Continuing recent posts updating my past descriptions of retirement strategies, let's look again at time-segmentation (TS) or "bucket" strategies.

The basic implementation of time segmentation strategies sets aside enough cash and short-term bonds to cover the next few years of retirement expenses, let’s say five, then covers the following few (let's say years six through ten) years' expenses with intermediate bonds, and finally allocates any remaining assets to stocks.

Note that this is a markedly different way of allocating assets than is typically used by other strategies that base equity allocation on the largest loss a retiree can stomach in a market downturn and the optimal asset allocation to avoid prematurely depleting a savings portfolio.

Many retirees will find that setting aside five or six years of expenses in a cash fund will be a significant portion of their investable assets so this might be a dramatically different allocation.

Here's an example. A retiree wants to spend $40,000 annually from a $1M portfolio. She invests a little less than $200,000 in cash and short-term bonds (the discount rate is low, especially in today's capital markets, so we can roughly just multiply annual spending by 5) to cover expenses for the next five years. She invests a little less than $200,000 (less because they yield a little more) in intermediate bonds and roughly $600,000 in stocks. It is her estimated future spending that determines her asset allocation of 20% cash, 20% bonds and 60% stocks.

TS strategies don't typically recommend an annual safe spending amount like the $4K in this example but this can be estimated by any of the (preferably variable) spending strategies.

This part of the TS strategy is based on matching asset duration[1] to the duration of expenses and is financially sound.

Asset duration, in simplest terms, refers to the recovery period typically needed after a market downturn or interest rate increase. The duration of an expense is essentially the number of years until it is due but expected inflation must be considered, too.

Matching a near-term liability with a long-duration asset like stocks would provide a greater expected return but less confidence that the money would actually be available when needed if stock prices declined. Matching a long-term expense with an intermediate bond would have greater certainty but a lower expected return. "Liability matching" provides the greatest asset return for which the expense can be reliably met and is a key component of TS strategies.

Short-term bonds may have a duration in the neighborhood of three years, intermediate bonds 5-10 years, and stock market duration is measured in decades. This simply means that we can be pretty sure of the value of a 3-year bond in three years but not less, the value of cash next year, and that we probably need to invest in stocks for 7-10 years to be pretty sure our investment won't be looking at a loss.

Planners often recommend that the bonds are set up as a ladder held to maturity to mitigate interest rate risk but many planners simply use bond funds of short and intermediate durations assuming that the results will be "close enough" to those of bond ladders.

The expressed goals of TS strategies are to match expense durations to asset durations, to help retirees better understand the purpose of their different assets, and to weather bear markets without the need to sell stocks at depressed prices and thereby avoid “panic selling” in a market downturn.

Liability-matching is a sound financial policy, while the latter two are primarily psychological benefits. In fact, from a financial perspective, to quote Wade Pfau:

“... it must be emphasized that on a theoretical level, income bucketing cannot be a superior investing approach relative to total returns investing.”[2]

The reason is that bucketing typically requires a much larger cash and short-term bond allocation than other (total return) strategies. The difference between the returns available from these two assets and what their value might have earned in the stock market is referred to as "cash drag." You simply earn less money if a larger portion of your portfolio is held in cash instead of invested in stocks.

In a paper entitled, “Sustainable Withdrawal Rates: The Historical Evidence on Buffer Zone Strategies”[3], authors Walter Woerheide and David Nanigan showed that the drag on portfolio returns from holding large amounts of cash can be significant.

In other words, the comfort of a large cash bucket can come with a heavy cost. According to the authors, the performance drag imposed by a large cash bucket actually leaves the typical portfolio less sustainable. That suggests that TS strategies increase the security of income for the next ten years but do so at the cost of less security of income in the years beyond.

Said differently, the goal of TS strategies is to reduce sequence risk, i.e., to reduce the probability of outliving one's savings, by encouraging the investor to avoid selling stocks at low prices. Woerheide and Nanigan, however, show that this strategy's cash drag is typically greater than the benefit of avoiding selling low and often achieves the opposite, a less sustainable portfolio.