Forget the 4% rule.
It’s time for financial planners and academics to stop mocking this rule of thumb and start researching and debating the merits of using the compartmentalized approach to create a retirement income plan.
That’s right. The compartmentalized approach – or what some call time segmentation or the asset-liability matching approach – may well be for some and perhaps many retirees the best method for creating reliable and sustainable income at the same time. retirement.
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How? ‘Or’ What? Well, although tactics vary, this approach – which proponents include Harold Evensky, co-editor of Retirement income reimagined, and Christine Benz from Morningstar, usually asks you to create two or three buckets of money.
In a compartment, the short-term compartment, you would hold assets that provide security of capital and liquidity, for example money market mutual funds, or a bond or CD ladder. This compartment would fund, say, one to five years of living expenses in retirement.
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And since this compartment finances your short-term living expenses, you don’t have to worry about what happens in the day-to-day stock market like you would if you were using the 4% rule, or what some call a static strategy. If you were to use the 4% rule, you may need to reduce your short-term living costs if the market was in the tank or what some call return streak risk. Or, if you haven’t cut your living expenses, you might have to worry about outliving your money in the long run.
Now in the mid-term fund, you might have a mix of stocks and bonds, maybe an equity income fund. This compartment is designed to fund, say, five to ten years into the future. And, the third compartment, the long-term compartment, could contain mostly stocks – as a means of financing expenses in more than 10 years, as well as to mitigate the risk of inflation.
And the way it would work is this: as each year passes, you would channel the equivalent of one year of living expenses from the long-term compartment to the medium-term compartment and one year of spending from the long-term compartment to the medium-term compartment. medium-term to short-term subsistence of the compartment. tub.
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So what are the proponents of this approach saying?
âIn practice, the compartmentalized approach is a rational and understandable way to turn savings into monthly income,â said David Macchia, Founder and CEO of Wealth2k. âRetirees grasp the logic of allocating specific amounts of money intended to generate income during specific phases of retirement.
Bucketing also tends to better mitigate certain risks that can derail a retiree’s financial security, Macchia said. âFor example, if a person is unlucky enough to retire just as stock prices start to fall, bucketing protects against the risk of streak returns compared to, say, the ‘4% plan,’ a strategy based on the systematic withdrawal of a certain percentage from the investment portfolio, âhe said.
The first bucket
Retirement expert Tom Hegna also agrees with the compartments approach, although he believes that the compartments for retirement need to be changed. âUsually in the compartment strategy you have a compartment for short-term needs,â he said. âIt would be cash – money market funds, CDs, short-term bonds, etc.,â he said. âIn retirement, you still need to have an emergency fund and money for short-term needs. ”
The second bucket
The second bucket is normally for medium term needs. âSo longer term bonds, low beta stocks, dividend paying stocks, and so on. Would be in that bucket. But in retirement, that bracket should be your lifetime guaranteed income bracket, Hegna said. âYou need to have at least a guaranteed lifetime income sufficient to cover your basic living expenses,â he said.
The third bucket
The third bucket is for longer term growth. Stocks and real estate have their place here, Hegna said.
Some retirees might also add, Hegna said, a “speculative” compartment containing cryptocurrencies, higher risk stocks, commodities and so on. âI’m not against retirees putting 1-5% of their portfolio in potential home run areas,â he said. “In fact, Guaranteed Lifetime Income actually gives you the ability to add risk to other parts of the portfolio.”
A contrary point of view
Javier Estrada, professor of finance at IESE Business School and author of one of the few studies on the compartmentalized approach, agrees that the compartmentalized approach is attractive for several reasons.
âFirst, it seems plausible; you don’t have to understand the risk of return streak to realize that selling an asset right after its price has fallen sharply is not a good strategy, âhe wrote in a 2019 article. published in The Journal of Investing.
âSecond, it’s heartwarming, allowing retirees to no longer worry about the possibility of having to liquidate assets at a bad time; their short-term withdrawals are covered. Third, it is consistent with the well-known behavioral bias of mental accounting; retirees are likely to find the separation between the withdrawal account and the investment account attractive, âEstrada wrote. âAnd fourth, it’s easy to implement; retirees need only determine their annual withdrawals for the next several years, protect those funds by placing them in safe and liquid assets, and invest the rest in more aggressive assets.
But a plausible strategy isn’t necessarily optimal, Estrada wrote. Indeed, citing research published by Michael Kitces in 2014, simple static allocations, which involve rebalancing, perform better than sub-fund strategies, unless the latter involve rebalancing. Bucketing with rebalancing according to Kitces research gives the same performance as static strategies.
In her article, Estrada attempted to answer two questions: how did compartmentalized strategies perform compared to static strategies in the United States over a 115-year period and how did compartmentalized strategies perform compared to static strategies in the world, in 21 countries, during the same period.
And what Estrada found is this: retirees had better use static strategies.
And he concluded that financial planners should strive to explain to clients the advantages of static strategies over those of compartmentalized strategies. âThey should explain that meeting the behavioral need for mental accounting imposes a cost in terms of performance,â he writes. “And they should try to convince retirees that, as plausible, heartwarming and easy to implement as the compartmentalized approach may be, a static strategy with appropriate asset allocation would be just as easy to implement and would eventually improve. “
the voice of reason
So who is right in this debate? Well, the voice of reason, in my opinion, is Joe Tomlinson, actuary and financial planner.
In 2020, he publishes research comparing the bucket approach to the static strategy and concluded the following: âWhen I started this research I thought I would write a negative article on bucket strategies, but now I am getting to the middle. I disagree with the Estrada study which claims inferior financial performance for sub-fund strategies, but I also reject the claims of some advisers that such strategies produce superior financial performance. If compartment strategies provide peace of mind and help clients maintain their long-term plans, then that’s a positive benefit. The caveat is that the costs associated with using compartment strategies must be reasonable in relation to the behavioral benefits provided. “