By Fay Khan: Senior Discretionary Fund Manager Specialist at Alexforbes

If you have not yet heard about the bucketing strategy, it has little to do with Johannesburg’s recent water crisis and plenty to do with solving the longevity conundrum for living annuity clients. The bucketing strategy for living annuities involves dividing a client’s retirement savings into different ‘buckets’ based on the time frame over which assets are expected to generate income. This approach typically involves spreading the retiree’s investment over short-, medium- and long-term buckets. This ensures a stable and predictable income for immediate needs while allowing the balance of the capital to grow over the medium to long term, irrespective of short-term market conditions.
The bucketing strategy for retirement annuities was embraced in South Africa to address several key challenges faced by retirees:
Longevity risk: The need for a strategy that ensures retirees do not outlive their savings became more pertinent with increasing life expectancies.
Income stability: Market downturns and the sequence of return risk can significantly impact a client who has just retired. Without the ability to time the market, allocating a portion of their assets to low-risk investments for a predictable stream of income over the next one to two years allows retirees to comfortably cover immediate needs, like living expenses. Meanwhile, the balance of their retirement investment can be placed in riskier growth assets that can withstand market fluctuations due to a longer investment horizon.
Psychological comfort: During market downturns, retirees may react emotionally and be tempted to sell investments, thereby locking in losses. However, knowing that immediate income needs are covered can provide peace of mind, reducing the stress associated with market volatility. This enables retirees to separate assets required for the long term, helping them avoid locking in losses.
Drawbacks of the bucketing strategy
Complexity: Implementing and maintaining a bucketing strategy can be complex and may require ongoing management and adjustments. Retirees need to monitor their investments regularly and make informed decisions about rebalancing their portfolios.
Potential for lower returns: If the strategy is not managed properly, it could lead to lower overall returns, especially if there is a significant portion allocated to low-risk investments. Overemphasising capital preservation can result in missed opportunities for growth, affecting the long-term sustainability of the retirement income.
Costs: There may be higher costs associated with managing multiple investment buckets, including transaction fees and advisory fees. These costs can erode overall returns and reduce the efficacy of the strategy,
An alternative approach is a hybrid annuity, which combines living and life annuities to provide a reliable income source, while also offering the opportunity to benefit from market gains and legacy planning. This hybrid annuity option can offer retirees a balanced solution that addresses both short-term income needs and long-term growth potential.
Similarly, the bucketing approach within a living annuity can provide a reliable and predictable source of income generation in the short-term bucket, while the medium- to longer-term buckets allow the retiree to benefit from compounding market returns over a longer period, with the ability to leave a legacy should the living annuity outlive the retiree.
A key advantage of the bucketing strategy is that it allows adjustments based on market conditions and any changes in the retiree’s personal circumstances. Retirees can rebalance their portfolios periodically to align with their changing needs and market dynamics. This flexibility assists in maintaining a stable income stream and allows the strategy to adapt to unforeseen expenses or changes in financial goals.
Proactive advice for the bucketing strategy
Alexforbes emphasises the importance of proactive advice in helping retirees simplify their decision-making process and structure their retirement savings appropriately. Experience shows that when retirees are given the Alexforbes choice of default annuities, 20% select the life annuity and 80% choose the living annuity, which includes the option to invest into a life annuity to provide a level of lifetime income. Many retirees initially opt for the living annuity without selecting the life annuity component, but they increasingly adopt this component as they move through retirement. They realise the longevity and legacy protection it offers.
Best practices for the bucketing strategy for living annuities
Professional advice: Seeking professional advice can help retirees navigate the complexities of the bucketing strategy and optimise their investments. Financial advisers can provide tailored recommendations, by partnering with a Discretionary Fund Manager (DFM) who will monitor and adjust the portfolios to align with the retiree’s objectives. They can ensure the client is on track to achieve their predictable, and sometimes changing, retirement income objectives.
Regular review and adjustment: Retirees should regularly review their living annuity with their financial adviser, who can adjust the buckets to avoid unintended consequences of being too conservative or aggressive. This is crucial to ensure that the retiree’s needs and goals are being met. Additionally, having a dedicated DFM constantly assess the performance of each of the retiree’s risk-profiled buckets, rebalance the portfolio and make necessary changes based on market conditions allows the financial adviser to focus on any changes required due to the retiree’s personal circumstances.
Diversification: Diversifying investments within each bucket across asset classes, styles and asset managers can further enhance risk management and improve returns. A well-diversified portfolio can mitigate the impact of market volatility on a growth portfolio and provide a more stable income stream in a low-risk capital preservation portfolio.
Use of an asset allocator with scale: A financial adviser who partners with a DFM can help contain costs incurred by the retiree. This is achieved through using the DFM’s scale to attract institutional-type asset management fees on behalf of the retiree, as opposed to an adviser or retiree typically having access to more expensive retail asset management fees. This lowers the risk of eroding overall investment returns for the retiree.
Best practice from advisers
The bucketing strategy for living annuities offers a structured approach to balancing risk and return while providing a stable income for retirees. By understanding the favourable and unfavourable aspects and following best practices, financial advisers can assist retirees in optimising their retirement savings and achieving their financial goals. Incorporating expert advice and the investment prowess of a DFM can further enhance the effectiveness of the strategy and provide retirees with the confidence to navigate their retirement journey.