Christine Benz: Hi. I’m Christine Benz for Morningstar. Bucketing strategies for retirement planning have taken off in popularity in recent years. Joining me to discuss the pros and cons of bucketing is Michael Kitces. He is a financial-planning expert.
Michael, thank you so much for being here.
Michael Kitces: Thanks, Christine. Great to be here.
Benz: Michael, let’s start talking by about why it seems that the light bulb really goes off in a lot of retirees’ heads when you start talking about segmenting that portfolio by time horizon. What do you think works about bucketing from a practical standpoint?
Kitces: I think the strongest thing about bucketing from the practical standpoint, it just fits with the way our brains work. We have this growing volume of research now, what we call the behavioral-finance research, and the particular version of this is called mental accounting, which basically is we tend to form lines and we make buckets around how we allocate and manage information in our heads. And that definitely includes how we treat our investment accounts.
So we see sort of the funny anecdotal stories like "I’ve got two $50,000 accounts. One is my checking account for my spending, and the other is grandma's inheritance. And I treat them completely differently because grandma always wanted me keep this money for a special occasion, whereas this is my spending account." The reality is they’re two $50,000 accounts, they’re cash, they’re liquid. They’re the exact thing. But we start accounting for them and tagging them in very different ways, and then really treating differently.
Some of that, I think, we do automatically because of the rules that we have. We tend to mentally bucket retirement accounts differently than spending accounts, which is easy because the spending accounts are usually at a bank and the retirement accounts are often IRAs and 401(k)s held elsewhere anyways. So some of that is easily conducive. I find it gets messy when we get to retirement though because suddenly everything funnels down to one big bucket; "My retirement bucket has got all my different monies."
Sometimes we literally consolidate accounts. We certainly start viewing the balance sheet a little bit more holistically. Then we find it starts to get a little bit messier, where we kind of want to still account for things in buckets, but we've consolidated everything down to one big pool that it gets a little bit challenging, I think, for retirees trying to get comfortable with "How do I live off of this one big pool of money that's sloshing around as markets do what they do?"
Benz: So in a lot of bucket frameworks, and I've written about them for our Morningstar.com users, you’ve got a cash component. It seems that’s central actually to every bucket strategy, maybe an intermediate-term bucket of the portfolio, and then the long-term or growth portion of the portfolio. Let’s talk about how from a returns standpoint you find that a bucket strategy like that can sometimes lead to suboptimal return results.
Kitces: So the that problem comes up, and certainly you articulated I think the very standard approach comes from three buckets, short, intermediate, long. Sometimes there are four or five, but the spirit is the same. As you said, one of the real problem areas actually becomes that really short-term bucket. There was a great study that came out in the Journal of Financial Planning about a year and a half ago that looked at this. They called them buffer-zone strategies, for the same idea like let’s hold some cash aside to buffer our spending while the longer-term money does its ups and down. What they found, it’s sort of simple and intuitive conclusion when you think about it, if you’re always going to indefinitely have this short-term bucket that you keep replenishing over time, it basically means a big chunk of your portfolio is going to be in cash forever. That’s lower return.
Now in the short term that’s not a big deal, but when you compound that out over a long period of time, that starts to add up. If we're spending 3%, 4%, 5% of our portfolio, and we’re going to hold three years in cash, suddenly we’re literally talking about 10% to 15% of the entire portfolio in cash, yielding, well right now, nothing for potentially several decades. That starts to materially drag down the cumulative return of the portfolio. And what they found in their study from last year was you actually get lower lifetime spending with the cash buffer than you do by just getting rid of it and not having it at all.
Benz: So what’s the downside of just reducing the cash buffer to maybe more like a year’s worth of living expenses and true cash, and then nudging out the rest a little bit on the interest-rate spectrum?
Kitces: We could manage it a little bit at that end, and you can get creative with cash-management strategies. Then again, we’re little bit constrained in today’s environment.
Benz: We’re running out of creative tools.
