Research Magazine has a nice piece on building retirement income portfolios. If you have clients that are aging baby boomers-and most of you do-or you are, like me, an aging baby boomer yourself, you’ll recognize that lots of people are suddenly thinking about this topic.
The two approaches to retirement income that are discussed are the total return approach and the investment pool approach, sometimes called the bucket approach.
Courtesy: Research Magazine
The graphic highlights the differences between the two approaches, although the article points out that advisors are trying to achieve the same end result:
While advisors may differ in the philosophy they follow for retirement clients, there are consistent elements among best-practice advisors that cut across both approaches. These common elements include:
- Generating an annual income or cash flow target of between 3 percent and 6 percent;
- Managing portfolios to support spending on essential needs such as housing, healthcare and other daily living expenses while also looking to maintain long-term purchasing power in light of potential inflationary pressures;
- Seeking to produce competitive returns for the client within agreed-upon risk parameters, but not striving for consistent above-average returns or outperforming market benchmarks;
- Focusing on broad diversification in asset classes, relying on vehicles they are highly familiar with, such as mutual funds, ETFs, individual securities, separately managed accounts and annuities;
- Emphasizing the process of constructing portfolios rather than the products or solutions available.
So which approach is best? The article doesn’t take a position on that question, but I think two things should be kept in mind when trying to decide.
1. There is no necessary functional difference at all between the two approaches. In other words, an investment pool approach with six equal 5-year buckets allocated progressively to Treasury bills, short-term bonds, intermediate-term bonds, large-cap value stocks, large-cap growth stocks, and emerging market equities is absolutely the same thing as a 50/50 balanced portfolio that uses the same asset classes.
2. As a result, the only thing that matters is which approach works best psychologically for the client. If the portfolios are functionally the same, ideally we should gravitate to whatever will help the client achieve their income and investment growth goals. Twenty years ago, the total return approach was dominant-and it still makes perfect sense from a financial point of view. However, over the last decade or so, the rise of behavioral finance has generated research that focuses on ways to nudge clients into more productive investment behaviors. There seems to be an innate tendency of humans to compartmentalize their finances; whether it is rational or not is beside the point. Even though we can all agree that the two leading retirement income approaches are functionally the same, if the client is more comfortable breaking an account into buckets-and will therefore have less emotional anxiety when the growth buckets bounce around in choppy markets-that’s the way it should be handled. Lousy emotional asset allocation is the root of most portfolio problems and anything that can improve results by alleviating emotional strain on clients should be encouraged.
