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.

While well intentioned, I fear these “bucket strategies” have numerous flaws the next bear market will expose, which will cause them to underperform expectations dramatically and could do more harm than good. Here’s why:

First, our experience over the past 25 years in managing retirement income portfolios through good and bad market cycles has convinced us that investors will likely look through the income security provided by the cash bucket and become fearful of the declines experienced by the invested asset bucket. They will see the losses in the invested bucket as a serious problem and sell declining assets to curtail further losses.

Second, significant bear market declines of 40% or more have historically occurred every six years on average. Declining pricing trends typically last 18 to 36 months and can cause the compound liquidation of capital when assets are sold annually to refill the cash bucket. And even if the investor stays fully invested and cash replenishing is deferred during market declines, cash replenishing will still weigh heavily on the invested bucket assets before they can fully recover from bear losses, which can take years to overcome.

So, if a bucket retirement income approach is not an effective enough strategy, what’s the solution?

We believe there are three pillars of building an effective retirement income strategy:

  1. Reduce loss of capital: We have found that most retired investors can stay invested down 10-15% in bear market cycles, but usually not more, so active risk management to minimize loss is critical.
  2. Provide income from cash flow, not capital withdrawal: Invest in a blend of high-yielding fixed income securities and dividend-paying stocks to provide cash flow from underlying investments to cover the majority, if not all, of needed income withdrawals.
  3. Unleash the power of dividends: Build inflation protection into portfolio income by investing in dividend-paying companies that have a history of increasing dividends.

While the right investment approach is important for investors at any stage in life, it is critical for investors who have reached their retirement income life cycle. Managing retirement income portfolios is the hardest job in the money management business and also the most important — because retiring investors cannot afford mistakes.