How to Improve Outcomes When Using a Time Segmentation “Bucket” Strategy
Time segmentation seems to be a more planful approach for creating a retirement income stream than simply taking three to four percent withdrawals from a portfolio of equities and fixed income (or higher if you read Bill Bengen’s recent article in this publication). Also known as the bucket strategy, its basic premise is to cordon off higher risk assets for withdrawals far in the future, perhaps at least five if not ten years, while limiting current withdrawals from a segment of low or no risk assets.
In any case, it is hard to argue against the efficacy of having the first five years of retirement income needs shored up in cash or the like and leaving equities and other higher risk growth assets to be tapped at least five years in the future. The challenge, however, is this: point in time risk. There is no law that says five or ten years from now, just as you are about to tap your equity bucket, it won’t hit a wave of volatility that drops the value of that bucket by ten or twenty percent in a heartbeat. As a result, many may think they need to populate not five, but perhaps ten full years of living expenses in very conservative, and thus very low return assets. Enter the structured annuity, which may be the ticket to a better early bucket.
Today’s latest structured annuities, also called registered index linked annuities, can be an excellent way to fund a segment bucket that can be tapped in about six years, based on the typical surrender charge schedule of these products. This bucket may be number two or number three and may even supplant the need for a fixed income bucket or tweener bucket between cash and equities.
For example, many of these annuity’s offer a six-year segment that provides ample exposure to the upside potential of the S&P 500 Index, while also protecting against some of the downside losses at the end of the period.
For example, assume a hypothetical product ( I say “hypothetical” because this is a fairly representative example of what is available from issuers) will provide upside potential of up to a cumulative gain of 70% at the end of the six-year period (as of this writing), if the S&P 500 price return index has performed as well or better than a cumulative 70% in six years. For cumulative performance between 0 and 70%, the contract will credit whatever that performance was, and do so with no additional fee. (Other index choices may charge an additional fee as may other products.) However, should the price return index lose value at the end of the sixth contract year, as compared to the initial purchase amount, the contract’s buffer feature will absorb the first 20% of losses.
This can be an excellent way to retain exposure to growth with a relatively short maturity window. Let’s examine two scenarios where a contract like this can add significant value over six years and perhaps absolve the need for a fixed income bucket as bucket number two:
- If markets do fine over the next six years, with decent if not spectacular growth, the RILA in our example can add value. For example, let’s assume the S&P 500 price return index (no dividends included) returned a cumulative total of 50% over the six-year period. That’s less than the average six-year return over that period (It is about 58% for all 700 rolling monthly six-year periods between March 15 of 1957 and June 15, 2021), but still far higher than what many would expect out of more conservative investment like fixed income. As such, that kind of growth could be a great way to populate and hopefully grow bucket number 2 or 3 in just six years’ time.
Less Bullish Case
- What If instead the index had lost value over that six-year period? It has declined over six-year periods about 14% of the time, and the average decline is roughly 9%. The hypothetical contract will eat the first 20% of losses. The index has only declined more than 20% over six-year periods about 1% of the time. That strikes me as a low probability event.
- Thus, a loss in the price return index after six years would likely be covered by the 20% buffer, if history is any guide. This would mean the client essentially ends up with the same value they started with at that point – the contract is totally liquid but has earned nothing, akin to what a cookie jar approach would have produced, and with a risk/reward profile that appears more favorable than fixed income.
- But that’s not the most important role played by the buffer. The buffer plays the role of confidence booster, such that the client feels comfortable having a bucket either fully or partially populated with an asset that has far higher growth potential than more conservative assets that may be more common inhabitants of buckets maturing in only six years.
Income planning without flooring is all about probabilities. The safe withdrawal strategy was predicated on a 90% probability of a 4% withdrawal lasting 30 years. Funding an early bucket with a RILA and a six-year strategy seems an excellent way to improve the growth of segment 2 or 3 with a risk profile no worse (if not better) than fixed income.
John Rafferty has spent much of his 30-year career building annuity marketing departments at MassMutual, AIG/American General, and Symetra. He holds a B.A. in economics from Colby College and an M.A. in public policy from Trinity College, and currently operates an annuity sales and marketing consultancy, RaffertyAnnuityFraming.com.