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An Asset Allocation Strategy Clients Will Understand

The concept of bucketing assets began with a Harry Markowitz paper in the Journal of Finance in 1952. The essence of his paper outlined how investors could efficiently allocate assets for the highest return with a given level of risk. This work would later earn Markowitz a Nobel Memorial Prize in Economic Sciences and redefine how financial advisors optimized investments for their clients.Tremendous advancements have been made to Markowitz’s early work in the last 67 years and asset allocation has proven to be more valuable than ever. While there are plenty of sophisticated measures on how to arrive at the asset allocation, it can be simply illustrated by showing an investor how their money should be invested in an allocation of uncorrelated assets between three segments: safe and liquid investments, conservative investments, and growth assets.For many advisors, that seems to be where the simplification stops, and they communicate asset allocation with pie charts of holdings, graphs, ledgers, and statistical analysis. All that data may be important behind the scenes, but it confuses the client. It is an art form to simplify the plan so your client can under-stand and have the confidence to move forward with your recommendations.

The Bucket Plan philosophy simplifies asset allocation in a way the general public can understand.

“BUCKETING” BEGINS

The bucket approach to retirement investing first started to work its way into the financial lexicon in the 1980s, when financial planning expert Harold Evensky developed this strategy as a way to combat the challenge of low interest rates. This resulted in investments not providing enough income for retirees, forcing many of them to delay retirement, reduce their standard of living, or take too many risks with their capital. Evensky built his strategy around three distinct buckets:

Bucket 1 - Living expenses for a year or more that are not covered by other income streams. This can also include an emergency fund for unanticipated expense

Bucket 2 - Five or more years’ worth of living expenses, with income distributions from dividend-paying equities going toward the refill of Bucket 1.

Bucket 3 - This bucket has more volatile, higher-earning products that can ride out a down market because the retiree does not need to draw living expenses from it.

The bucketing concept gained momentum during the 1990s, then really began picking up steam with the dawn of the information age. By the time the Great Recession hit in 2008, Bucket 3 was the haven for a client’s investments to ride out the ups and downs of the market without affecting the immediate income that was being withdrawn from Bucket 1 and reloaded from Bucket 2. Having long-term goals for Bucket 3 protected the retiree from making rash decisions during market fluctuations and taking a hit on their investments by cashing in during a downturn.Over time, The Bucket Plan has been adapted to not just facilitate retirement income planning but to be a viable strategy for asset allocation for all clients in any demographic.

THE BUCKET PLAN PHILOSOPHY

One of the most important things that a bucket plan provides is peace of mind for your clients. Financial planning is a complex process, but utilizing the bucket plan philosophy provides a simple but effective way for you to explain – and your clients to understand – the investment strategy that you have developed for them.The key to a successful bucket plan is strategically positioning, and then protecting, a mutually agreed-upon portion of your client’s assets in order to buy a time horizon that allows them to invest the remainder for long-term growth. This structure will provide them with a reliable income source throughout their retirement. Here’s how the buckets are constructed:

NOW BUCKET

This is the safe and liquid money that your client can access whenever they need it. A fully funded Now bucket will give your client a feeling of security and prevents them from having to cash in investments when they need money…which would also open them up to losses when the market is down, unforeseen taxes and unexpected penalties. Although there will be little return on the Now bucket funds, that is a small price to pay for your client’s peace of mind.The Now bucket is set up for free main situations:

Emergency or comfort fund for unplanned expenses

Major planned expenses – new car, wedding, college tuition, etc.

Up to one year’s income for a retired client

The amount that goes into the Now bucket varies by individual and their needs. There should be enough to meet every day needs or emergencies, but not so much that your client will miss out on growth for that money. There are several dangers in both scenarios.Whatever the amount decided upon for the Now bucket, all parties involved should agree on it and feel comfortable knowing that their needs and expenses will be met.

SOON BUCKET

The Soon bucket is your conservative investments or income money and can be used as a planned income source for the first phase of retirement. It is set up for growth to offset inflation but invested conservatively to negate the effects of a big correction or downturn in the market, avoiding the full swing of the stock market that could impact your client’s income or spending plans. This money has little to no exposure to market risk (stocks), interest rate risk (bonds), or sequence of returns risk, which protects your client from having to sell low because they need the money for income withdrawals.The Soon bucket also serves as an inflationary hedge, giving your client that extra cushion as the cost of goods and services continue to rise. When paired with the Now bucket, the Soon bucket buys your client a time horizon so that their investments in the Later bucket can continue to grow, riding out the market highs and lows, without being touched. It keeps this segment of their assets stable and reliable in case they need to access it, helping them avoid sequence of returns risk.For client’s that have a longer time horizon before retirement, the Soon bucket might serve as their opportunity bucket. This way, if a good investment opportunity arises, such as starting a business or buying a new home, but the stock market is down, they have the funds available.For a client approaching or in retirement, the Soon bucket will provide a reliable income that will pour into their Now bucket for everyday spending. There are three primary ways of structuring income from the Soon bucket:

The Bridge Approach: You fund reliable income for a specific period using the minimal amount of assets required to construct the bridge. An example might be a 10-year bond or CD ladder, a period-certain annuity, an indexed annuity with penalty-free withdrawal provisions, or a conservative investment portfolio in which you will be consuming both principal and interest.

