A Unique Alternative to the 4% Rule

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THE MUCH-DEBATED 4% rule—which I wrote about back in July—is a popular way to think about portfolio withdrawals in retirement. But it isn’t the only way. Another approach, called the bucket system, is also worth understanding. Below is some background.

What is the bucket system? As its name suggests, an investor divides his or her portfolio into multiple containers. Each container, or bucket, is then assigned a different role.

The most popular implementation of the bucket system involves three containers: The first is earmarked for a year or two of spending and is held entirely in cash. The second is earmarked for another five to 10 years of expenses. Because of the longer time horizon, this can be invested with somewhat more risk—in high-quality bonds, for example. Finally, the third bucket is earmarked for expenses beyond 10 years. Because of that, it can be invested entirely in stocks.

What’s the purpose of all this? In constructing a portfolio, retirees face a fundamental dilemma: If a portfolio is too conservative, meaning it holds too little in stocks, inflation can erode its buying power over time. On the other hand, if it’s too aggressive, with too much in stocks, there’s the risk of a large, sudden loss.

The bucket approach is designed to help balance these risks. The first two buckets—the more conservative ones—won’t provide much long-term growth, but they protect against short-term stock market risk. That, in turn, allows the investor to take lots of risk with the third bucket. Result: The bucket system helps an investor thread the needle between too much and too little risk.

The bucket strategy is a lot like the asset-liability matching system used by insurance companies. To cover future claims, insurers also set aside funds using buckets. As I’ve noted before, this has contributed to making insurance companies very durable.

What are the benefits? The bucket system can help retirees sleep at night. This is especially true when the market drops. Retirees who have, say, a year of spending money in cash, plus another seven years in bonds, will have a much greater ability to tune out the bad financial news because they know that they can survive a multi-year stock market downturn.

Buckets can be particularly helpful in those early retirement years, when sequence-of-returns risk is greatest. Because funds are earmarked so clearly, new retirees need not worry about a nightmare scenario in which they retire on Monday and the stock market drops on Tuesday. With buckets, that kind of scenario might be unnerving, but it wouldn’t derail a new retiree’s plans.

What are the disadvantages? Critics cite two drawbacks. First, the system can be complicated to manage. If you search online for illustrations of the bucket strategy, you’ll see they involve a fair amount of maintenance. Interest and dividends need to be moved periodically from bucket Nos. 2 and 3 to bucket No. 1. A retiree also needs to monitor the market to determine which bucket to draw from and which to refill. During periods of extreme market volatility, like last year, the bucket system can send retirees scrambling as they work to maintain their buckets.

Another potential issue with the bucket system: Some studies have found that bucket portfolios, on average, might underperform. Why? A 2014 paper identified a key weakness in bucket portfolios: They don’t enforce rebalancing. Specifically, there’s nothing in the bucket system that would lead an investor to buy more stocks when the market is down. By contrast, a traditional investor, following rebalancing rules, would buy more stocks when the market drops.

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Take last year. When the market fell more than 30%, a bucket investor would have simply been withdrawing from his or her cash bucket, but not necessarily adding to stocks. A traditional investor, on the other hand, would have been rebalancing and adding to stocks when they were on sale. That would have resulted in a performance boost as the market recovered. More recently, another study came to the same conclusion—that bucket portfolios may have a performance disadvantage. The difference isn’t dramatic, but it’s measurable.

On balance, is the bucket system a good idea? Yes and no. If you’re trying to decide on an asset allocation, I think the bucket idea provides an excellent place to begin. Suppose you’re heading into retirement with a $4 million portfolio and plan to withdraw $100,000 a year for expenses. Under the bucket system, you might set aside eight years of spending, or $800,000, in bonds and cash. That would translate to an asset allocation of 20% in bonds and cash ($800,000 ÷ $4 million), and hence 80% in stocks.

Would that be the right asset allocation? In my view, that would be aggressive for someone entering retirement, but it isn’t totally unreasonable. It is, at a minimum, a good starting point for discussion—and better, I think, than starting with an arbitrary allocation, such as 50% stocks-50% bonds, which doesn’t have any relationship to the investor’s spending needs. That’s why, in setting asset allocations, I always start with a calculation like this. In that sense, buckets are a useful idea.

Still, I’m not sure I’d 100% follow the bucket system. That’s because the ongoing maintenance of buckets takes work. Instead of managing a single portfolio, a bucket investor effectively needs to manage three. It’s much simpler, in my opinion, to manage a portfolio the traditional way—with assigned percentages for each asset class. In addition, I see a lot of value in rebalancing and agree with the research cited above, which calls this out as a weakness of the bucket system.

For these reasons, I don’t recommend strict adherence to the bucket system. But I don’t want to be too critical. Conceptually, I see a lot of value in the way the bucket system uses an investor’s spending needs as the all-important yardstick. For risk management, I see no better way to assess a portfolio than to measure an investor’s withdrawal needs against a portfolio’s holdings of bonds and cash.

The upshot: I recommend a hybrid approach. Use bucket calculations to help settle on an asset allocation, but then translate those calculations into percentages that you use to monitor and rebalance your portfolio. That way, you can enjoy the peace-of-mind benefit of buckets, while also benefitting from the simplicity and potential performance benefit of a traditionally managed portfolio.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm.

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