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Taking Stock

Using a bucket strategy to manage living annuity portfolios

22 May 2019
Author: Jaco van TonderAdvisor Services Director

This article is a follow-up to our ongoing series on living annuities which focuses on how to maximise a pensioner’s chances of drawing an inflation-hedged income for life.

During our engagements with financial advisors about our research findings on income and portfolio strategies for living annuities, several additional questions were raised. One of the most frequently asked questions pertains to the value of using a ‘bucket strategy’ for a living annuity’s investment portfolio.

In this article we take a closer look at bucket strategies and explore when they can be useful.

What is a bucket strategy?

A bucket strategy for a living annuity entails grouping assets into two or three clusters. Each cluster of assets is assigned a time frame over which that cluster is supposed to generate income for a pensioner.

Here is a simple example. Let’s assume a pensioner has R10 million for their retirement in a living annuity. A possible bucket strategy would be to invest as follows:

  1. You allocate 12 months’ income (R500 000) to a money market portfolio (or bucket).
  2. You allocate a further three years’ income (R1.5 million) to a more flexible bond and income portfolio.
  3. You allocate the remainder of the assets (R8 million) to growth assets such as local and international equities.
  4. You only draw the pensioner’s income from the money market bucket.
  5. At the end of every year, you top up the money market bucket, i.e. you switch some assets from the flexible bond and income bucket two into the money market bucket.
  6. At least once every three years you switch some assets from the growth bucket to top up the flexible bond and income bucket.

Example of a bucket strategy

Although there are many variations on this basic investment strategy (a different number of buckets and different strategies to top up the various buckets over time), the principles are always the same.

How are bucket strategies promoted?

A bucket strategy for a living annuity feels intuitively correct, because it is often promoted in language referencing valid long-standing investment principles, for example:

  • Don’t sell a growth asset when the price is depressed just to fund an income – wait until the valuation has recovered.
  • Individual units/shares give you growth potential – try to only draw the income and dividend declarations and never the units/shares.
  • It is not about what your shares/units are worth – in the long run what is most important is how many shares/units you own.

Because bucket strategies feel so in tune with proven investment principles, many people believe that they are superior strategies for income portfolios. Some commentators have even suggested that by not constantly selling units out of growth assets to fund regular incomes, bucket strategies are guaranteed to outperform more traditional investment strategies (e.g. where income is funded by selling units across the entire investment portfolio).

Unfortunately, bucket strategies do not offer a silver bullet solution. Let’s examine them in a bit more detail, starting with some international research on the topic.

What does current research conclude about bucket strategies?

Various international and local publications have appeared over the past few years investigating whether bucket strategies do in fact improve the performance of an income portfolio. One of the most recent research papers was published by Javier Estrada in October 2018.1 He modelled various portfolio strategies, including bucketing strategies, to determine the extent to which they affect the success rates of living annuities.

The paper makes for an interesting, albeit slightly heavy and technical, read but concludes as follows regarding bucket strategies:

“Although this strategy is not devoid of merit, the comprehensive evidence discussed here, from over 21 countries and over a 115-year period, questions its effectiveness.”

Estrada goes further to conclude that bucket strategies are not superior to other strategies, as is often believed. They actually delivered inferior results compared to conventional multi-asset investment strategies during his model testing.

Why don’t bucket strategies produce a better outcome?

Unfortunately, studying the detailed modelling done by researchers such as Estrada and others on this question does not leave one with a simple answer as to why bucketing does not deliver a superior outcome. Sure, the modelling is robust, and the answer must therefore be correct, but modelling does not always aid one’s understanding of the answer in a ‘common sense’ way.

Estrada attempts to explain the results from his modelling by highlighting how bucket portfolios aren’t optimally rebalanced. For example, he mentions that those who use bucket strategies avoid selling equity assets after a market collapse, but they don’t buy more equities after a market downturn.

We can also apply some of the conclusions we reached in our earlier Investec Asset Management research on living annuities to help us understand what is happening with bucket strategies.