Lifetime Income: You fund an annuity to provide lifetime guaranteed income. This can be done through a SPIA, DIA, fixed, indexed or variable annuity. If the annuity payment is going to begin within 10 years, we would consider that a “Soon bucket” asset. If deferral will be 10+ years, we would generally place that asset in the “Later bucket”.

Portfolio Yield: Some high net-worth clients are fortunate enough to never tap into principal for supplemental retirement income and can live off the dividends, interest, or yield produced by their investment portfolio.

In some cases, a combination of these approaches might be best suited for the client.

LATER BUCKET

The money in the Later bucket provides long-term growth and legacy planning. Your client will have the confidence to ride out any fluctuations in the market because it’s a long-term commitment, and they know they have the security of the Now and Soon buckets to rely on during the first decade or so of retirement. The longer they can wait before accessing the Later bucket, the better the chances for favorable returns.In addition to growth, legacy planning is a critical component of the Later bucket. It should also be noted that legacy planning is not just for leaving money to the children, as many people assume. Legacy planning also covers the needs of the surviving spouse. When one spouse passes away, the household’s income usually goes down (loss of lower Social Security benefit) while many of the expenses (mortgage, car payments, real estate taxes, utilities, etc.) stay the same and taxes can actually increase. The Later bucket allows you to put a plan in place to protect the surviving spouse!

BENEFITS OF THE BUCKET PLAN FOR YOUR CLIENTS

In addition to being an effective asset allocation strategy, the Bucket Plan also has several other benefits:

It’s educational – Your clients will learn about every aspect of their financial lives, which leaves them much more confident to face the future.

It eliminates “freak-out risk” – Your clients will feel more relaxed about their financial future because the different buckets are tailored for each person’s comfort level with volatility and risk. Their unique financial situation is considered as the plan is being put together.

It provides an overall view of each client’s financial situation – The holistic approach enables a client to see their entire financial landscape and how everything fits together instead of just seeing an investment here and an insurance policy there.

It mitigates sequence of returns risk – Your clients won’t be forced to take withdrawals from their investments when the account balances are down, because the three-bucket system takes that risk into consideration.

When meeting with new clients, we often find that they only have two buckets – The Now Bucket and The Later Bucket, something we call “The Not Quite Plan”. In other words, they are going directly from accumulation to distribution, missing the preservation phase altogether. The Soon Bucket serves as that preservation bucket and helps protect retirees from falling prey to “behavior economics”, where investors react irrationally to changes in the market, potentially to their detriment.Richard Thaler, winner of the 2017 Nobel Prize in Economics, has written a number of books on this phenomenon, and has been quoted as stating that “conventional economics assumes that people are highly-rational – super-rational – and unemotional. They can calculate like a computer and have no self-control problems.” Obviously, we know that this is not the case when it comes to our clients’ money. This is why clients need you to advise them. You can explain it and keep it simple for them.There are four investor behavioral mistakes that having a Bucket Plan eliminates:

Trying to “beat” the market but ending up buying high and selling low – not what an investor wants to do with their retirement money.

Panicking during volatile times and selling holdings – resulting in losses. Afraid of venturing back into the market, those investors then sit on the sidelines and miss the recovery times.

Letting the possibility of a bad surprise override the possibility of a good one. In other words, investing too conservatively and missing out on potential gains with a riskier option.

Lumping investments together without separating Now and Soon bucket-type money from funds that can be invested for the longer term.

BENEFITS OF THE BUCKET PLAN FOR YOU

Adopting the Bucket Plan process as the way you do business has myriad benefits for your clients; but it also has benefits for you as their advisor.

It is an asset allocation strategy that your clients will actually understand. Explaining complex financial plans and concepts to non-financial clients can be challenging. Couching them in terms of bucket allocations for specific goals makes the plans much easier for your clients to understand and buy into.

It will help modify investor behavior for better outcomes. Knowing that their immediate and short-term needs are provided for in the Now and Soon buckets will help your clients stay calm during market downturns, lessening the chances of them wanting to cash in when the markets are at their lowest points in order to “save” their investments in the Later bucket. Your phone won’t be ringing off the hook when we experience the next market downturn.

It will differentiate your business and help you scale by doing things the same way with each client. Differentiate yourself by encouraging the client to put the amount of money into their Now bucket that they feel comfort-able with – they’ll be disarmed because you’re not trying to talk them into putting as much money as possible into your investments! Not having to reinvent the wheel for every client and using proven, documented processes every step of the way will improve both your reputation and your bottom line. Clients will want to work with you because they know what to expect.

At the end of the day, you provide the comfort level that clients have when they understand the asset allocations between the three buckets; they know why the allocations are set that way, since they worked with you on setting the goals for each; and they can sleep at night knowing that they have bought time for the Later bucket to grow by adequately funding and utilizing the Now and Soon buckets. They will also be confident that you, as their trusted advisor, will be with them every step of the way as they begin this journey toward retirement.While you’re on the go, listen to our podcast for more insight.