The Bucket List

December 10, 2010

A really nice how-to article from Morningstar on how to implement the bucket approach for retirees. I think they get most of this right in terms of implementation, and agree with them that the approach resonates with actual retirees. Here’s an excerpt on implementation:

1. Determine the Paycheck You Need From Your Portfolio
If you’re attempting to create the equivalent of a paycheck from your portfolio, the first step is to gauge your income needs during retirement, either on an annual or a monthly basis. Start by tallying your total expenditures, then subtract steady sources of income that you can rely on, including Social Security and pension income. What’s left over is the amount that you’ll need to extract from your portfolio each month or each year.

2. Make Sure Your Withdrawal Rate Is Sustainable
The next step is to evaluate whether your desired portfolio withdrawal amount is too large or just about right. Most financial planners consider a 4% annual withdrawal rate, combined with annual upward adjustments to accommodate inflation, a safe withdrawal amount. For another check, Morningstar’s Asset Allocator tool can help you determine whether your current portfolio puts you on track to meet your retirement-income needs. (Just bear in mind that it’s using fairly rosy return expectations for stocks.)

3. Put in Place a Short-Term Bucket Holding of at Least Two Years’ Worth of Living Expenses
Assuming your desired withdrawal rate is sustainable, set up a short-term bucket consisting of at least two years’ worth of living expenses set aside in highly liquid (that is, checking, savings, money market, and certificate of deposit) investments.

Where you hold these assets depends on where you are in retirement as well as where you’re holding the bulk of your retirement savings. Being strategic about where you take withdrawals from can help you stretch out the tax-savings benefits from your tax-sheltered accounts. This article provides more detail on sequencing withdrawals to maximize your long-term tax savings, but here’s a quick overview:

  • If you’re older than 70 1/2 and taking required minimum distributions from your IRA or the retirement plan of your former employer, some or all of your near-term paycheck should come from those accounts. (Bear in mind that the amount of your RMD will vary from year to year, based on your account balances as well as your age.)
  • If you’re not 70 1/2 or your RMDs won’t cover your cash needs, turn to your taxable accounts to see if they will cover your cash needs during the next two years.
  • If your RMDs and taxable accounts won’t cover at least two years’ worth of living expenses, carve out any additional amount of living expenses from your IRA or company retirement plan assets using the sequence outlined above. Save Roth accounts for last because they offer the most flexibility and long-term tax-savings benefits.

4. Put It on Autopilot
Once you’ve identified where your cash will be coming from during the next few years, contact your financial-service provider to see if it can help automate your withdrawals, sending you the equivalent of a paycheck at preset intervals. (Better yet, your firm should be able to deposit the paycheck directly into your account.) The larger your fund company or brokerage firm, the more likely it is to offer such an option.

5. Other Important Tasks
In addition to getting your paycheck plan up and running, it’s important to periodically replenish your cash assets as they become depleted. Once you’ve set aside your cash position, put in place a plan to periodically refill your cash stake so that it always will cover at least two years’ worth of living expenses. Plan to incorporate this step into your rebalancing process. Ideally, you’d fill up your most liquid bucket with proceeds from rebalancing-related sales or with money from your next most liquid pool of assets (for example, intermediate-term bonds).

Bravo, Morningstar! I think there is some wiggle room about how many buckets to use, and what assets go into what buckets, but the general approach is sound. From my point of view, the psychological advantage of using buckets is that you might have a better shot at getting retirees to leave the capital growth portion of the account alone. I think it’s also important to make sure that the buckets cover the entire risk spectrum. If you use three buckets, but they are all fairly conservative, your client is not going to end up with enough growth over time. Mentally, you might want to think of the buckets as 1) generally stable, 2) somewhat balanced, and 3)growth-y. That gives you a lot of latitude to customize the buckets for individual clients. For example, a client who has an existing pension and a healthy retirement account balance might be able to use short-term bonds for the first bucket, something like the Arrow DWA Balanced Fund for the second bucket, and a 50/50 blend of a value manager and the Systematic RS Aggressive portfolio for the growth segment. You can change the volatility of the overall account by dialing the volatility level of the individual buckets up and down. And, keep in mind that there is no functional difference between a total return approach and the bucket approach if the overall allocation is the same. The only difference is in the mind of the client—but if a bucket approach helps the client to behave better, it’s a big plus.