Kitces: Yes, we’re running out of creative cash tools until rates go back up a little bit. But we see some folks who try to just bring the size of the cash bucket down a little bit. We see some that look at alternatives, so we see in a couple of recent studies in the Journal of Financial Planning finding things like, well, instead of having a cash bucket, let’s have a line of credit against the home or even a reverse mortgage line of credit against the home. We’ll tap that if we need it for a year or two of expenses. Then replenish it when the market recovers, but in the meantime the portfolio is fully invested. And we don’t have any loan interest except the brief one- or two- or three-year stint where we actually pull a little bit of money out because the market is down, and then we repay it when the market recovers.
So we end up with much less of a drag over time because we’re only occasionally incurring small amounts of interest, and we’re not dragging zero cash returns for extended periods of time. So we’ve seen sort of the reduction strategies: "Let’s just have a smaller cash buffer." We’ve seen kind of the alternative strategies: "There's something we could use for liquidity instead of the buffer." Frankly, my challenge to it at really high level, these are basically all ways that we just allow our asset allocations to shift over time.
So if I were going to be 60/30/10 stocks, bonds, cash, because that’s kind of how the buckets work out when you do the math, and I’m going to spend the 10% bucket down in a market decline, it's basically just a nice way of saying I'll reduce my cash allocation when markets are down. I’m going to let equities have a little bit more, and then I’m going to reallocate it later. To me, at the end of the day, that’s actually just a rebalancing strategy. That’s all we’re really doing with a slight tactical shift. If markets are down, I’m going to allocate a little more to equities; if markets are up, I’m going to peel it back a little.
What we’re actually seeing from some of the research we’re working on now is, we could actually just do slight tactical tilts without having the cash bucket. If the goal is I want to allocate a little bit more to equities when they’re down and allocate a little bit less when they’re up, which is really just a rules-based system for buying low and selling high, we get better results, and we don’t have the cash drag. So I think we’re going to see more different ways that we can replicate versions of what cash buckets are meant to do, certainly from the asset-allocation investment perspective, which is "Don’t liquidate equities while we’re down and liquidate them when we’re up." We can do that by other means besides just cash buckets. I think that’s ultimately sort of the direction that we see things going.
Benz: So in terms of someone implementing bucketing in their own portfolio, if they like the strategy and want to use it, what are some key messages that you would impart? Don’t hold too much cash is one.
Kitces: Yeah. So where do we go from here? Certainly, I think be cautious about just how much cash you’re holding is one.
Recognize that you’re actually accomplishing a lot of the goals that you’re trying to do with bucketing just with simple rebalancing. The reality, just to make the math easier, if I’ve got a 50/50 portfolio and the market does something bad and the stocks fall and the bonds go up, when I do my rebalancing at the end of the year, I’m already selling the bonds and buying more stocks or selling the bonds and doing my spending and then taking whatever is left and buying more stocks. The reality is I didn’t need some third cash bucket to make sure I didn’t sell stocks when they were down. Rebalancing alone was going to do it. So I think recognize what rebalancing already does for us and the benefits that are there.
And the third, which to me is sort of the ideal of where we get, I would love to see us start adapting how we track our investments that we report as buckets. I don’t necessarily want to invest it differently because if I let the bucket tail wag the investment dog, now I start changing my allocations and I can end up with too much cash and have problems. But I would love to see us have better means to just wrap our investments and label them as buckets.
If the reality is I’m going to have a 60/40 portfolio, let’s not call it stocks and bonds. Let’s call it long-term and short- to intermediate-term, and recognize that what will happen in that context is when stocks are down I’m going to spend from the short-term bucket because that’s simply what happens with rebalancing. And if stocks are up a lot, I can come back and say, "You know what, things are going really well. I’m actually going to spend a little from the long-term bucket because it’s up."
Rebalancing actually does all that anyways, but we can start labeling it in much more comfortable manners and say, "We’ll spend from the short-term bucket when it’s down, and we’ll spend from the long-term bucket when it’s having a great year and take a little bit off the table." It’s just another way to think about the same portfolio but I think in a manner that really is a little more intuitive, a little bit more constructive, and hopefully gets us a little bit more comfortable navigating some of the volatility that frankly we’re starting to see these days as markets do what they do.
Benz: Well, Michael, thank you so much for being here to share your perspective on what has been a really hot topic in the retirement-planning space.
Kitces: My pleasure. Absolutely.
Benz: Thanks for watching. I’m Christine Benz for Morningstar.com.