UBS Wealth Management has a nice white paper on using asset buckets for retirement income. I’m not shilling for UBS—it’s just the first formal presentation I’ve seen of the bucket approach.
Essentially, there are two schools of thought when putting together a portfolio from which a retiree will draw income. The first is to put together a single balanced and diversified portfolio and then to draw a rational amount of income annually, say 3-4%. The second is to break the client assets into separate buckets, each with its own time frame and risk parameter. The first approach has the advantage of trying to put the entire portfolio at the right spot on the efficient frontier, if you believe in modern portfolio theory in the first place. The second approach allows you to use the client’s natural psychological urge to segment things—often counterproductive, by the way—to their advantage. It’s not clear right now if one approach or the other is to be preferred. There’s just so little quantitative research in the area that it’s hard to tell.
UBS’s approach in the paper is to use three buckets. Bucket 1 is composed of low-volatility, highly liquid assets and is designed to be the bucket from which income is pulled. Bucket 2 is the core bucket where most of the assets are held. Bucket 2, in fact, might look quite a bit like the single core portfolio in the alternative approach. Bucket 3 is the risk bucket where the client shoots for capital gains but doesn’t have to worry about drawing on the assets for income.
One can imagine numerous variations on this theme. More than three buckets could be used, each with slightly increasing volatility. Or the income bucket could periodically be replenished by capital gains from buckets 2 and 3 when they occurred. Relative sizes of the buckets could change depending on client’s risk parameters and needs, and so on.
I think there will be significant research done in how best to fund a retirement, primarily because the Baby Boom generation is just now starting to retire. I don’t think anyone has many answers yet, but maybe by the time the Baby Boomers are finished retiring, we will all have a better idea of what works and what doesn’t. The industry is finally starting to address retirement income issues, so this UBS paper is an interesting step.
