Worried that you will never be able to invest enough for retirement? Do the results of a retirement calculator scare you? Learning about the 'bucket strategy' might help cope with these issues.
How much do I need to retire? Most people (among those who bother to ask!) are troubled by the answer to this question. The corpus required and therefore the monthly investment required seems so high that some think inflation is an urban myth! A middle-aged person who has not paid attention to retirement earlier is likely to end up with a much lower corpus than required. How does one cope with such grim realities?
At the end of the day whatever the numbers show one can only invest what one can. Efficiently investing this amount and creating a nest egg is a hard enough task. The even harder task of ensuring that the corpus outlives the individual follows. Hard because unlike other financial goals (eg. child’s education or the car we always wanted), the retirement corpus does not get spent in one-shot.
So how does one efficiently invest the corpus and draw from it to meet expenses and ensure it lasts a lifetime? Obviously like most problems there is more than one solution. The ‘bucket strategy’ is one of them. Subra suggested I make a calculator based on this resulting in a simulator and this post.
Wait a minute. My retirement is decades away. Why should I worry about withdrawal strategies now? So is mine (I hope!). Learning about corpus withdrawal strategies and playing with the bucket simulator helped me understand corpus accumulation strategies better. It also gives me some comfort, if not confidence, that even if the corpus falls short for some reason I can (try to) use it efficiently. It would probably help you in the same way. So do read on.
First let us review the methods of investing a corpus post-retirement and drawing an income from it. In all cases it is assumed that investing has been done with a good idea of the corpus required estimated with a retirement calculator.
I. Systematic Withdrawal (fixed return). This is the simplest way to do it. Invest the entire corpus in one safe instrument. In the initial years of retirement the interest earned will take care of expenses. Down the line as expenses increase due to inflation you start drawing from the principle. Ideally the lifetime of the corpus matches your own. Of course there is no way to ensure this … financially that is! So the risk of you outliving the corpus is quite high.
II. Systematic Withdrawal (averaged return). In this case you invest in different instruments. For example 40% of your corpus in FDs, 20% in a debt fund and 20% in equities. If you need 1 lakh for your expenses in the second year of retirement you draw 40% from FDs, 20% from the debt fund and 20% from equities. This is the irrespective of the performance of individual instruments. Depending on the allocation % and performance of each instrument this strategy may or not outperform the fixed return method.
III. Defined Withdrawal or Bucket Strategy. Here you invest in different instruments. However the way you withdraw from them is quite different. Let’s say you choose to put 40% in FDs which will take care of your expenses for the first 8-10 years of retirement. You then put 20% in a balanced mutual fund, 20% in a large-cap fund and 20% in a small- and mid-cap fund (this is one way to do it. There are several others). During the first 8-10 years you allow the mutual fund investments to grow. If the returns are phenomenally high in a few years you take out some profits and put them in FDs. If the returns are low or negative, you do nothing and hold. Towards the end of 8-10 years you take out enough to cover your expenses for the next 4-6 (or less) years of retirement depending on the performance of the funds. Then again you allow the fund balances to grow. Again if there is a good year or two you convert some portion into FDs and continue doing this. You can take also a call regarding transferring from one mutual fund to another. This method of not selling your MFs during bad market phases as much as possible allows these investments to grow and if played right can significantly beat the performance of both the above strategies. In this case there is no formula involved and all the decisions are taken by the investor. In this case each investment instrument is called a bucket since you hold the balances for as long as you can. The buckets will depend on the investors risk appetite. For example a debt fund can replace the balanced fund in the above example. The second bucket can also be FDs or debt funds which mature after 8-10 years and can then be transferred to the first bucket. A similar approach can also be used with the 3rd bucket. However there may not be significant differences bet. strategies II and III in this case.
Here are a couple of comparisons of the three strategies made with my simulator:
Here strategies II and III use a corpus 20% lower than I. Still you can see both of them outperform I more than comfortably. Strategy I was designed to last for 25 years. The bucket strategy (blue line) in this case lasts for 22 years more, which is incredible! Before we get carried away we must realise that such phenomenal success is not always possible and depending on: investor decisions, allocation choices, sequence of returns and inflation things can go awfully bad. Here is an example.
The inflation in both cases is 8%. However unlike the first case in the first few years of retirement, returns from the ‘growth’ buckets (mutual funds in the above example) were poor year after year. I made some wrong choices and year 13 the portfolio went on a free-fall. So a reasonable understanding of the markets and when to exit or transfer holdings is the key to success.
The Bucket Strategy Simulator
When Subra suggested that I make a calculator based on the bucket strategy, I looked around for what was available. I found a wonderful free bucket investment simulator offered by ISG Planning. I decided to create such a simulator from the ground-up but with a lot more flexibility and features than this free version. I believe this is necessary to combat high inflation economies such as ours.
Here is a brief description: You have 5 buckets to choose from. You let bucket 1 be a ‘fixed income’ source (like FDs) where returns are fixed. The other buckets can be anything of your choice. You must input an average return and extent by which an asset can deviation from the average return (more the deviation, more the risk). For example mid-caps will deviate more than large-caps. A little bit more on this can be found in the excel file. Once you allocate to each bucket, you are ready to play. You advance year by year (of retirement) and take decisions: hold or transfer some amt to bucket 1. As you advance you can see the performance in the above graph. The idea of course is to beat the other strategies. As you play more and more you get better.
Bucket 1 return is fixed and the other returns are varied randomly. The random returns when collected over many years (30 or more) will resemble a ‘bell’ shaped curve with the peak representing the average return and the width of the curve (half-way from the top) representing the deviation or risk. This is known as a ‘normal distribution’.
More details can found in the excel file. It has instructions and a few more examples and a detailed read-me section. Do give it a go and let me know what you think. Much more advancements can be made. I will make it if there is enough interest. The excel file uses macros. So you will need to enable them before using. I had a great time playing and learning. Hope you do too. Feedback Please!
Latest version --> Download the Retirement Bucket Strategy Simulator (bugs fixed). Credit: V. Muthu Krishnan
(.xls file made with Excel 2002. Enable Macros)
(.xlsm file made with Excel 2007 Enable Macros)
* UPDATE: Thanks to Vandhana Rajendran for extensively testing the simulator and pointing out bugs. These have now been fixed.
Buy our New Book!You Can Be Rich With Goal-based Investing A book by P V Subramanyam (subramoney.com) & M Pattabiraman. Hard bound. Price: Rs. 399/- (Rs. 359/- at Amazon.in). Read more about the book and pre-order now!