8.4 The “old” investor Part 3 – Mindful bucket plan and conclusions
Article 8.3 defined the contents of three buckets for mindful “old” investors. Here’s where we put them together into an overall mindful plan so that all the buckets work seamlessly together.
The mindful bucket plan for “old” investors
- Cash and bonds historically have performed nearly identical ballast functions in terms of portfolio success rate.
- Using some bonds in place of cash for ballast will increase (perhaps only slightly) the terminal value of your portfolio in most cases.
- After a period of about 2 to 3 years, the risk of permanent losses from intermediate duration bonds is low.
- After a period of about 5 years, the chance of permanent losses in stocks is likely less than about 20%.
To honor all these facts, a mindful break down of the buckets is:
- Short-term – The next 3 years-worth of spending in cash
- Mid-term – The following 2 years-worth of spending in intermediate duration bonds (with a potential preference for TIPS to hedge against inflation).
- Long-term – The remainder will be in stocks, representing any spending that is more than 5 years away.
Because of the inherent uncertainties about future market and economic conditions and your specific health and retirement situation (among other factors), somewhat different buckets may be more mindful and rational for you. For example, if you expect to spend more early in retirement, you might make the short and/or mid-term buckets bigger. Similarly, if you intend to tighten your belt in the first few years of retirement as a safety measure, you might make these ballast buckets smaller. And given some of the studies I reviewed in Article 8.2, I can make a mindful case for simply holding 100% stocks along with a plan to reduce spending if/when a stock crash occurs. Even with these sorts of personal variations, I would say the facts support that most investors should define:
- The short-term cash threshold as no more than 5 years, because too much cash is a substantial drag on portfolio performance.
- The mid-term bond threshold as no more than the next 5 years for the same reason that too much ballast will drag down portfolio performance. Also, the risk of a permanent bond loss is extremely low beyond this threshold.
- The long-term stock threshold as no more than 10 years, because stock returns are very unlikely to be negative when held for more than this time span.
We must also consider 1) how to use the bucket contents as market gyrations unfold and 2) how/when to replenish shorter term buckets with money from longer term buckets. This process has been described as bucket “maintenance”.
Mechanical Approach – The simplest approach to bucket maintenance is to let money flow from one bucket to the next each year as shown in my rudimentary graphic. (I know. I shouldn’t quit my day job for a career in graphics production.)
This is sometimes called the “mechanical” approach. To implement the mechanical approach in any given year you would:
- Replenish the short-term cash bucket by selling a years’ worth of bonds from the mid-term bucket
- Replenish the mid-term bucket by selling a years’ worth of stock from the long-term bucket
This process is then repeated each year. It maintains 5 years’ worth of spending as ballast in the short and mid-term buckets, or about 20% of your portfolio, assuming you are using the mindful bucket plan described above. (Of course as the stock value moves up and down and eventually grows over time, the ballast won’t represent exactly 20% of the total portfolio value all the time.) One clear problem with the mechanical approach is that in the very first year we must sell some stocks, even though the original intent was to hold stocks for at least 5 years. If we intend to avoid the threat of permanent losses by selling stocks too soon, the mechanical approach doesn’t help us much.
Sequential Depletion Approach – It’s important to remember that we are trying to avoid the scenario of permanent stock losses in the vulnerable period, which is early in the spending phase. Consequently, we don’t need to keep the short and mid-term ballast buckets full throughout the entire spending phase. We only need the ballast in the first few years, because we have established that after about 5 years the stocks will likely have a positive return. This is the reason that Michael Kitces and some others recommend that ballast be maintained only in the first part of the retirement period, which creates the so called “ascending glide path” for stocks as discussed in Article 8.2. We need an approach where we deplete the ballast over time to reduce the need to sell stocks early in the spending phase. The simplest of such approaches is to use the ballast in sequence without replenishing it. You can accomplish this “sequential depletion” approach by using:
- The short-term cash bucket over the first three years (and not touching the mid or long-term buckets)
- The mid-term bond bucket over the next two years (years 4 and 5)
- The long-term stock bucket after year 5.
Using this “sequential depletion” approach, the first bonds you sell will have been bonds for at least 4 years and the first stocks you sell will have been invested as stocks for at least 6 years.
However, if we look at the amount of ballast in the first five years of the “sequential depletion” approach, it gets progressively smaller each year. As I discussed in Article 8.3, to boost the recovery of your portfolio after a crash in the vulnerable period you want a substantial amount of ballast available to buy stocks. By using a simple no growth assumption, which is one possible scenario for stocks and bonds over any given 5-year period, we can eliminate a variable and make a rough comparison of the ratio of ballast versus stocks for any given ballast depletion plan. For the sequential depletion approach, the percentage of ballast in the first six years looks like this:
- Year 1 – 20%
- Year 2 – 17%
- Year 3 – 13%
- Year 4 – 9%
- Year 5 – 5%
- Year 6 – 0%
For the five years before the ballast is gone, the ballast only averages 13% of the portfolio. This means for most of this period you won’t have very much ballast to invest if a stock market crash occurs.