In our research paper on optimised investment portfolios we concluded that, for two living annuities with the same start date and paying the same level of inflation-adjusted income, there are only two characteristics of the investment portfolio that determine the annuities’ success:

  1. The expected real return of the portfolio; and
  2. The expected standard deviation of the real return.

We can now look at our bucket question in more detail. Let’s assume you have two living annuities with identical initial asset allocations and you draw identical income levels over their entire lifetime. Your approach is as follows:

  • You manage annuity number 1 according to a bucket strategy.
  • You manage annuity number 2 by selling units across the entire portfolio to fund the income.

Under what conditions will these two annuities give you identical success rates?

From our research work, the answer is that the two annuities will only be identical if you manage them to produce the same real return and volatility. And the simplest way to do that? Just constantly rebalance the portfolio for annuity number 2, say, monthly, to match the aggregate asset allocation of annuity number 1. Matching the asset allocations will cause the annuities to have very similar real return and volatility signatures over time, leading to similar success rates.

The answer to successful living annuities lies in smart management of your asset allocation, and not in some unknown additional investment return generated by the bucketing strategy itself.

However, this is not the end of the story.

We are dealing with human beings here – not computer programmes

When it comes to investment strategies, we cannot ignore the human effect. Investment decisions do not happen in a vacuum, and human emotions and behavioural biases persist in every investment decision.

In the case of living annuities, the principles of behavioural finance are ever present in the interactions between the pensioner (who is always anxious about the longevity of their retirement pot and being sufficiently funded) and the advisor (who has a fiduciary responsibility to ensure that the advice delivered is appropriate for the pensioner). The classic traps of switching between cash and equities at the wrong time, or even having an overly conservative investment portfolio, are ever present with living annuity pensioners.

This is where bucket strategies add their value. Many advisors will attest to the fact that it is much easier to talk a pensioner out of making unwise portfolio changes driven by fear or greed if the bucket strategy is used, as the next three years’ income is always secure in their respective income buckets. Bucket strategies undeniably reduce the risk for behavioural portfolio management mistakes in a living annuity, and therein lies their biggest value to advisors.

Conclusion

A bucket strategy is not a silver bullet portfolio management technique that is guaranteed to generate additional investment returns if followed blindly. It just represents one way to manage the asset allocation in a living annuity and has its own pitfalls. The major factors driving the success of a living annuity portfolio remain:

  • The real return of the portfolio (having enough equities); and
  • The volatility of the portfolio (managing investment risk).

Getting the asset allocation wrong in a bucket strategy will be as devastating as with any other portfolio strategy.

However, bucket strategies do have their uses. If implemented responsibly, they can help advisors minimise behavioural portfolio management mistakes. Advisors can use bucket strategies for vulnerable living annuity pensioners, particularly those who started their annuities with initial incomes in the ‘income danger zone’ of more than 5% p.a. of pension capital. Bucket strategies can help these pensioners to maintain the correct long-term asset allocation, which ultimately is the most important driver of the success of a living annuity.

In the next article we will look at the common pitfalls when implementing a bucket strategy for living annuity investors, and how to avoid them.

 

1 “The bucket approach to retirement: A suboptimal behavioral trick?” – Javier Estrada – IESE Business School October 2018

Jaco van Tonder
Jaco van Tonder Advisor Services Director

Important information

This Viewpoint details Investec Asset Management’s (Investec’s) research findings on income withdrawal strategies for income- generating portfolios. The information presented here is not intended to be relied upon as investment advice. Various assumptions were made. There is no guarantee that views and opinions expressed will be correct. The findings expressed here may not reflect the views of Investec as a whole, and different views may be expressed based on different investment objectives. Investec has prepared this communication based on internally developed data, public and third-party sources. Although we believe the information obtained from public and third-party sources to be reliable, we have not independently verified it, and we cannot guarantee its accuracy or completeness. Investec does not provide any financial advice. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down.
Prospective investors should consult their financial advisors before making related investment decisions. This is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Investec Investment Management Services(Pty) Ltd and Investec Asset Management are authorised financial services providers. Issued, May 2019.

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