One of the enduring debates among financial advisors has been the preferability of the traditional asset allocation method versus the “bucket approach” to retirement-income planning.
In the traditional approach, the client’s portfolio is set to some diversified allocation–60/40 equities/fixed income is the classic blend–and income withdrawals are managed around that standard.
The bucket approach divides the clients’ funds into buckets or separate pools of money that match each bucket’s volatility to the client’s goals and risk tolerance. Clients with modest assets, for example, would have most or all of their assets in very low-risk buckets; wealthier clients could create additional, riskier buckets.
UBS Wealth Management Research recently published a report, “Retirement Planning Now – Risk: How Much Is Enough?” It discusses the firm’s adoption of the bucket method. The full report is available online; here are some of the highlights.
In the past, the traditional investment planning strategy to restore balance to a retirement portfolio involved examining the retirement “trilemma,” which includes boosting savings (working longer), scaling back goals and reassessing the investor’s risk appetite.
In this new approach, as outlined by UBS, investors should segment their portfolios to help them identify how much financial risk they need to take on to meet their retirement goals. With this in mind, UBS suggests the following “buckets” when planning for retirement:
o The first risk bucket should contain funds required to fulfill the liquidity needs for an individual over some predefined time horizon. The sole purpose of this bucket is to provide an investor with a level of security in any contingency.
o The core bucket contains the bulk of an individual’s assets and should reflect the investor’s risk preference and be positioned for the maximum return versus risk. It is important this bucket is viewed within the context of an investor’s total assets.
o The leverage bucket contains a mix of riskier assets that should be used as a risk overlay and offers the investor the opportunity to dial up or dial down their risk tolerance.
“The benefits of a segmented approach are found not so much in characteristics of the portfolios, but the ability to construct a portfolio that addresses the investor’s loss aversion concerns, while at the same time allowing enough financial risk-taking to meet the investor’s goals,” says Mike Ryan, head of Wealth Management Research-Americas.
The risk-overlay strategy, provided in the third bucket, offers some probability that investors will be able to at least partially realize their wishes (such as travel or a second home), while at the same time helping to narrow the retirement gap.
For example, using this investment strategy, investors who lower their spending objectives in retirement and transfer the difference to riskier assets might find themselves taking only a slight reduction in their immediate liquidity while availing themselves of greater upside potential.
“It is important to note that this strategy isn’t for everyone and will not eliminate financial risk from a portfolio,” explains Ryan. “However, coupled with sound investment advice, this approach provides advantages for those investors seeking to limit overall downside risk, while still attempting to achieve a certain set of goals.”