Executive Summary
Financial planners have always sought to adjust their strategies and communication techniques to the realities of client needs, although the increasing volume of behavioral finance research is now beginning to document exactly how we as human beings sometimes think in very irrational ways, which in turn provides insight about how to best adapt to deliver effective advice. One common challenge area regarding investments in particular is our tendency for mental accounting - where we break up and categorize assets based on various needs and purposes, even if the underlying investments are flexible or entirely fungible - which in turn has spurred the growth of so-called "bucket strategies" that seek to allocate portfolios based on various goals, needs, or time horizons.
Unfortunately, though, recent research has shown that stringent applications of bucket strategies can potentially result in less optimal retirement outcomes, not better ones, particularly due to the "cash drag" and portfolios that can dial down too conservatively too fast; in addition, the reality is that mathematically, most of the benefits of bucket strategies are captured simply from traditional rebalancing strategies, which already ensure that stocks are bought (not sold) when they're down and that cash and bonds are used for spending needs when appropriate.
Nonetheless, from the behavioral perspective, using bucket strategies remains appealing, if only to help clients stay the course during stressful times. But ultimately, perhaps the best solution is not just to weigh the trade-off between managing with buckets (even if the results are worse) versus helping clients psychologically (which is still better than having them bail out at the worst of times), but to accomplish both by improving performance reporting to overlay buckets and goals on top of the portfolio. In other words, maybe the key is not that we need to change how we invest for clients, but simply to more effectively frame how we report the results?
Mental Accounting And Bucket Strategies
Over the past several decades, behavioral finance research by Richard Thaler and others has found that we have hard-wired tendencies for "mental accounting" where we tie assets to particular goals or purposes, and treat them differently, even enough the underlying investments are otherwise flexible or entirely fungible. For instance, we might treat $100,000 of stock we just inherited from Mom (keep it, since she owned it for 50 years) different than the same stock if it was the company we worked for (keep it because we know and trust the company), which in turn we might treat differently than the same stock if it was just one of many in a diversified brokerage account (keep or sell it depending on investment outlook). The context of the asset changes how we treat the investment and make use of it, even if the reality is that it's the same stock investment with the same risks and rewards in all cases.
The phenomenon isn't unique to stocks; we even do the same thing with cash, often treating the money in an account different depending on whether it's mentally earmarked for goals ranging from "spending" to "emergency funds" to "house downpayment" even though, once again, cash is cash and we could really apply it to any goal or purpose we wish, regardless of what account it's in. Nonetheless, mentally we tend to carve up and separate the money; in fact, sometimes we create different real world accounts just to help facilitate keeping the mental accounts separate, such as when we actually put the $30,000 of emergency funds in a different savings account than the $50,000 house downpayment, even though both may be funds we don't intend to touch anytime soon and we could easily have put them in $80,000 one account and just remember how much was to be allocated to each goal.
The "bucket strategy" - also called a "time segmentation strategy" - is essentially a version of mental accounting, where the client's portfolio is broken apart into several buckets; for instance, one group of investments might be used to cover expenses for the next 3 years, the next might cover spending goals for years 4-10 out, and the last would cover spending needs in the longer term (e.g., 11+ years away). Because of the different time horizons, those buckets could then be invested differently - the short-term bucket might hold cash, the intermediate bucket mostly bonds, and the longer-term bucket would hold stocks. Of course, we could hold the same mixture of cash, bonds, and stocks in one account with the same allocation; nonetheless, our tendencies for mental accounting make it desirable to keep them separate, especially if they're assigned to different goals.
The upside of this separation to facilitate mental accounting is that many planners report in practice that clients are more easily able to stick with their investment portfolios and retirement plans, especially during difficult times. When we can point to a specific cash bucket and say "See, this is where your spending will come from for the next several years" and then point to a second bucket to say "And here's where the spending will come from for the years after that" it makes market volatility easier to handle; as the bucket strategy helps to illustrate for retirees in particular, those equities really won't have to be touched for 10+ years, and it's clear exactly where spending will come from over the next few years, which makes the ups and downs of the market far less worrisome.
The Problem With Retirement Bucket Strategies
Unfortunately, though, the desire to keep the money separate potentially distorts the asset allocation in the long run, which can ultimately have a negative impact on achieving retirement goals.
For instance, while it's appealing to identify short- and intermediate-term buckets that will be used for near-term spending, such that the "equities bucket" won't need to be touched for 10 years, we can't just keep executing on the strategy that way for the next 10 years without making adjustments; otherwise, by a decade from now, all the cash and bonds would have been liquidated for those early years' spending needs, and the even-more-elderly client would actually hold 100% in equities, which would almost certainly be indefensible at that point in time!
As a result, portfolio buckets must be rebalanced periodically back to their original allocation. Yet if the reality is that for a 30-year retirement time horizon, there are 3 years of cash, 7 years of bonds, and 20 years of equities (to take a simplified bucket example), then next year there must still be 3 years of cash and 7 years of bonds (since we still have to fund the subsequent 10 years) and only 19 years of equities remaining, which means that after rebalancing the effective result is that we're actually spending the stocks in the near term (which dropped from 20 years of investments to only 19 years' worth) and keeping the cash and bonds, rather than the opposite that was implied! This in turn makes the portfolio systematically more conservative over time, and as a result research last year found that such bucket or "buffer zone" strategies (where an allocation to cash is held as a buffer against market volatility) can actually lead to more conservative portfolios, lower returns due to the drag of big cash positions, and worse retirement outcomes, unless you manage to be a good "market timer" for when you actively rebalance the buckets!