Hybrid Depletion Approach – We are looking for a bucket maintenance approach that provides a balance between selling too much stock too early and not having enough ballast in the critical early part of the spending phase. We can accomplish this by moving some stocks into ballast during the first few years of the spending phase, but not so much that we lock in large permanent losses should the stock market crash in those specific years. Such a “hybrid depletion” approach looks something like this in the first 12 years, with no change in the pattern in the subsequent years.
|Summary of the Hybrid Depletion Approach|
Years Invested in Each Bucket Before Being Spent
Percent Ballast (No Growth Assumption)
This table needs a little explanation. The columns headed “Years Invested in Each Bucket Before Being Spent” track how long each years’ worth (let’s call them “chunks”) of money was invested over time before it was spent. For example, the chunk spent in Year 6 would have been previously invested as cash for the last three years, as bonds for the two years prior to that, and as stocks for one year prior to that.
This hybrid depletion is accomplished by:
- For the first four years, spend the available cash and replenish the cash bucket each year by selling some stocks to buy bonds and selling some bonds to provide cash
- In the fifth year, start sequential depletion of all remaining ballast (cash and bonds) and hold all remaining stocks until the ballast is all spent. The ballast will be finally depleted at the end of the eighth year.
- Sell stocks to fund spending from the ninth year onward.
The red text in the above table shows the critical period where you would be spending chunks of money that had been invested in stocks for only one to three years. But because these same chunks were subsequently invested in bonds for 2 to 5 years, some or all stock losses for these chunks might be recouped by the subsequent bond returns. So, there is some susceptibility to permanent stock losses with the hybrid depletion approach, but it is mitigated somewhat by the subsequent investment of that same money in bonds. The other side of the balance we are trying to achieve is maintaining a substantial ballast proportion during the vulnerable early phase. The left most column in the table shows the hybrid depletion approach keeps the ballast right around 20% for the first 5 years, which is considerably better than using sequential depletion.
It’s important to note that the above table represents only one flavor of hybrid depletion. You can tailor your own bucket maintenance to achieve slightly different goals consistent with your specific situation. As appropriate, you could replenish ballast for more or fewer years than the above example before starting the sequential depletion procedure. If you have absolutely no interest in attempting to tailor your own plan, I think the above example would work well for most, but perhaps not all, “old” investors.
Switching Horses – All the above scenarios assume that the stock market does not crash like it did during the six worst events in history that I discussed in Article 8.3. Obviously, if the stock market crashes in the first few years of your spending phase, the ballast should be immediately invested in stocks and the ballast buckets would all go to zero, except for your most immediate spending needs. This was the whole point of holding the ballast in the first place. If a crash happens in the first five years of your spending phase, that’s when you will need to buckle your seat belts, use all your mindfulness powers, and invest almost all your “safety” money during a time when there’s blood in the streets and every news headline screams “sell everything”. Knowing that you planned for years to execute exactly this game plan will mostly likely help steady your nerves and allow you to proceed.
One remaining concern is deciding when it’s time to depart from the hybrid depletion plan, switch horses, and convert any remaining ballast to stocks. Should you convert the ballast to stocks if the market declines by 20%, 30%, 50%, or something else? There are an infinite number of stock market scenarios that could play out, and we can’t anticipate them all. However, we can develop some general guidelines about which horse to ride, and for how long, during various possible stock market gyrations. I will discuss that subject in more detail in Article 8.5 on “Timing the Market” (coming soon).
Withdrawal plan for “old” investors
Our mindful investment plan for “old” investors is taking shape. We now know how much money to allocate to cash, bonds, and stocks at the start of the spending phase, and we know how to maintain and use the buckets as we proceed through the spending phase. However, for the plan to work, we need a third leg to the stool, which determines how much to withdraw each year during the spending phase. Because the Mindfully Investing website is focused more on how to invest than how to spend, I won’t get into the withdrawal rate topic in detail. However, there are a few key spending and withdrawal concepts I should briefly describe to help you create a stable investing stool.
The 4% Rule – If you regularly withdraw more than your portfolio of investments can sustain, you may end up poor at a relatively young age. You probably noticed that I keep using a 4% withdrawal rate assumption in the previous discussions of portfolio success rates and performance.
