Despite the frequency of discussion about the need for retirement income, the 2016 PLANSPONSOR Defined Contribution (DC) Survey data on plan benchmarking shows many plans holding off on utilizing in-plan retirement income products.
When asked whether their fund lineup allows for “systematic retirement withdrawals,” overall just 64% of plan sponsors said it does. The likelihood of offering systematic withdrawals increases with a plan’s market capitalization, the data shows, with just under half of micro plans offering some sort of systematic withdrawal option compared with 75% for mega-sized plans.
The implication of this is that significant numbers of defined contribution plan participants, upon retirement, are left to determine on their own the best way to organize and spend down their assets. Unfortunately, experts nearly universally agree that the spending phase of retirement planning is much more subtle and potentially difficult to control than the relatively straightforward effort of accumulation.
One possible path forward for these participants is to craft a “bucket” strategy—preferably with the support of a financial adviser but, if necessary, on their own.
A bucket approach is essentially a reliable way to fund immediate cash-flow needs in retirement while also maintaining a diversified portfolio that can generate continuing returns. In the strategy’s simplest form, a retiree sets aside assets in cash to fund the next year or two of living expenses, then maintains other investment “buckets” that will be liquidated at the appropriate time later in retirement.
Harold Evensky, chairman, Evensky & Katz/Foldes Financial in Coral Gables, Florida, who is often credited with popularizing the approach, says one basic bucket strategy is based on time, or age. Individuals would have a bucket of assets to use from age 65 to 75, another for age 75 to 85, and another for after 85, for example.
A second simple strategy, according to Evensky, is based on goals or fixed vs. variable expenses. One bucket could be set aside for basic living expenses, another for a child’s or grandchild’s college fund, and another for travel or whatever other goal or variable expense a retiree has.
Evensky says he is, frankly, not a big fan of either of these simplistic bucket strategies. The problem with the goals-based strategy is, if the goals are not prioritized chronologically, the individual may over-save and have too little money for the short term, or vice versa.
“The time-based bucket strategy is perhaps more manageable: An individual would invest the short-term bucket in bonds and the longer-term buckets in stock,” Evensky explains. “But, as the individual gets older, the tax and transaction costs of rebalancing buckets will eat the person alive. That strategy is cost- and tax-inefficient.”
The Tax Bucketing Approach
Daniel D’Ordine, founder of DDO Advisory Services LLC, in New York City, says another approach is to have three buckets: one for tax-deferred assets, one for taxable dollars and, finally, one for any tax-free money the investor has accumulated.
He says the goal is to prevent a situation during retirement in which everything is in the tax-deferred bucket.
“If all of the assets/accounts from which retirees are drawing are tax-deferred, then [those individuals] are at the mercy of ordinary income tax brackets,” he notes. According to D’Ordine, in many states—such as New York, California and Massachusetts—that can mean that to spend $100,000, a retiree would need to withdraw up to $140,000 or $150,000.
In the three-pronged approach, the tax-deferred bucket would include money held in employer-sponsored defined contribution and defined benefit (DB) plans, individual retirement accounts (IRAs) and nonqualified deferred annuities—on all of which retirees would pay ordinary income tax, on distribution. The taxable bucket includes anything from after-tax brokerage, mutual fund or investment accounts held outside of qualified plans—on which retirees would pay capital gains taxes; those are currently more favorable than ordinary income taxes, D’Ordine observes. Finally, the tax-free bucket would include Roth IRAs, Roth 401(k) or 403(b) accounts, and cash value life insurance, when present. D’Ordine says municipal bonds fall into this last category, because the income is typically tax-free.
With these buckets, if individuals need $25,000, they should determine the least expensive way to tap assets to get this money, D’Ordine says. “It could be a loan or withdrawal from a cash value insurance policy, or it could be a withdrawal from a tax-deferred account, depending on the individual’s tax bracket.”
Making these determinations will obviously be very difficult for the typical retirement investor, both experts warn. The typical retirement saver will not be a tax expert and may not even fully grasp the differences between these three buckets.
Therefore, advice can be extremely helpful around this time in one’s financial lifecycle. D’Ordine adds that some people will be in a low tax bracket in retirement, and, depending on the total assets they have, dividing these into different tax buckets may be immaterial. However, in general, he says, “The decisions you make while accumulating savings can make a big impact on your experience taking distributions. Small decisions now can make a big difference.”
D’Ordine is especially adamant that younger people currently putting money into retirement plans and other investment accounts should think about how money will eventually flow out. “You can vastly improve the tax efficiency of your retirement spending by making a few simple adjustments today,” he says.
