Income bucketing

Income bucketing is a family of decumulation strategies, i.e. ways to convert financial wealth into retirement income. Bucketing involves mentally placing financial assets into buckets used to provide income for different time horizons.Pfau WD (2017a) Time Segmentation as the Compromise Solution for Retirement Income. Advisor Perspectives, March 27, 2017, viewed February 1, 2024.Pfau WD (2017b) How to Make Time Segmentation Work in Practice: Three Options for Extending a Bond Ladder. Advisor Perspectives, March 29, 2017, viewed February 1, 2024.Pfau WD (2017c) Is Time Segmentation a Superior Strategy?. Advisor Perspectives, April 3, 2017, viewed February 1, 2024.Benz C (2016) The Bucket Approach to Retirement Allocation, Morningstar, September 19, 2016, viewed January 23, 2024. For instance, there could be three buckets: cash for short term needs, fixed income for medium term needs, and stocks for longer term needs.Pfau W, Cooper J (2014) The Yin and Yang of Retirement Income Philosophies, report for Challenger Limited, 28 p. This group of strategies is also known as "time segmentation".
==Who would choose this style?==
Murguia and PfauMurguia A, Pfau WD (2021a) A Model Approach to Selecting a Personalized Retirement Income Strategy, working paper available on SSRNMurguia A, Pfau WD (2021b) Selecting a personalized retirement income strategy. Retirement Management Journal 10:46-58, available on SSRN have developed a four quadrant matrix of retirement income styles. Income bucketing fits in the upper-left corner:
:
In this quadrant, investors value safety of income sources, so they are interested by the idea of having cash and fixed income products (individual government bonds, GICs) held to maturity to protect at least of certain number of years’ worth of retirement income from stock market fluctuations. They don’t like the idea of having to sell stocks during a downturn, as might happen with the "total return" approach in the upper-right quadrant. 
People attracted to an income bucketing strategy also seek optionality: they want to maintain control of their capital and keep their options open, rather than commit to an irrevocable solution. So life annuities and other approaches from the lower-left quadrant ("income protection") will not necessarily work for them. Another possible reason for not funding a lifetime income floor with annuities is that investors might not have saved enough for that; with the bucketing strategy, at least the first phase of retirement is funded from safe sources (the cash and fixed income ladder).
Direct access to the four strategy groups:
:
 
Bucketing 	Total return
Income protection	Risk wrap
==How it works==
===Asset allocation and framing===
In the bucketing approaches, the same asset classes are used as in the total return approach, but the way investors look at them is different. In the total return approach, the portfolio is viewed as a whole: cash, fixed income and equities (stocks) are different asset classes that complement each other and provide diversification, but they are all seen as belonging to "one pot" (bucket). Withdrawals are taken from "the portfolio" (although in detail, they can be taken from an asset class that is above target to rebalance the portfolio). 
In contrast, in the bucketing approaches, cash, fixed income and equities each have different roles in that they are used to provide income for different time horizons: they are seen as two or three distinct buckets. The cash and individual GICs or bonds (held to maturity) provide income over the short and medium terms, while more volatile equities will cover expenses further into the future. Note that a constant maturity bond mutual fund (or ETF) would not work for the fixed income bucket: instead, individual government bonds or GICs are held to maturity to provide certainty of income over a certain number of years. This involves a fixed income ladder.
Instead of basing asset allocation on risk tolerance questionnaires, the effective asset mix is a result of how many years’ worth of cash (bucket 1) and fixed income (bucket 2) the retiree is comfortable with, and the rest goes to stocks (bucket 3). This can feel more intuitive than the total return approach to portfolio construction, where asset classes don’t have separate roles or time horizons (they form "one pot"). Also, bucketing promises to avoid selling stocks during downturns, protecting the portfolio against sequence of returns risk.
