In an earlier lesson I argued that a bear market early in retirement — i.e., when you start withdrawing money from a portfolio — can have a devastating impact on the sustainability of your income stream. This irrefutable mathematical fact has been demonstrated by a number of authors including myself and has led many advisors to consider FinSurance products, such as guaranteed minimum accumulation, withdrawal and income benefits to guard against this risk.

Yet, some commentators have expressed the view that placing a few years worth of retirement spending needs into safe investments — and then planning on not touching the remaining funds in the event of a bear market — can somehow avoid the ruinous impact of a poor sequence of investments returns. A fringe element of this sect believes that if markets decline retirees should simply be counseled to take only income from their bond allocation and then “wait for the stock allocation to recover” and thus avoid selling at a loss.

I believe these strategies are an optical illusion at best and create a potential for grave disappointment at worst. If you are unlucky enough to earn a poor sequence of initial returns, so-called bucketing of your retirement income is not a guaranteed bailout. In this lesson I will try to convince you of this fact using what logicians call a counterexample.

As in any discussion (or debate), one’s assumptions are critical and my current argument is no exception. To make this a fair apples-to-apples comparison I will arrange my story so that all else is equal, or as economists say ceteris paribus. Thus, I start with two hypothetical retirees: Ms. Stephanie Swip and Mr. Brett Bucket. They both begin their retirement with exactly $100,000 in liquid assets from which they would like to receive or generate $750 per month, which is $9,000 per annum, for as long as possible. Forget about inflation for the moment. Note that under a fixed 7 percent investment return per year the funds would only last for about 21 years. Granted, this is a (very) high and therefore unsustainable spending rate and I would never counsel either of them to withdraw this much. My point for this lesson is not to suggest a prudent spending rate but to examine the impact of two strategic alternatives.

Now, Stephanie chooses to invest her entire $100,000 in one balanced mutual fund that internally has 30 percent of its assets allocated to cash instruments and the remaining 70 percent allocated to diversified equities. This allocation is periodically rebalanced by the fund manager so that Stephanie has a 70/30 equity/cash mix on an ongoing basis at all points in time. I will also assume that this balanced portfolio is expected to earn an arithmetic average of 7 percent per annum net of all fees. Remember that each month Stephanie liquidates as many units as necessary (more during a bear, less during a bull) to create the desired income of $750. This is known as a systematic withdrawal plan (a.k.a., SWiP).

In contrast to Stephanie, Brett decides to implement a so-called “buckets” approach to retirement income generation. He places $25,400 of his $100,000 nest egg in cash instruments to cover the next 3 years (36 months) of $750 per month expenses. The remaining $74,600 is invested in a pure equity portfolio that — I am assuming — is expected to earn an arithmetic average of 8 percent per annum. This bucket will not be touched or tapped for three whole years.

I have picked these numbers carefully. Brett has set aside precisely $25,400 because I have assumed cash is yielding a constant and predictable 4.0 percent per annum. The present value of 36 monthly cash flows of $750 at 4.0 percent / 12 = 0.333 percent per month is exactly $25,400. This bucket of cash will generate the desired payments and Brett will not have to liquidate any stocks (at a loss) if the market takes a tumble during the first three years of withdrawals, a.k.a. the retirement risk zone.

Notice that if we focus on the total portfolio held by either Stephanie or Brett at the time of retirement, they both are expecting their total investment portfolio to earn 7 percent per annum. Stephanie selected a mutual fund that is projected to earn 7 percent, while Brett has 25.4 percent (=$25,400 / $100,000) allocated to cash earning 4.0 percent and 74.6 percent (=$74,600 / $100,000) allocated to equities earning 8 percent. This also works out to an average of 7 percent.

It is very important to keep track of the total asset allocation since it will have a direct impact on my subsequent arguments. In fact, all of the above return assumptions — i.e., 4 percent for cash and 8 percent for equity and 7 percent for the balanced fund — were not arbitrary. They were selected so that at the point of retirement Stephanie and Brett have the same initial asset allocation but different dynamic strategies. Otherwise, any comparison is meaningless.

One final assumption that I will now make for the sake of my counterexample — and this one is a bit artificial — is that equities as an asset class will earn one of only three possible investment returns with equal probability. Some of you may have seen this handy triangle before. Namely, equities will either earn 8 percent (the average) or earn 35 percent or they will lose 19 percent in any given year. The arithmetic average of these three numbers is exactly 8 percent. The standard deviation of this variable consisting of three possible investment returns is the square root of the expression: (1/3)(0)+(1/3)(0.27)^2+(1/3)(0.27)^2, which is approximately 21.9 percent.