This income strategy can help financial advisors steer clients through multiple stock market environments.

There isn’t a one-size-fits-all approach to investing. For financial advisors looking to help steer their clients who are in, or close to retirement through stock market volatility, strategy in the decumulation phase is key. 

Having spent a few decades managing client money, I often used a method called the “bucket strategy” which is a form of a more institutional strategy called Liability Driven Investing or LDI. 

It sounds complicated, right? 

Here’s how it works:  

This strategy has been researched by many institutions and analysts. Credit should go to Harold Evensky for being one of the first, if not the first analyst to bring the idea to light. Several other well-known investment firms, associations, and insurance companies have all made major contributions to the research behind this method since it was first introduced.

My take on it is derived from studying this research and implementing the methodology over the years. I used multiple asset classes and strategies to stick to the theme of first building an income floor with a fractional amount of the total assets and then exposing the remaining amount of money to risk in growth accounts. Each bucket of money would be used to fund  income needs over a certain time period in retirement. The near-term buckets take on little to no risk and the longer dated buckets take on more exposure to a growth allocation but over a longer period of time. I specifically deployed this strategy when working with newly-retired or soon-to-be retired investors. 

Running money for individuals is difficult. Having done so for 23 years with not only individuals, but family offices, corporations, charitable foundations and hedge funds, the hardest accounts to run were with individuals. Why? They have expiration dates, limited incoming cash flow, and they get very emotional. Sitting across from someone who hands you their life savings of $10 million+ can be stressful if you do not have a disciplined approach and a process to follow. The biggest fear for these individuals is retiring into an event that has an immediate drawdown on the invested assets like the markets are delivering here in 2020. The fear is ultimately based on running out of money in the retirement chapter of their life. And that has other underlying meanings, like being a burden on their children, and about having enough to leave a legacy for their grandchildren or their favorite charity. 

Life expectancy has increased since the early 1990’s but not as much as you would expect.  The typical life expectancy in 1990 was roughly 75 years old. Today that number is ~79 years old. Gender makes a difference as does wealth, mental fortitude and lifestyle. Another study, shows that the average 65-year-old male has a life expectancy of 76 and where a woman of the same age shows 81 as her life expectancy. In almost every country in the world, women outlive men. And, the mortality tables often point out that as a person hits certain age milestones their likelihood of continuing to live is increased. 

These are statistical projections and there are plenty of exceptions. I’m sure we all know folks who have lived into their 90’s, if not longer.  As an advisor, you should plan for the 25+ years of life expectancy between 90-95 just in case. 

Set Up Dedicated Accounts for Income and Investments

The idea here is to ensure that the money in the near-term buckets is safe, predictable and not subject to loss for the early part of retirement, while the longer-dated accounts are growing and do get drawn down in periods of a down market.  This is done so that if/when markets act the way they are here in 2020, retirees aren’t bailing out of their true, long term investments. This gives them a mental defense system, so they are not overly concerned about market fluctuations in the near term. 

This is LDI and over the years I used several different asset classes in the shorter buckets, depending upon interest rates, risk tolerance, size of the account, age, income, expenses and lifestyle wants. For instance, I had a client who had sold his business and cleared over $10 million. He lived well under his means and had plans for donations and legacy needs for his family and he was 72. So his short term bucket wasn’t very long and didn’t need to generate a ton of income since he lived so frugally. 

A very different case was when a family hit the Powerball for over $200 million. They cleared roughly $80 million and were only 40 at the time. This is a much different case especially since they weren’t going to retire anytime soon. They too lived frugally and splurged a little bit after the check cleared, but much less than the typical lottery winner. 

These baskets are difficult to construct in this current interest rate environment in addition to the normal risk associated with goals-based planning. You have obvious uncertainty in the air with the Covid-19 virus. This can be a great guide to help you consider a new structure for your current accounts. 

Bucket 1: for period years 0-10

The first part of the equation is to do a rigorous lifetime cash flow analysis and build the income statement and balance sheet of your client. This is the only way to engineer the initial income portfolio to make sure you have ample income to cover the needs, wants and liabilities in the near term. This first bucket could be for the first 8-10-year period in retirement. Typically, I used some combination of individual investment grade bonds, hard assets (rental properties), cash and single premium immediate annuities. Monthly cash flow is the goal. Again, the process is to create dedicated accounts used solely for cash flow in the initial years. This first account is critical and allows for the longer dated assets to grow over time. 

Bucket 2: For period years 11-15

As the term of the bucket increases so does the risk along with the potential return. The second bucket could be for years 11-15. And you could use a combination of asset classes like zero coupon bonds, a balanced asset allocation, a deferred annuity and individual investment grade bonds that are non-callable. It just depends on the evidence that you’ll uncover in structuring this account like current interest rates, tax bracket,  market environments and your client’s current circumstances. Using multiple asset classes also gives you flexibility to make changes along the way. For instance, had you set this account up 10 years ago and used investment grade bonds, today you’d have outsized gains in those bonds which you could swap for assets that generate the next leg of immediate income. In other words, you could have replenished bucket 1, perhaps with just one part of bucket 2. 

Bucket 3 For period years 16-20

This dedicated group of accounts can lean toward the growth side of investing. In this account you can run several types of investing methodologies. You might deploy multiple managers that have non-correlated strategies, or if you have your own model, run a core-satellite type of account. A sector rotation model might be a good choice as the satellite that revolves around the core consisting of several index ETFs, third party manager models or mutual funds. The idea here is to invest using a disciplined approach that can be a little more courageous because you know, after a detailed analysis, that this sleeve of accounts will be dedicated to a longer period. 

This bucket is where you will have years that you outperform and underperform, sometimes dramatically. Set client expectations and use the years where you have unusual gains that might produce 20%+ returns and others where you might generate a loss or lag the general markets significantly. In my experience, the real opportunity is to use the years where large gains occur to prune cash and potentially replenish or extend your less risky buckets 1 and 2. Think of it this way, the hypothetical bucket has overflowed and you are re-allocating the excess reserves to the current investment accounts. Clients like this process because it’s easy to follow and it makes sense. 

Show any client the chart of the markets overtime and they understand that markets climb, but they always ask, “what if it doesn’t?”. The answer is, to stay invested in this longer dated period of accounts to weather the storm. They can handle that because 1) they inherently know that markets usually produce gains over multiple years, just not every year and 2) not all of their money is at risk in this area of allocation.  

Look at this graph from BlackRock. It’s set up to view the returns of each asset class relative to a zero-return rate over the last 10 years: 

Bucket 4: For period years 21-25+

This region of the account structure is where a more aggressive allocation can live. It doesn’t have to be concentrated in a single stock nor should it be, but it most likely should be heavily weighted towards a diverse equity allocation. Over time the equity horse wins the race from year to year. The compounding effect in this account should be given the most opportunity to grow. Again, you might want to trim cash from this period if you get massive, unexpected returns, but doing so could lessen the long-term compound effect. This is where your expertise of the market environments and awareness can pay off for your clients. A great type of allocation was a risk on/risk off trend following strategy. Using a core-satellite method where the satellite is a sector rotation strategy might be useful as well. 

Having the right tools in place to monitor this strategy is important. Tools like our ETF screener can be effective in helping you stay the course in the right sectors at the right time.  

Pete Carmasino is Managing Director at PortfolioWise, an ETF ratings system powered by Chaikin Analytics. Pete has over 25 years in the capital markets industry. He previously ran his own RIA firm for several years where he created his own ETF model strategy. In prior roles, Pete was a High Net Worth Advisor and Institutional Sales Trader.

Follow Pete on Twitter @carmasino.

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