===Withdrawal rates and methods===
To determine how much to put in each bucket, the investor evaluates the desired yearly withdrawals. For example, in a 2017 brochure, one large Canadian bank illustrates a bucket strategy in which Jane, a new retiree, withdraws $50k a year from a portfolio with an initial value of $1M, or a 5% initial withdrawal.RBC Global Asset Management, Bucket Portfolios, February 2017, viewed February 15, 2024. The $50k figure represents Jane's "cash flow needs", not necessarily something presented as a sustainable amount. In this example (and many other descriptions of 'bucketing'), the implicit withdrawal method seems to be a constant dollar amount, with no inflation adjustment, and no flexibility. 
The initial withdrawal rate is, in effect, determined by the short term cash flow needs, not sustainability over long periods; this runs the risk of prematurely depleting the portfolio. And the withdrawal method is assumed the be the same dollar amount every year, rather than considering the full range of possible withdrawal strategies, including those that demand variable spending.
===A behavioral approach===
Bucketing is sometimes described as a mental accounting framework or a behavioral strategyEstrada J (2019) The Bucket Approach for Retirement: A Suboptimal Behavioral Trick? The Journal of Investing 28:54-68, preprint available here, viewed January 24, 2024., since it might make equity bear markets more psychologically tolerable by viewing the stocks as long-term assets. 
But in practice, the retiree is still reliant on good stock market performance to maintain spending levels over time. There is no lifetime income floor from guaranteed sources. So longevity risk is not fully addressed, unlike in true safety-first approaches with more commitment (lower-left quadrant). In practice, income bucketing is likely not actually ‘safer’ than the total return approaches, as discussed below. Some authors actually classify bucketing as a probabilistic approach since it still relies on uncertain stock market growth.
==Example and decision rules==
An example of a three-bucket strategy is as follows:
* Bucket 1 is two years’ worth of cash (e.g. HISAs, money market funds, ...)
* Bucket 2 is five years of fixed income, using individual government bonds or GICs in a rolling ladder to provide certainty of income
* Bucket 3 is stocks (or a diversified portfolio of stocks and bonds)
Each year, the retiree spends cash from bucket 1 to cover living expenses. This depletes bucket 1 by half, but it is automatically replenished every year by a maturing rung in the fixed income ladder (bucket 2).
So far, so good. But those maturing rungs in the ladder have to be replaced, in order to replenish bucket 2; otherwise, the portfolio ends up with nearly 100% stocks. This means periodically selling some stocks from bucket 3 to maintain the rolling fixed income ladder. Whether or not to sell some stocks at a certain time should be based on decision rules, to avoid guessing. For example, if the stocks are down at the end of the year, don’t replace the rung in the ladder (wait for the stocks to recover); if the stocks are up, replace the maturing rung and any other missing rungs. 
Many other possible decision rules exist, involving bond interest rates, stock market valuations, etc.
==Back tests and simulations==
Bucketing strategies are popular with financial advisors and DIY investors, yet are one of the least academically studied decumulation methods. Some of those rare studies that provide backtesting are reviewed here.
===Dynamic asset allocations===
Pfau (2007b) shows simulations illustrating that depending on implementation details, time segmentation strategies involving a bond ladder can result in very dynamic asset allocations, i.e. the asset mix can change dramatically over time, including cases where it reaches 100% equities, or 100% fixed income, even with a start at 50% stocks, 50% bonds. This lack of rebalancing in most bucketing approaches makes the comparison with total return approaches involving a fixed asset allocation and yearly rebalancing more difficult.
===Two buckets===
A two-bucket strategy has been tested by Estrada (2019) using a 4% initial withdrawal. Bucket 1 is two years of domestic ‘bills’ whereas bucket 2 is domestic stocks, from 21 countries over a 115-year period (1900 to 2014). Three rules dictating whether to withdraw directly from bucket 2 (stocks) and if needed, replenish bucket 1, are examined: (i) when stock returns are positive for the year; (ii) when one-year stock returns are higher than their long-term geometric mean; (iii) when five-year stock returns are higher than the long-term geometric mean. 
