Many financial advisors employ time segmentation buckets (sometimes simply referred to as “bucketing”) to help their clients fund their desired retirement spending. This usually involves three buckets based on the expected timing of future spending: short-term, intermediate-term and long-term spending. The Actuarial Approach advocated in this website encourages the use of a different bucketing strategy that involves two buckets that separate future expenses into “essential” and “discretionary” spending. This strategy was recently discussed in the October 30 Financial Advisor article entitled, “Michael Kitces warns Advisors About Sequence Risk, Defends 4.0% Rule.” Mr. Kitces is a well-known retirement thought leader for financial advisors.
This post will set forth some of Mr. Kitces’ comments about the bucketing-by-expense-type strategy we recommend and will supplement Mr. Kitces’ comments with our commentary.
The Financial Advisor article sets forth the following comments by Mr. Kitces (or comments attributed to him by the article author) with respect to bucketing strategies used to mitigate sequence of return risk. We have added our commentary on his comments in [ ]s.
“The essentials bucket I'm going to cover with guaranteed income. These are true essentials: food, clothing, shelter kinds of things, not the Netflix account I can’t live without,” he said. “The whole point here is you cannot outlive your essentials expenses. They’re essential.” [We think he probably meant to imply that his Netflix account is an example of a discretionary expense that can actually be lived without, but maybe his Netflix account is something Mr. Kitces actually considers as an essential expense. Also, it is important to remember that taxes are usually essential expenses and may increase in the future, especially if you have large tax-deferred accounts that will become taxable in the future. It is also important to remember that in years when inflation rises faster than expected (like it did in 2022) or essential spending otherwise increases, the Floor Portfolio used to fund essential expenses may need to be strengthened. Therefore, the adequacy of your Floor Portfolio funding should be examined periodically]
“Many clients in practice cover the bulk of their essentials bucket with Social Security, he said, but if they don't have enough they can buy an immediate annuity to fill in the shortfall. They don’t need to annuitize the whole portfolio, he said, just enough to cover the essential expenses.” [We agree. The Floor Portfolio used to fund essential expenses can also be funded with defined benefit pension benefits and other low-risk investments]
“All other spending is considered discretionary [sic], and that is covered by portfolio withdrawals. “If bad things happen in the portfolio, the only thing that's at risk are the discretionary expenses ... wants, not needs,” he said. “So in essense [sic], we manage the sequence of returns risk by compartmentalizing only the expenses that we would be able to lose if we have to. We’re hoping we don’t, but we can compartmentalize the risk down to the spending that would not be castrophic [sic].” [Agreed. Also, these wants and needs may change from year to year for many possible reasons.]
“When a client covers essential expenses with Social Security plus an annuity topper as needed, the rest of the portfolio can be invested for growth, without much concern that a bad market will ruin the client. The value of the discretionary portion will rise over time.” [We agree with the first sentence, but the second sentence is based on the assumptions that essential expense spending will not increase more than expected from year to year and that the upside portfolio invested for growth will grow as expected.]
“From an income perspective, they're just kind of different channels. But from an asset perspective, they look very different. My guaranteed-income streams are essentially a proxy for fixed income. Social Securtity [sic] functions like a government bond,” he said. “I could carry my Social Security payouts as an actual asset on my balance sheet. Most of us don't calculate the capitalized value, but we could.” [Our model does calculate the capitalized values (present values) of Social Security benefits, pensions, life annuities, etc. and includes them in the household Actuarial Balance Sheet to be used to fund the present value of future planned essential expenses and to compare with the present value of expected expenses to determine the household Funded Status.]
“Dynamic Spending
On top of the safe withdrawal rate, and with or without dynamic asset
allocation, clients can also address sequence risk by tinkering with
their spending through a “ratcheting” strategy or by using floor/ceiling
guiderails.
For clients who like the feeling of spending more when times are good and don’t mind reining in their spending in when times are tough, adjusting spend levels can result in clients enjoying their retirement more than if they’re forced into a level spend over 30 years, Kitces said.” [We believe the author meant to use the term “guardrails” rather than “guiderails.” We agree with Mr. Kitces and recommend increasing or decreasing discretionary spending when the household Funded Status falls below or above certain specified levels (or guardrails).]
Summary
The Actuarial
Approach recommended in this website is a dynamic, two-bucket approach
that requires the household (and/or the household’s financial advisor)
to distinguish between expenses that they consider to be either
essential or discretionary. Matching the present value of future
essential expenses with the present value of low-risk, or lifetime
guaranteed assets is part of the Actuarial Approach’s recommended
Liability-Driven Investment (LDI) strategy. The Actuarial Approach
involves using a deterministic model (the Actuarial Financial Planner)
to produce an actuarial balance statement and an annual Funded Status
that is remeasured periodically (annually) as part of a general
actuarial process to determine when household spending changes may be
necessary (or desired). It is a relatively straight-forward approach
that can help you manage your risks in retirement, including sequence of
return risk.
