After decades of saving, your clients want their money back. And they might need their retirement savings pot to cough up an income for the next 30 years or more.
Presented with this challenge, how do you typically arrange their retirement income?
When deciding which route to take, your clients’ health, income, and attitudes to risk all need to be considered.
Perhaps your clients, as some do at this stage, value certainty above all else, and prefer the ‘income for life’ option of an annuity.
Others may be swayed by the potential benefits of a flexi-access drawdown approach, taking up to a quarter of their pot as tax free cash and investing the rest until they need it.
Though both these options, and others, satisfy the basic need of your client – to take an income – they swerve two crucial considerations: when do your clients need their income, and how might their risk attitudes shift as time passes?
After all, capacity for loss in retirement may mean whether a client can bear a drop in regular income, rather than a loss of capital.
William Bengen’s famous ‘4% rule’, referring to an apparently ‘safe’ withdrawal rate from a £100,000 tax-advantaged portfolio, has underpinned retirement income strategies for years.
But it isn’t without challenge, not least that the rate is based on a fund value fixed at a certain point (and, if you’re interested, on US returns, not UK). In reality, its value will rise or fall with markets and, though 4% may be sustainable one year, it may not meet expenses in another.
Recently, the Institute and Faculty of Actuaries proposed that a typical 65-year-old would require a flat rate of 3.5% from their pension pot to avoid running out of money.
And, what if markets are falling when that extra income is needed? Retirees may be forced to liquidate assets on the cheap.
This is where buckets come in.
The central premise behind the bucket concept is to create a series of buckets invested according to when the client may need the money, with each run in isolation.
There is a ‘cash bucket’ that will provide income over the short term (say, one to two years), meaning retirees don’t need to liquidate assets in down markets to fund withdrawals.
The remaining buckets invest according to the retiree’s anticipated timescales and attitude to risk.
Ultimately, this approach gives advisers greater control over how to deliver income.
How might it work?
There is no ‘right’ number of buckets, but three or four are fairly common. Here are two possible approaches; one possibly more academic, the other potentially more aligned to retirees’ typical risk attitudes. First, in a three-bucket scenario:
Bucket one is for immediate needs and holds cash, plain and simple. For the duration of your clients’ retirement, spending money is only taken from this bucket.
Bucket two is a low-risk multi-asset bucket. Any income produced or, if necessary, capital withdrawn can be pushed into bucket one to meet the client’s income needs.
Bucket three is left untouched over a longer time horizon, say ten years or more, and is designed to produce the income the client needs for the remainder of their retirement.
This is one approach. In a four-bucket scenario…
Bucket one, again, is a cash bucket and provides money for immediate needs.
Bucket two is for short-term needs – let’s say years one to five following retirement. It is designed primarily to preserve capital so contains cash but also includes some investments that, historically, have proven relatively stable.
Bucket three is for medium-term needs, in this case for five to ten following retirement. It is there to both preserve capital while generating retirement income, and includes more assets with growth potential.
Finally, bucket four is designated to provide income in year 10 and beyond. It contains investments that have the most potential for growth.
You know at some stage (and pretty soon) that bucket one, where your client takes all their income from, is going to need topping up. By having more buckets invested for different time horizons, it gives you the flexibility you need.
For example (and depending on your approach), if there is an equity boom and one bucket enjoys above-expected returns while another is comparatively static, you could take profit from that bucket to put into the cash pot.
So, if your clients need, without fail, a certain amount each month to live on, this approach gives you the flexibility to dip in and out of the different buckets when you need to.
Questions for you and your investment team include how many buckets to have, whether to adopt an income or total return approach, and whether to use ‘real’ assets to inflation-proof a longer-term bucket.
Is the bucket approach a hit?
Though the bucket approach has been around for a while, it isn’t universally admired.
One consideration is the attitude to risk of a segment of clients typically biased towards low volatility investments. Might some look through the income security provided by the cash bucket and become fearful of any declines experienced by the invested asset bucket?
Some could see losses in the invested bucket as a serious problem and wish to sell declining assets to curtail further losses. More on that next time…
In the next article in this series, we will take a closer look at the pros and cons of the bucket approach to taking an income.