He found that these bucketing strategies had a higher rate of failure (complete portfolio depletion) than a simple static (total return-like) strategy of yearly rebalancing with portfolios ranging from 50% to 90% stocks, in the US data. In the Canadian data, the first two bucketing rules also had higher failure rates than static portfolios with 60-90% stocks, although those failure rates were very small. So Estrada considers bucketing to be a strategy that sounds plausible, has behavioral benefits, but has a suboptimal performance.
===Cash wedge===
Estrada’s two bucket strategy somewhat resembles the common idea of starting from a total return perspective (diversified portfolio) but adding a 1-3 years ‘buffer’ of cash (or "cash wedge"), to be used during years of negative portfolio performance. Woerheide and Nanigian (2012) have tested this, with a variety of withdrawal rates and asset allocations, and conclude that cash buffers are "generally inferior to a simpler static asset allocation at minimizing longevity risk".Woerheide W, Nanigian D (2012) Sustainable Withdrawal Rates from Retirement Portfolios: The Historical Evidence on Buffer Zone Strategies, Journal of Financial Planning, May 2012, p. 46-52, preprint available from SSRN, viewed January 23, 2024. 
One interpretation of these findings is that holding cash for decades is a drag on portfolio returns (opportunity cost), and this has a bigger effect on success/failure rates than any advantage conferred by not having to sell stocks when they are down.Rational Reminder Podcast, Episode 277: The Cash Wedge w/ Phil Briggs, November 2, 2023, viewed January 24, 2024. Woerheide and Nanigian (2012) do mention that the cash wedge strategy "may provide a psychological mechanism to induce clients to accept stock exposure", i.e. it may have behavioural benefits, including a mental justification for not selling stocks during a bear market.
==Pros and cons==
The following table lists some of the strengths and drawbacks of bucketing strategies:
Pros 	Cons
Relatively easily to explain (if the nitty gritty details are ignored) 	Asset allocation is not constant over time, and depending on implementation details and asset class returns, might eventually reach 100% stocks or 100% bonds
If the retiree favours optionality, but is not comfortable with holding a significant percentage of stocks in a total return strategy, then bucketing might provide a mental framework that makes this possible (behavioral benefits)	Backtests have not demonstrated superior performance relative to total return approaches
Framed as protecting against sequence of returns risk 	No protection for longevity risk, inflation risk, and investment risk (strategy still depends on stocks)
 	The initial withdrawal rate is a function of cash flow needs, but there is no assurance that the withdrawal method is actually sustainable
Another criticism is that "decomposing the portfolio into loosely connected buckets doesn’t change the fact that there is one pot of assets funding all goals and runs some risk that the decomposition leads to a sub-optimal strategy in aggregate".Butt A, Khemka G, Lim W, Warren G (2023) Primer on Retirement Income Strategy Design and Evaluation. Society of Actuaries Research Institute, 104 p.
==Alternatives==
Time segmentation strategies are a hybrid of total return approaches and income protection approaches. Investors who really believe that the stock market will fund their retirement over the long term, and want optionality, should investigate the total return (upper right) quadrant. In this quadrant, several withdrawal strategies exist, with abundant research studying these methods.
Investors who believe strongly in income protection should investigate the true "safefy-first" approaches in the lower left quadrant. These approaches require more commitment (decrease flexibility) but actually provide a safe lifetime income floor, i.e. protection against longevity risk and investment risk.
==See also==
*Canada's retirement income system
==References==
==External links==
*Retire with Style podcast, Episode 99: Time Segmentation as a Retirement Income Strategy
*Retire with Style podcast, Episode 101: Uncovering How Time Segmentation Actually Works
*Retire with Style podcast, Episode 102: Practical Implementation of Time Segmentation
*Moshe Milevsky Can Buckets Bail Out a Poor Sequence of Investment Returns?
*Michael Kitces, Managing Sequence Of Return Risk With Bucket Strategies Vs. A Total Return Rebalancing Approach
Category:Retirement planning
Category:Retirement living