residing in this bucket. They were regarded as outside the retirement investing system. I will explain later why I believe that this is a misleading view.
Bucket 3 contains assets meant to fund needs further out, say beyond 10 years. Mostly these assets would be stocks, although such things as limited partnerships, real estate, commodities, and "alternative assets" can all be considered to reside in this bucket. The idea behind the long-term bucket is that its assets are not needed immediately, so the retiree can more easily tolerate market vacillations, knowing that the money in Bucket 3 won't be needed for several years anyway.
The overall management of the buckets can be referred to as rebalancing or asset allocation. The approach of Heron Financial Group (see the link under the diagram) is typical:
[T]he "rain" of investment returns continues to fall into the "Risk Asset" and "Fixed Income" buckets. Once or twice a year we rebalance the client's allocation among the respective buckets, which generally means "pouring" excess assets from the "Risk" bucket into the "Fixed Income" bucket and from "Fixed Income" to "Near Cash." We had two major "droughts" in the last decade, 2000-2002 and 2008-9, which meant that sometimes no funds transferred from the "Risk Bucket" for a year or even two years. But the reserve in the "Fixed Income" bucket kept the cash flowing.
Charles Rotblut of AAII has stated, "It [the bucket strategy] anticipates that the allocation will shift over time to traditionally more conservative asset classes as the retirement savings are drawn down…. Depending on the preference of the investor, the funds may be redistributed among buckets more or less frequently."
Some of the most lucid writing about the bucket strategy comes from Christine Benz at Morningstar. She has written several articles about the bucket strategy, interviewed Harold Evensky (a pioneer in the field), and interacted with retirees about their approaches.
Benz has noted that some investors see the bucket approach as old wine in a new bottle. At the end of the day, most portfolios - bucketed or not -- will include cash, bonds, and stocks. But on the other hand, many investors find the bucket system to be a useful visualization. It helps them to see the purposes of different kinds of assets, and (Benz says) "it helps take the guesswork out of asset allocation."
Most writers about the bucket strategy note that the cash portion helps retirees sleep better, knowing that their short-term needs are covered no matter what happens in the markets. Some writers extend that to Bucket 2 as well, since bonds are traditionally regarded as safer than stocks.
Again, we are talking about a visualization here, not claiming that bucketing is necessarily different from what retirees have been doing for years. Benz writes:
Instead, the main advantages of the bucketing strategy are psychological. Although retirement brings many joys--namely, time to pursue enjoyable pastimes that you couldn't while working--the financial component can bring some angst. It's a scary mental adjustment to transition from earning a paycheck to tapping a portfolio for living expenses. And the process of creating a portfolio that balances near-term income needs with long-term growth for your later years--and figuring out how much you can safely take out of it to ensure that you don't run out of money prematurely--is overwhelming to say the least.
Some of the benefits of the bucket visualization listed by Benz include:
- Helps simulate the security of a steady paycheck.
- Helps you ride out volatility in aggressive assets.
- Gets you away from an unhealthy form of mental accounting, namely expecting never to touch principal and live only off the interest kicked off by the portfolio. ("[N]ever touching principal might lead a retiree to underspend, forsaking quality-of-life considerations and leaving more to heirs than would be optimal.")
My own visualization for retirement funding is a cistern.
The idea behind the cistern visualization is to bring all elements of retirement's financial dynamics into one picture. There are several ways in which this construct differs from the bucket picture:
- At 1, it shows money flowing into the system. Pre-retirement, this represents contributions and investments that the individual is making during their accumulation years to prepare for retirement. After retirement, it can include money from Social Security, a pension, annuities, or a part-time job. The idea is not to ignore the fact that most retirees derive income from sources other than their investments. This inflow pipe helps the cistern visual to work for pre-retirement years as well as during retirement.
