27 Nov 2020

No hole in this bucket

Stock market crashes create anxiety for investors, especially those who – like most retired people - are withdrawing regular sums from their investments to provide the income they need. But FiveWays’ retirement income planning strategy, which we call ‘bucketing’, means clients are insulated from all but the very worst possible stock market disasters.

When creating a financial plan for retirement, we create an ‘income reserve’, a sum of money which is held in safe and secure deposits or equivalents like NS&I. Because your income needs are met from this ‘cash bucket’, any short-term decline in the stock market does not affect you.

This year provides an example. Between the first and fifteenth of March 2020 the UK All Share Index plunged by 35%. A typical Balanced portfolio fell by 25%. Suppose you had a Balanced portfolio worth £100,000 at January 2020 and took a £5,000 withdrawal from it every year in mid-March. In March 2020, your portfolio would have been worth £75,000 and your withdrawal would have reduced that to £70,000.

Fortunately the market rebounded quickly and by the end of October 2020 the Balanced portfolio had risen by 29%. If you had taken no withdrawal in March, your portfolio would have been worth £96,800 at the end of October. If you had taken your £5,000 in March, the portfolio value would have been £90,300 at that date. Taking the withdrawal from the portfolio meant you gave up the gain on that £5,000 and worsened the outcome by £1,500. But in fact it’s worse than that, because the potential gain from your investments for future years is based on the £70,000 value of your portfolio at mid-March after taking the withdrawal. That means that if we assume a normal pattern of stock market returns, the gap in returns between the ‘no-withdrawal’ and the ‘withdrawal’ portfolios will continue to grow over the years ahead. That single withdrawal will go on making you worse off indefinitely.

In this case, we were lucky – in 2020 the stock market rebounded very quickly. In previous ‘bear markets’, such as 1987-1990 and 2001-03, it didn’t, and continuing to take withdrawals from a portfolio whose value was declining became a road to ruin. If the markets had stayed down for a year, in 2021 you could have been withdrawing the next £5,000 from a portfolio worth £70,000, and you can see that you would now be on a fast-moving downward escalator. In that situation, you would simply have to stop taking withdrawals, hoping you could resume when the market recovers.

Our ‘bucketing’ strategy is designed to avoid such disasters. It sets what we believe to be a realistic level of withdrawals, but gives your portfolio a head start by taking withdrawals at the outset from the cash bucket. While that means you won’t make such big gains as you would if you had all your money invested and if the stock market simply went up in a straight line, we know that just doesn’t happen. So when the inevitable crises and crashes come, our bucketing strategy means you do not exacerbate the situation by taking money out at the wrong time, have no need to worry and can sleep peacefully.

As with most of what we do, we adopt a cautious stance. As financial advisers, it’s our job to ask what could go wrong and take steps to protect clients from disaster. Bucketing is a simple example of this.

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