A world of low yield makes building retirement income strategies even more difficult for investment managers and advisors.
Einstein said compounding is the eighth wonder of the world and the most powerful financial force in the universe. Compounding is your greatest ally when you are growing assets in positive trending markets, but also can become your greatest enemy in bear markets as you sell shares or liquidate assets at lower prices to fund withdrawals. Income withdrawals dependent on gains or positive returns can unleash compounded liquidation of your capital base when selling in negative trending markets. Retired investors’ portfolios were severely damaged by this phenomenon during the 2000-2002 and 2008-2009 bear markets.
Investors in the retirement stage of their investing life cycle are acutely sensitive to risk and capital loss as they start withdrawing income to support their lifestyle. Retiring investors intuitively know their income is at risk when their capital begins to decline in bear market cycles. As retired investors watch losses unfold, they will often intervene by selling to protect remaining capital.
This behavior can derail carefully designed portfolio strategies and set the investor up for failure, as fear of losing more capital causes them to sit on the sidelines in cash for extended periods of time. They can then miss the most powerful early bull rallies off bear market bottoms that allow them to recover lost capital and post positive returns. While investors wait to get reinvested, they also continue to need income and can end up liquidating a good portion of their capital while they wait.
One of the portfolio construction and management strategies that emerged after the 2008 bear market to deal with these issues is commonly known as a retirement income bucket strategy. The central premise behind this portfolio design concept is to create a large “cash bucket” that will provide three to five years of income, so retired investors don’t need to liquidate assets in down markets to fund withdrawals. At a 4% income withdrawal, this can total 12-20% of total capital positioned in cash. The balance becomes the “invested bucket” and is normally positioned more aggressively to capture the higher returns needed to make up for the return drag created by the cash bucket. Income withdrawals from the cash bucket are typically replenished at least annually by selling a portion of the invested asset bucket.