(It’s important to note at this juncture that in the previous analyses I often assume a constant 4% withdrawal rate to provide simple examples of what percentage of a portfolio would be held in each investment type. In other cases, like determining the success rates of various portfolios over 30 years, I use an inflation-adjusted withdrawal rate or online calculators that do the same. In this case, the withdrawal rate starts at 4% of the total portfolio value but then increases by the amount of inflation each year. The 4% rule that I discuss below is based on the inflation-adjusted approach unless otherwise noted.)
The 4% “safe withdrawal rate” assumption comes from the so-called “Trinity Study”. The Trinity Study, and related studies pre- and post-dating the Trinity Study, are described at the Bogelheads website in more detail. Although the results vary somewhat across these studies, they all support the concept that there is very little chance of running out of money in a 30-year period with a 4% withdrawal rate, if you have a substantial portion of your portfolio in stocks (typically in the 30 to 80% range).
The blogger calling himself the “MadFientist” reviews the 4% rule for early retirees using mostly information from Michael Kitces and concludes the 4% rule is “very safe”. He also notes that even for very early retirees, a 3.5% rate is the lowest you would probably ever need to go. I highly encourage you to read his article, because it is very consistent with a mindful approach (it’s rational, relatively objective, and empirically based). So, I won’t repeat that discussion.
Similarly, the folks at Early Retirement Now (ERN) conducted a very detailed analysis and posted a 12 part series on safe withdrawal rates that specifically targets early retirees. They calculated over 6.5 million safe withdrawal rates based on all possible combinations of:
- retirement starting dates from 1871 to 2016
- retirement horizons ranging from 30 to 60 years
- portfolios with 0 to 100% stocks
- five different final asset values
- nine withdrawal patterns.
In other words, it’s a comprehensive analysis! You can read more of the details of the methods and results over at ERN, but the key results are shown in this table.
You can use this table to pick the withdrawal rate that you consider “safe” for your situation. Assuming you are using the mindful bucket approach described above (80% stocks in the vulnerable period ascending to 100% for the rest of retirement), a 3.5% inflation adjusted withdrawal rate is very likely to ensure you have sufficient money in retirement, even over 60 years. Using a mindful perspective, where you don’t worry so much about low probability outcomes, might lead you to a withdrawal rate that is a little higher than 4%, especially if you think your retirement period is likely to be 40 years or less.
Tailoring Your Withdrawal Rate – Because there are many variables, I highly encourage you to conduct your own calculations or closely review detailed studies like the one at ERN and avoid rules-of-thumb in general. The 4% rule is a good starting place, but why would you leave your retirement up to a one-size-fits-all estimate? In addition to the ERN analysis, you can use online calculators such as:
Using any of these approaches you will need to consider factors such as:
- The types of investments you expect to make (like the bucket approach above)
- How you will maintain your investing plan over time (like the hybrid depletion approach above)
- How much in dollar terms you would like to withdrawal annually
- A reasonably conservative estimate of how much money you expect to have accumulated by the time you start retirement (or the spending phase in general).
To help determine this last variable (how much you will have at retirement), various free retirement calculators are reviewed by:
By planning your spending just like you plan your investing, you can answer questions like:
- Is your planned retirement date reasonable? Or does it need to change?
- What is the amount you will have to live on year-to-year? Is keeping to this level of living expense realistic for you?
- What are the dynamic spending options applicable to you that might improve your plan’s probability of success?
- How much flexibility do you have to drastically reduce your spending during and after market downturns?
- How aggressively (more stocks and less ballast) do you need to invest to meet goals that are consistent with the answers to these other questions?
I may do some blog posts in the future that explore the whole spending and withdrawal rate discussion more, but I’ll stop here for now.
Conclusions for the “old” investor
We’ve come up with a pretty mindful investing plan for the “old” investor. Although there is no perfect answer or ideal plan that works for everyone in all future unpredictable situations, the Mindful Investing Plan for the “old” investor sets some key guidelines you can use to develop your own plan:
- When you enter the spending phase, you need to avoid the bad luck of early stock declines, so called “sequence of return risk”
- The best way to avoid this bad luck scenario is to add some ballast (intermediate bonds and cash) to your portfolio just prior to and during the vulnerable period; long-term bonds should not be used as ballast.
- Even experts don’t agree that one ballast approach is always better than another
- Bucket investing is one useful concept to help you decide how much ballast to include in your portfolio and how to maintain or deplete that ballast over time
- Ballast in the 20% range that is maintained for the first 5 to 10 years of the spending phase provides a reasonable safety margin against bad luck, while not dragging down your overall portfolio performance too much
- Ballast should be used to buy stocks if a large stock market decline occurs early in the spending phase; this is the primary way that ballast mitigates portfolio declines
- Your withdrawal approach must dovetail with your investment plan to ensure you balance spending with reasonable growth expectations for your overall portfolio.
