Bucketing Strategies for Portfolio Protection

When discussing Sequence of Returns(SOR) Risk and strategies to de-risk from SOR, I briefly mentioned bucketing strategy as one of the tools. In this post we will dwell deeper into it and evaluate a few bucketing strategies

One question that keeps giving retirees sleepless nights is how to plan withdrawals during market downturns. So much so that during these periods of extreme volatility, they panic and dump their equities portfolio to the detriment of their financial health. On any other regular day, we would all agree that the right time to buy into equities is when they are down, and for any balanced portfolio (both Stocks and Bonds) a yearly rebalancing takes care of buy low, sell high by design. But in the real world especially for retirees with SOR risk, when they see “Red” on their portfolio, reason drowns in that sea of red.

2 Bucket Strategy

Back in the 80s a Financial Planner, Harold Evensky faced similar “Behavioural” issues with his clients and came up with a “Behavioural Finance” hack which he termed “2 bucket strategy”. The trick was simple. Remove the money needed for immediate use from the portfolio and set side a small bucket of funds to meet upto 2 years of financial needs. Invest this money in safe and highly liquid assets such as savings ac, money market or arbitrage funds and meet all your daily to day needs from this bucket. Every year refill / top up this bucket during annual rebalancing, except when there is a significant market downturn. In such a year, continue drawing from the safe bucket till the markets recover (most downturns bounce back in a couple of years).

This buys peace of mind for the retiree and keeps one from self harm during market meltdowns. The cost of such a bucketing strategy is lower overall returns as highly safe and liquid assets typically yield lower returns. But as the bucket holds only upto 2 years of expenses, the cost benefit analysis tilts in its favour.

3 Bucket Strategy

Well if 2 buckets were good, then by extension 3 buckets should be better. Or so some of the Financial Planners in the community think. The approach is to create 3 buckets.

• Bucket 1 is 2 years worth of expenses kept in highly liquid assets, just like in 2 bucket strategy.

• Bucket 2 is next 5 years upto 10 years, kept in bonds that have higher yields than liquid assets but may not be as liquid.

• Bucket 3 is equity or long term investments that have higher variability.

Money flows from buckets 2 to 1 and from 3 to 2. Annual refills to bucket 1(liquid) are done from bucket 2 (bonds). The annual rebalancing happens between buckets 3 and 2.

The expectation is that if we allow equities a longer runway (10 years) without withdrawing for consumption regularly, we can mitigate the SOR and secure better returns. At the same time bucket 2 provides thicker cushion against extended downturns.

An Alternate, Annuities

When asked about annuities, Harold Evensky was not very enthusiastic. It’s because the interest rates have stayed too low for too long in the west. That means one needs really high investments to get anything worthwhile through annuities. But I believe in the post covid era, where US 10 yr treasury rates jumped to 7% in Oct-23, annuities may be a decent play. In India, our own 10 year treasury yields currently (June-24) are hovering around 7% mark. With inflation cooling to 5%, we may have a window of opportunity to secure a 7% Internal Rate of Return(IRR) on annuities.

The approach is to list and add all the essential expenses. Be it the electricity bill, gas bill, taxes, medical insurance, grocery bills, phone bills etc. and secure them through single payment, immediate annuity plans. Most insurance companies such as LIC, HDFC Life, SBI Life offer such plans. Once the essentials are covered for life, drawing up a Dynamic Withdrawal Plan with the remaining corpus should be able to take care of market turbulences.

We have discussed the longevity conundrum here. Some of us who worked for central and state govt. have pensions, while people in private enterprises don’t have any such benefits. We do have NPS but as NPS itself is less than 10 years old, the NPS corpus for people retiring now is limited. For those who are starting off their professional journeys and have their employers contributing to NPS may expect a substantial corpus as they retire 30 or more years from now.

For those who do not have any social security or pension, buying annuities is an option. At the time of retirement, one typically gets a sizeable corpus as EPF, PPF, Gratuity, Superannuation etc. add up. Right at that time, one may evaluate these immediate annuity plans for single or joint / survivor. Safeguarding the essential, existential expenses through annuities eases a retiree's mind. There are various versions / options available. There is money back, there are guarantees (5-10-15 years) and then there are plain vanilla ones that pay till the annuitant is alive and cease once they pass away, just like social security and pensions. The only challenge is most of the plans have a fixed amount every year which is not adjusted to inflation. There are alternatives that increment the amount by 3%-5% on the original annuity amount but over a 30-40 year period it just does not compensate for inflation. The retiree may have to buy additional deferred plans at the start or incremental plans to bridge the gap between inflation and annuity from time to time or hope that the growth in the equity/bond portfolio over 10-20 years gives them the required cushion.

In my Longevity post, I mentioned that for retirees in India, the life expectancy at 60 is good 18+ years moving to 20 years. For healthy couples in the US, there is 20% chance that at least 1 of the two will live to be a 100. Buying annuities is a good call for those retiring early or those who are generally in good health because “Mortality Returns” are in their favor. The actuarians working for Life Insurance companies create a mortality chart to come up with the annuity amounts. The basic tenet is that as time passes, some of us who bought the annuities will die earlier than the others leaving some money on the table. This money will be used up by the surviving retirees who outlive the unfortunate souls.

The bucketing strategies are varied in the way they are conceived and implemented. From a pure performance point of view, they may be suboptimal to varying degree compared to one big portfolio. Yet, in some form all of them offer protection from Portfolio Failure due to excessive market volatility. For most retirees, the behavioural and psychological support bucketing approach provides is worth giving up a few basis points of returns. Retirees are encouraged to evaluate whichever strategy works best for their unique needs.