In fact, as it turns out, standard rebalancing actually makes most bucket strategies unnecessary in the first place, at least from an asset allocation perspective. While the standard refrain for bucket strategies is that they're "a way to avoid selling stocks when they're down" the reality is that if the stock allocation in a portfolio declines in a market crash, the stocks wouldn't be sold anyway. The stocks would actually be underweighted at that point, the bonds would be overweighted, and the rebalancing portfolio would actually be selling bonds and buying stocks (along with liquidating bonds for any spending needs); that's just the way the rebalancing math works out, regardless of any bucketing!
Reporting In Buckets Without Bucketing?
Notwithstanding the fact that many bucketing strategies don't actually help improve the mathematics of retirement outcomes - in fact, as noted above, they can actually hurt - the reality remains that clients seem to clearly understand and appreciate strategies when they are framed as buckets. Which means at best, practitioners must balance the psychological benefits of clients being able to stick with a bucket strategy against the potentially-less-favorable outcomes of rigidly implementing one. The alternative, though, is that perhaps portfolio reporting software can be improved to allow even comprehensive, total return portfolios to be reported on a bucketing basis, even if the portfolio isn't specifically managed that way.
For instance, consider the "typical" million dollar client portfolio below, with a moderate growth 60/30/10 allocation.
| Type/Investment | $$$ | %age |
| Equities | ||
| Large Cap Stocks | $300,000 | 30% |
| Small Cap Stocks | $150,000 | 15% |
| International Stocks | $150,000 | 15% |
| Subtotal | $600,000 | 60% |
| Bonds | ||
| Corporate Bonds | $200,000 | 20% |
| Government Bonds | $100,000 | 10% |
| Subtotal | $300,000 | 30% |
| Cash | ||
| Money Market | $100,000 | 10% |
| Subtotal | $100,000 | 10% |
| Total | $1,000,000 | 100% |
Assuming this portfolio is sustaining $50,000/year withdrawals and is regularly rebalanced, the reality is that when there is a bull market, spending liquidations will come from equities (which will be sold for rebalancing purposes), and when the market is down, cash flow will come from bonds and cash (which will be sold because they will have outperformed equities at that point). In other words, even with everything in one giant bucket, managed on a consolidated household basis, rebalancing alone allows the portfolio to be effectively managed.
Nonetheless, the reality is that dealing with market volatility in real time is still frightening for most clients. Thus, notwithstanding the fact that the liquidations may occur in the intended order and from the desired asset classes, the bottom line total of the portfolio is still going to be very volatile, driven by the ups and downs of equity prices in particular.
Imagine instead, though, if the same portfolio were re-cast in the context of buckets, such as the following:
| Type/Investment | $$$ | %age |
| Short-Term Spending Needs (1-3 yrs) | ||
| Money Market | $100,000 | 10% |
| Government Bonds | $50,000 | 5% |
| Subtotal | $150,000 | 15% |
| Intermediate-Term Needs (4-9 yrs) | ||
| Government Bonds | $50,000 | 5% |
| Corporate Bonds | $200,000 | 20% |
| Large Cap Stocks | $50,000 | 5% |
| Subtotal | $300,000 | 30% |
| Long-Term Bucket (10+ yrs) | ||
| Large Cap Stocks | $250,000 | 25% |
| Small Cap Stocks | $150,000 | 15% |
| International Stocks | $150,000 | 15% |
| Subtotal | $550,000 | 55% |
| Total | $1,000,000 | 100% |
Notably, in this context, the allocations to the asset classes and the mixture of stocks and bonds are actually no different than they were before. The difference is simply some of the investments have been shifted and re-categorized slightly, and categorized in a manner to acknowledge which "buckets" they would be associated with; essentially, it is a form of goals-based reporting.
If the market declines, spending will be drawn from the short-term bucket, as expected; in reality, this would have happened anyway, simply given rebalancing, but clients may be eased to see that in fact the withdrawals really do come from the short-term bucket. If the market is up, stocks can be liquidated, which can either be characterized as "taking gains off the table to spend" or "replenishing the short-term bucket" although the reality once again is that the transaction will actually just be normal rebalancing.
Unfortunately, the reality is that in today's marketplace, portfolio performance reporting software is constrained to the "traditional" approach that separates investments by their asset class categories, without allowing buckets to be wrapped around them. But perhaps at some point in the future, performance reports can be adapted to group investments based upon buckets - even if they're not necessarily managed under a bucketing approach - to allow for the best of both worlds, where portfolios can be managed effectively for total return but clients can account for their investments using buckets that help make market volatility more manageable?
What do you think? Would you find it helpful to have a way to show investment results using buckets as a form of goals-based reporting, even if you still manage a portfolio on a total return basis?