- At 4, it shows Mr. Market's impact on the resources in the cistern. Traditional withdrawal strategies (such as the 4% rule) are based on the expectation that market forces will increase the value of unsold assets to make up for the withdrawals. If this fails to happen, the level in the cistern will fall. Some retirement plans based on withdrawals do fail - the owner outlives the assets. While most traditional retirement planners consider bonds to be "safe" assets, in reality nearly all assets are subject to market risk. Over the past 35 years, bond fund investors have become accustomed to receiving both income and capital gains from their bond holdings. That has been the case with yields generally falling for such a long time. But with rates now near their minimums, yields have nowhere to go but up. When that happens, the capital gains in bond funds that have become customary for more than a generation of investors will turn into losses.
- At 5, it shows the leak in everyone's retirement assets: Inflation. As we all know, inflation sucks purchasing power out of money. In the cistern, it would be as if your level were going down, even though the nominal value stays the same or even goes up. The leak represents what is really happening to your purchasing power.
At the top of the assets in the cistern, the surface is shown as a pie chart. That ties the cistern into the third and most common visual way of looking at retirement assets.
A pie chart can be used to illustrate the allocation of assets. For example, the traditional 60-40 mix of assets would be shown like this:
As a simple example, an investor might have 60% of total assets invested in a general stock fund such as State Street's SPDR S&P 500 ETF (SPY) and 40% in a general bond fund such as the Vanguard Total Bond Market Index Fund (BND).
A problem of this representation is that it does not include the allocation to cash that most investors have. According to Richard Shaw's recent article, AAII's recent survey shows that its members hold 62% stocks, 21% bonds, and 17% cash. At about 17%, cash is too big an allocation to be ignored. So let's add it.
This is still an incomplete picture. As I explained in a recent article, you may also consider it proper to include "effective allocations" to fixed income to round out the picture even further.
What is an "effective allocation"? If you have the right to receive Social Security benefits or a monthly pension payment, those legal rights have a present capital value to you. We need to convert the rights that you have into their capital value.
An easy way to "capitalize" those rights is to use the calculator at Immediate Annuities.com. Since your rights are to receive monthly payments for the rest of your life, they are analogous to owning an annuity.
Say you own the right to receive Social Security payments of $1700 per month. According to the calculator, such benefits are worth $282,092 to a 65 year old male in New York. That is what it would cost to purchase an annuity that would pay the $1700 per month that you already have the right to receive from Social Security.
In my opinion, this "effective capital" should be displayed in the pie chart. So let's say that a retiree has accumulated $500,000 during his working lifetime, and that he has invested that into the three major asset classes (stocks, bonds, and cash) according to the AAII breakdown. If he also receives Social Security payments of $1700 per month, this is what his pie chart looks like:
If you add up the three categories, this retiree has, in effect, $782,092 - not $500,000 - in accumulated capital.
Furthermore, when compared to either the traditional 60-40 asset allocation or to the AAII survey results, this retiree has an excessive amount allocated to fixed income, nearly 50% of assets. To bring that down to 40% of the total, he or she would need to sell about $55,000 of bonds and place that money into stocks. To get to the AAII averages, the conversion of bonds to stocks would be about $203,000 of assets.
Summary and Conclusions
In my own real life, I have implemented the kind of asset allocation described here. In my cistern, I have the rights not only to Social Security, but also to a pension. When combined, they practically equal in "effective capital" the 40% traditional allocation to bonds. So I have been systematically selling off old bond funds. Now we own very little in the way of bonds.
So if graphed in the traditional fashion - leaving out the capital value of our Social Security and pension rights - the straight-down view of the pie chart at the top of our cistern would look about like this.
I suspect that most financial advisors would state flatly that this allocation is way too heavy in stocks and too risky for that reason.
My response would be that I have plenty of fixed income allocation - from Social Security and my pension. This nearly all-stock asset allocation for our investable assets is just right for us. Since most of our stock investments are in dividend growth stocks, we find that the combined income from our dividends, pension, and Social Security more than covers our monthly income needs.
For more information on the combination of dividend income plus fixed income rights to cover retirement, please see David Crosetti's fine recent article. He links to a calculator that can be used to estimate future dividend payouts.