We can safely say there are quite a few possible investing plans for the “old” investor that fit these mindful guidelines. Moreover, when you start to build in flexibility to change your withdrawal rate over time, many more mindful options become available. For example, you can reasonably decrease the amount of ballast in your plan if you intend to:
- Adjust your withdrawal rate relative to changes in your portfolio value
- Reduce your withdrawal rate later in the spending phase
- Severely reduce your withdrawals if an early stock market crash occurs
- Start with a relatively low withdrawal rate, like 3% or less, and assess changes to the withdrawal rate as you start to see how your portfolio growth is playing out.
Also, per the Estrada study, a 100% stock portfolio might perform better than some ballast approaches even if you maintain a preset inflation-adjusted withdrawal rate. So, if you add in the benefits of a highly flexible spending plan, a 100% stock portfolio is likely the most mindful approach, and you can simply ignore the mindful investment plan presented in Article 8.3 and above. This makes me wonder why I even wrote that stuff!
Other important conclusions for the “old” investor worth reiterating or mentioning are discussed below.
Bucket Mirage – Michael Kitces discusses that bucket investing is in some ways a “mirage”. He notes that bucket approaches typically produce outcomes that mimic simply holding similar amounts of ballast and proportionally withdrawing from all holdings each year. However, if we apply Kitces observations to our mindful investing evaluations, I would say the portfolio ratio should still be about 20% ballast and 80% stocks in the vulnerable period, which provides a good balance of portfolio success rate with reasonable expectations for portfolio growth. In contrast, Kitces and others often recommend higher amounts of ballast early in this period. A mindful approach also suggests moving toward holding 100% stocks after the vulnerable period, and Kitces would agree with this “ascending glide path” for stocks based on his research with Pfau.
No Ideal Plan – Although there may be more ideal “looking” ballast plans based on back-testing (like the Kitces bond tent idea), any ballast approach will still be subject to future market unpredictability. Just like the diversification discussion in the Article 7.3, trying to highly optimize a retirement plan is fooling yourself into thinking you have more control over your investments than objective facts indicate. Therefore, a simple investing plan that does not attempt to be “ideal” is often going to be an easier one to follow and maintain. For this reason, Ben Carlson rightly points out that we should all:
- Have a plan, even if it’s a bad one. A bad plan is better than no plan at all.
Bonds Still Problematic – The mindful bucket plan described above makes some assumptions that, moving forward, bonds will at least approximate their historical function in the mid-term bucket. However, as I have copiously pointed out in the Article 6 and 7 series, the current economic and market conditions strongly suggest bonds are unlikely to provide this historical function anytime soon. As of the writing of this article, a typical 3-7 year bond ETF (like symbol IEI) yields only about 1.3%. A typical 5-year TIPS ETF (like symbol TDTF) currently yields only 1.9%. And importantly, these bond funds (and their underlying bonds) may soon produce negative returns if they are not held for a sufficient duration.
In contrast, it’s easy to start a savings account right now for amounts as little as $10,000 that currently yields 1.0%, and with almost zero risk of losing principal. From a mindful perspective, a virtual guarantee of a 1% return is likely better than taking a gamble that you will either gain a mere fraction of a percent return or possibly just lose money. As interest rates rise, intermediate duration bonds are expected to slowly return to their proper place in the mid-term bucket, but for right now, an equally good choice for “safe” ballast in the mid-term bucket is cash. As suggested in Article 7.3, intermediate bonds will probably make sense again when the yield on a 10-year U.S. bond is around 4%. This assumes inflation does not unexpectedly flare up, in which case it would be prudent to seek an even higher bond yield.
There are quite a few other mechanics involved in retirement investing, particularly related to retirement account regulations and tax laws. This includes issues like:
- When to use tax advantaged accounts
- Different ways to use tax deferred versus tax-free (Roth) accounts
- How to reduce your tax burden both early and late in retirement
- Considering different tax rates for capital gains, dividends, and ordinary income
- Minimum required distributions from tax advantaged accounts
- Factoring in Social Security or pension payments
- And other issues.
These are important details that, if properly considered, can save you substantial money, boost your portfolio growth over time, and provide a wider range of sustainable withdrawal rates. Although I may hit some of these topics in future blog posts, for now, I refer you to:
Article 8.5 (coming soon) will address another aspect of investing over time: whether it is prudent to attempt to “time the market” as part of executing either “young” or “old” investing plans. Article 8.5 will also present some broad guidelines for when to convert ballast to stocks as market gyrations unfold during implementation of your Mindful Bucket Investing Plan for the “old” investor.