Time Segmentation as the Compromise Solution for Retirement Income

The Financial Planning Association (FPA) divides retirement income strategies into three categories: systematic withdrawals, time-based segmentation and essential-versus-discretionary income. Time-based segmentation provides a middle ground between the two extremes represented by systematic withdrawals (relying on a total-return investment portfolio for all distributions) and essential-versus-discretionary (using insurance-based products to implement a lifetime-income floor before considering investments). In occupying this middle ground, time segmentation is wildly popular in practice and it goes by many different names. But it is also the least studied retirement income approach. Whether time segmentation is a superior investing approach for retirement income has led to many heated debates. I anticipate a lengthy discussion will show up at APViewpoint about these issues.

This column is the first of a three-part series on time segmentation. In this first column, I will provide the case for time segmentation strategies provided by their advocates, as well as how it fits into the spectrum of retirement-income approaches. Part 2 will then demonstrate how time segmentation can work in practice by considering three different approaches for managing the strategy over a long retirement. Part 3 will answer the question of whether time segmentation is a superior investing strategy for retirees.

Introducing time segmentation

Time segmentation serves as a middle ground for retirement approaches. It differs from systematic withdrawal strategies in that fixed-income assets are held to maturity to fund future retiree expenses over the short and medium term. A growth portfolio is also built with more volatile assets having higher expected returns, to be deployed to cover expenses in the more distant future. This is not total-return investing, since different investing strategies are used to cover different time horizons.

Time segmentation also differs from an essential-versus-discretionary strategy because it does not build a lifetime income floor. Rather, there is an income front-end with contractual protections. The assumption is that people have not saved enough to fund their entire lifetime of spending. Importantly, time segmentation also accounts for the fact that spending needs may change, and this requires flexibility and the avoidance of irreversible decisions.

Defining time segmentation as it is used in practice is challenging, but I must do that in order to test the approach quantitatively. Time segmentation, also known as bucketing, is used by countless financial advisors, each of whom defines their process in a unique way. Differences can be found with regard to the number of time segments and their respective lengths, the choice of asset classes used within each segment, whether individual bonds are used in place of bond funds, the degree to which the overall asset allocation is allowed to change over time and how and when the different segments are further extended as time passes. These issues may not always be addressed, and critics of time segmentation wonder if there is really a “there there,” as Jonathan Guyton questioned in a 2014 Journal of Financial Planning column.

At its core, though, time segmentation involves investing differently for retirement spending goals falling at different points in retirement. Fixed income assets with greater security are generally reserved for earlier retirement expenses, and higher volatility investments with greater growth potential are employed to support later retirement expenses.