Bucket strategy deployed in retirement needs a refill rule

My friend Sharad, who had recently retired, was showing me his investment plan for the retirement corpus. In accordance with conventional wisdom, he planned to keep the next two years of expenses in a “safe” liquid fund, and the balance in an equity index fund for growth in the later years of retirement.

 

This separate buckets strategy for retirement sounds wonderfully simple. Keep perhaps two years of expenses in a safe liquid or debt bucket. Put the rest in equity. Meet your monthly expenses from the safe bucket. That way, if equity markets fall, you do not have to sell equity at depressed prices. It is also emotionally comforting. 

 

But there is a question that often gets missed. What happens after you start spending the safe bucket? If it is meant to hold two years of expenses, it has to be refilled from time to time. Otherwise, after one year it contains only one year's expenses. After another year it is empty. So, the real issue with the bucket strategy is not how you create the buckets. It is how and when you refill them.

 

Consider both directions. If equity has risen sharply, do you sell some and refill the bucket — after a 10 per cent rise, or 20 per cent, or do you wait for more? If equity has fallen sharply, you clearly do not want to refill by selling at a loss — so you wait. But how long do you wait? Until the market recovers 10 per cent, or gets back to its old high, even if that takes years and the debt bucket runs dry first?

 

There is no obvious answer. This is where a strategy that appears mechanical suddenly requires a human being to decide whether the market is “good” or “bad”. And that is precisely when human beings are least reliable. When markets keep rising, greed tells us to wait a little longer before selling. When markets fall, fear tells us not to touch equity. A supposedly safe strategy has quietly introduced a market-timing decision.

 

There is another way. Start with the desired proportion of equity and debt, then rebalance automatically. This forces the investor to do what is emotionally difficult — sell equity after a rise and buy equity after a fall. A hybrid fund, such as a balanced or equity-savings fund, does this automatically. Withdrawals can happen alongside this process.

 

Like the bucketing strategy, a hybrid fund restrains itself from selling equity when it falls. But it goes further — it also moves money from debt into equity. The process itself makes and implements this decision, saving the investor from having to take it every month.

 

That does not mean a hybrid fund is automatically superior to every bucket strategy. A sophisticated bucket strategy can also have a predetermined replenishment rule — and once it does, the two are not really different strategies. They are the same asset allocation strategy wearing different labels.

 

Sequence-of-returns risk is often cited as the strongest argument for separate buckets: the danger that poor returns in the early years of retirement, combined with withdrawals, can permanently damage the portfolio even if long term returns turn out fine. That risk is real, but it exists in both approaches if weak markets last longer than the debt cushion. The hybrid fund has one advantage: after equity falls, it automatically moves money from debt into equity instead of leaving that decision to the retiree, so the portfolio recovers faster once markets turn.

 

Truth be told, I told Sharad there is nothing wrong with a separate safe bucket if that gives him comfort — but equity will fall anyway, whether it sits in a separate bucket or inside a hybrid fund. A separate bucket without a refill rule is only half a strategy. A hybrid fund completes the circle by having an inbuilt refill rule and executing it automatically. The bucket is only the container. The refill rule is the strategy.

 

The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor; X: @harshroongta