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Posted by Mike Moody

Volatility Is Not The Same Thing as Risk!

June 16, 2010

We repeat this to our investors often, so often I probably mumble it in my sleep. You can imagine, then, how excited I was to read this great article on risk and volatility by Christine Benz, the personal finance writer at Morningstar. The article makes so many outstanding points it’s hard to know where to start. I highly recommend that you read the whole thing more than once.

Ms. Benz starts with the “risk tolerance” section of the typical consulting group questionnaire. They generally ask at what level of loss an investor would become concerned and pull the plug. (In my experience, many clients are not very insightful; every advisor has seen at least one questionnaire of a self-reported aggressive investor with a 5% loss tolerance!) In truth, these questionnaires are next to worthless, and she points out why:

Unfortunately, many risk questionnaires aren’t all that productive. For starters, most investors are poor judges of their own risk tolerance, feeling more risk-resilient when the market is sailing along and becoming more risk-averse after periods of sustained market losses.

Moreover, such questionnaires send the incorrect message that it’s OK to inject your own emotion into the investment process, thereby upending what might have been a carefully laid investment plan.

But perhaps most important, focusing on an investor’s response to short-term losses inappropriately confuses risk and volatility. Understanding the difference between the two-and focusing on the former and not the latter-is a key way to make sure your reach your financial goals.

There are three different issues she addresses here, so let’s look at each of them in turn.

1) You’re a crummy judge of your own risk tolerance. We all are. That’s because our money is personal to us. One of my psychologist clients once exclaimed, “Money is my most neurotic asset!” It’s much easier to take an outside view and look at it with some psychological distance. An experienced advisor is more likely to be able to gauge your risk tolerance correctly than you are. There are also good resources like Finametrica for learning more about psychologically appropriate levels of portfolio risk. But Ms. Benz really gets to the heart of things: your risk tolerance will change depending on your emotions! That’s something no advisor can calibrate exactly, nor are you likely to guess how powerfully the swell of fear will hit you after a particularly heinous quarterly statement.

2) It’s not okay to panic. As Ms. Benz points out, discussing loss tolerance in this fashion implies that it is ok to bail out emotionally at some point. If you have losses that are uncomfortable, perhaps you need to revisit your overall plan, but it’s unlikely that major modifications are needed if you were thoughtful when you put it together in the first place. Markets, and strategies, go through tough periods and it’s important to be able to persevere.

3) At the height of emotion, volatility and risk get confused. Volatility is just a measurement of how much your investments are whipping around at the moment. Risk isn’t the same thing. Ms. Benz clarifies the difference:

…volatility usually refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period-a day, a month, a year. Such fluctuations are inevitable once you venture beyond certificates of deposit, money market funds, or your passbook savings account. If you’re not selling anytime soon, volatility isn’t a problem and can even be your friend, enabling you to buy more of a security when it’s at a low ebb.

The most intuitive definition of risk, by contrast, is the chance that you won’t be able to meet your financial goals and obligations or that you’ll have to recalibrate your goals because your investment kitty come up short.

Through that lens, risk should be the real worry for investors; volatility, not so much. A real risk? Having to move in with your kids because you don’t have enough money to live on your own. Volatility? Noise on the evening news, and maybe a frosty cocktail on the night the market drops 300 points.

This is one of the best descriptions of risk I’ve ever read, one that puts opportunity cost front and center. Risk isn’t your portfolio moving around; that’s just volatility—noise, really. Risk is eating Alpo in retirement, or as she mentions, being forced to move in with your kids.

Source: Purina

Risk is the very real possibility of having a severe investment shortfall if you avoid volatility like the plague. Low volatility investments earn low returns (or worse if they are Ponzi achemes).