Carving Out Near-Term Cash
The bucket approach Evensky has suggested for many clients since the 1980s is a split between a cash-flow reserve and an investment component. Some of an investor’s portfolio needs to be invested over a long time-horizon to maximize potential returns, he says. But, for income needed in the short term, investors need to minimize risk and maximize tax efficiency.
Evensky suggests that individuals carve out of their portfolios the amount they would need in the next five years and put that money in a money market account, short-term bond fund with a duration of one or 1 1/2 years, or possibly a certificate of deposit (CD), depending on the individual’s tax bracket. The rest of the person’s portfolio would be invested for the long term, D’Ordine says.
That amount should be really invested, meaning in a professionally managed, global portfolio that does not shy away from investment risk, he says.
With recent market developments, Evensky now even advises that people at or near retirement carve out one year at a time. For example, if a person decides he needs $40,000 per year as income in retirement, he could put that amount into a CD and invest the rest. This strategy addresses one of the major risks in retirement, he notes—the sequence of withdrawal risk, or risk of having to take money from investments when markets are down.
Where do defined contribution plans and Social Security fit into Evensky’s bucket strategy? He says these are factored in when determining an individual’s needs in retirement. “Typically, we would encourage deferring withdrawals from DC plans as long as possible—typically, it’s the last place from which we would suggest withdrawing—so those accounts would be part of an individual’s long-term investment bucket,” he says. However, occasionally they make an exception when a person wants to delay Social Security and needs to access other funds in order to do that.
D’Ordine concludes that every person is different and will have different circumstances. “My only blanket approach is not to have a blanket approach,” he says, advising that financial professionals and plan sponsors use as much information as possible to help participants make the right decisions. —John Manganaro and Rebecca Moore
NOT EVERYONE BACK'S 'BUCKETS'
Barbara Reinhard, managing director, asset allocation at Voya Investment Management in New York City, can be counted among the industry experts who are not big fans of “bucketing” as a retirement income strategy.
Reinhard points to Voya’s Global Target-Payment (GTP) fund as an example of an approach that may be far simpler for a retirement investor to utilize—it basically requires investment in a single fund of funds instead of the division of assets among different buckets. According to Reinhard, the GTP fund has a specific targeted payout ratio each year, “very similar to what one may see with a university endowment—where you’re looking to pay out X or Y percentage every single year from the portfolio, with a strong degree of predictability.”
“Over the last year, we saw a big drop in bond yields, and, importantly, it has been a very steady slope downward, even in the face of not-so-terrible economic news,” she says. “So investors are saying, ‘Wow, I’ve got 1.6% at the most that I can earn on all my fixed-income assets, and I’m taking a tremendous amount of interest rate risk by tying myself to longer-duration securities—probably 10-year securities—even to make this much.”
So, when investors think about earning income in retirement to maintain a particular lifestyle and outpace inflation, they simply must go to a multi-asset strategy, where they can pull more levers than just taking interest rate and duration risk, Reinhard believes.
“Solving these problems is the goal of our GTP fund and any similar products that are out there,” she says. “We see a number of participants really buying into this strategy already, and they’re generally in the 50-plus or even 55-plus range, really getting ready for retirement. And the folks who are in the fund right now have shown a real willingness to stay in [it] through retirement, so that is validating our theory, I think.”
Further spelling out her opposition to bucketing, Reinhard explains that many investors have turned to high-yield bonds, master-limited partnerships (MLPs) or real estate investment trusts (REITs) to try to generate alternative sources of return in one bucket or another.
“They are overlooking the simple fact that every single one of those asset classes is leveraged to one thing, and that is duration,” she warns. “So in a year like 2015, when you had a crash in oil prices, suddenly the MLP part of your partnership was under tremendous pressure. It didn’t matter what the yield curve was saying. That’s why we are thrilled about the GTP strategy. It really speaks to this key series of questions that the bucket strategy is meant to address.”
Those questions, Reinhard says, can be boiled down to the following: Can you get the dividend payments you need from your stocks? Can you get the option override strategy on the equities to throw off some income? Can you make sure your equities will have good, free cash flow and that they are going to grow? Can you also have a buttress of some fixed-income portfolio that will help during any downturns?
“On the idea of bucketing in general, I think a lot of people are thinking and talking about it still because of the lingering effects of the global financial crisis,” Reinhard concludes. “That was an event that showed people that asset correlations, during events like this, can go to 1. With the exception of U.S. Treasurys, that happened, and it really disturbed people.”
Consequently, to this day, investors are concerned about how their assets will perform during periods of stress.
“Even skilled advisers feel they can’t be confident or really trust where the correlations may go in times of stress, and so they think about it in this framework of creating more independent buckets,” Reinhard says. “It’s certainly an informative metaphor to think about buckets, but, again, we are having much more success, and we have much more conviction [about] the target-payment approach.” —JM