The challenge of every individual investor, hopefully with help from a qualified financial advisor, is how to balance volatility and return-while keeping risk from sneaking up and biting you you-know-where. Ms. Benz has some thoughts on this as well:

So how can investors focus on risk while putting volatility in its place? The first step is to know that volatility is inevitable, and if you have a long enough time horizon, you’ll be able to harness it for your own benefit. Using a dollar-cost averaging program-buying shares at regular intervals, as in a 401(k) plan-can help ensure that you’re buying securities in a variety of market environments, whether it feels good or not.

Diversifying your portfolio among different asset classes and investment styles can also go a long way toward muting the volatility of an investment that’s volatile on a stand-alone basis. That can make your portfolio less volatile and easier to live with.

Again, she makes several very cogent points, so let’s deal with them one by one.

1) Volatility is inevitable. Deal with it. Preferably by constructing your portfolio thoughtfully in the first place.

2) Better yet, volatility can be your ally. Buy on dips. (Easy to say, harder to do.) In truth, high-return, high-volatility strategies can be tremendous wealth builders because the long-term returns are good and you get plenty of opportunities to add money during the dips. Toward that end, we publish a High RS Diffusion Index each week to help identify those dips in our particular strategy.

3) Diversify appropriately. We believe it’s often more fruitful to mix strategies as opposed to asset classes. For example, relative strength strategies tend to work very well when blended with deep value strategies.

Ms. Benz lays out the real definition of risk: failing to accomplish your goals.

It also helps to articulate your real risks: your financial goals and the possibility of falling short of them. For most of us, a comfortable retirement is a key goal; the corresponding risk is that we’ll come up short and not have enough money to live the lifestyle we’d like to live.

Clearly, the biggest risk for most investors is their own behavior. They avoid volatility rather than embracing it. Instead of buying on dips and being patient with proven strategies, they sell during pullbacks and buy only after an extended period of good performance. When you start to conceptualize risk as shortfall risk, you can also see that another of your big risks is not saving enough in the first place. At the risk of sounding like my mom, if you don’t have any money, no investment advisor is going to be able to help you retire. Savings, too, is behavior that can be modified.

What can be done to help clients embrace volatility, or at least deal constructively with it? Are there any ”nudges” that can be applied in order to increase their patience and their overall good investment behavior? Ms. Benz makes a suggestion in this regard:

Many financial advisors have begun to embrace the concept of creating separate “buckets” of a portfolio-and in particular, a bucket for any cash the investor expects to need within the next couple of years. By carving out a piece of your portfolio that’s sacrosanct and not subject to volatility or risk, you can more readily tolerate fluctuations in the long-term component of your portfolio.

Sure, it’s a cheap psychological trick that plays to the mind’s natural tendency to segment things-but if it helps, why not? We’ve discussed in the past that a portfolio carved into buckets is functionally equivalent to a balanced or diversified portfolio with the same asset allocation, but if it helps clients behave better then it’s worth trying.

Whether you are an advisor or an individual investor, educating yourself about key concepts like the difference between volatility and risk will pay large dividends down the road.

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Posted by Mike Moody

Two Approaches to Retirement Income

May 25, 2010

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.

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Posted by Mike Moody

Investing for Income

April 16, 2010

As the front end of the baby boomers hit retirement age, investing for income has become their mantra. Retirees are often sold terrible investments because of their known propensity to lunge at income the way a starving fish attacks a baited hook. But is investing for income desirable, or even possible? Let’s take a look at the income possibilities from bonds, stocks, and alternatives.

Bonds are boring and safe, and are usually the first place investors go for income-except that with current interest rates, there isn’t much income available. Most retirees can’t live on 2-year Treasury yields of 1.04%, and moving out to the 30-year Treasury at 4.72% brings with it a significant chance of getting hurt by inflation. Yields on junk bonds (euphemistically known as high-yield bonds) are higher, but that crosses over from investing for income to its less glamorous cousin, “reaching for yield.” Junk bonds might work for a while, as long as the economy is in recovery mode, but are probably not a long-term solution for a retiree. As the saying goes, “More money has been lost reaching for yield than at the point of a gun.”

Many investors have looked to the stock market for dividend yield. Doug Short has a nice piece on the disappearing yields in stocks on his excellent site. The chart below is taken from his article. Stock prices have been rising, but dividend yields have been going the other direction.

Click to enlarge. Source: dshort.com

The traditional high-dividend sectors for investors were always banks, oil stocks, utilities, and REITs. When stock prices plunged in 2008, many banks eliminated or severely slashed their dividends. Some REITs had the same problem. Oil stocks and utilities don’t have nearly the dividend yields they used to. All of the dividend cuts and reductions caused the high-yielding equities to do worse than the general market. (See the chart below for a comparison of the S&P 500 to the Dow Jones Select Dividend Index ETF.)

Source: Yahoo! Finance

Alternatives range from MLPs (typically finite lives and unstable income streams) to all sorts of structured products. This morning someone sent me an offering flyer for a 12-year 8% CD, where the quarterly rate is based on the slope of the yield curve. 8% was the cap rate, but it could drop to 0% if the yield curve flattened out. I’m not sure Mrs. Jones is ready to speculate with derivatives.

All in all, it appears that the income investor has hit a rough patch and there seems to be no easy way out. I’m going to let you in on a secret that very few investors know: capital gains can be spent just as easily as dividends. Ok, that’s not really a secret at all, but many investors act like it is. They chase yield so they can spend the income, but really, total return is all that matters.

Segmentation, like the distinction investors often impose between income and principal, is a natural function of the mind. Many retirement planners have been using this human tendency to segment things by presenting a retirement income solution that consists of a number of buckets, a solution that is generally well-received by clients.

The first bucket is the liquidity bucket, where spending will be drawn from. The second bucket is the income bucket, which is typically put into some kind of fixed-income investment. The third bucket is the growth bucket. By segmenting the growth portion, the investor might be more willing to leave it alone as it gyrates with the market.

When there is a particularly good quarter or good year, the growth bucket can be trimmed back and the proceeds “deposited” into the liquidity bucket. Obviously, you could use any number of buckets depending on how finely you choose to segment the investment universe. The relative size and specific composition of each bucket would be determined by the client’s situation. Most often, all of this can be done within one account. The buckets are mental, but they help separate the investments and their specific purpose in the client’s mind.

When viewed in the context of buckets within a single account, it becomes quite apparent that total return is what counts. Investing for income may be a misnomer; investing for total return is the real deal.

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Posted by Mike Moody

Retirement Income

February 2, 2010

As baby boomers age, retirement income has become a hot topic. Most of the discussions revolve around determining the best way to structure a retirement portfolio to generate the maximum income from it. I know of no studies that specifically address this issue from a quantitative standpoint, but from a psychological perspective, the idea of dividing assets into buckets has been gaining favor. In this transcript from Consuelo Mack’s Wealthtrack program, several financial experts discuss retirement income ideas and I note that the buckets idea is mentioned frequently.

Although holding up to five years worth of spending in cash is not likely to optimize the overall portfolio return, the idea of buckets is designed to allow investors to hold growth assets with less fear. Spending comes from the liquidity bucket, which given the mind’s natural tendency to segment things, does not seem as connected to the growth part of the portfolio as when the assets are combined in one large portfolio. The investor may have a tendency to leave the growth bucket alone, perhaps using occasional gains to replenish the liquidity bucket.

The additional psychological advantage of separating the liquidity and growth buckets is that investors may not feel pressure to liquidate when the market is weak. If they feel that their spending needs for the immediate future are covered, they may be more willing to let the growth investments fluctuate-and not sell out at inopportune times. If using the bucket approach leads to better investor behavior in the long run, I’m all for it.

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Posted by Mike Moody

The Bucket List

January 6, 2010

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.

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Posted by Mike Moody