Friday, March 20, 2015

A Second Look at Time Segmentation Strategies

One of the retirement income strategies that I didn't discuss in my last post is Time Segmentation (TS). (See Unraveling Retirement Strategies: Time-Segmentation for a description of the strategy.)  I have a tough time nailing down my feelings on this strategy and here's why.

I looked at a Time Segmentation strategy portfolio next to a Sustainable Withdrawal Rates (SWR) strategy portfolio and I couldn't tell them apart. I pointed a bright light at the two of them and still couldn't see the difference. I put on stronger reading glasses than I normally wear and when that didn't help, I took off the glasses and squinted really hard. They still look a lot alike to me.

The big idea behind Time Segmentation strategies (sometimes referred to as "bucket strategies") is that retirees who hold five years or so of expenses in cash may be less likely to panic-sell in a market downturn. It appears comforting to many retirees to know that, no matter how the market behaves, their living expenses are covered for the next five years.

This is a behavioral strategy, not a financial one, and I will be the first to say that a strategy that lets retirees sleep at night has significant value, even if it isn't financially optimal.

I did a web search and found that I wasn't the first to note that these strategies seem to be "twins separated at birth." Michael Kitces wrote about it back in 2011 in a column entitled, "Research Reveals Cash Reserve Strategies Don't Work… Unless You're A Good Market Timer?"

An SWR portfolio is most often organized into asset classes like stocks and bonds, and perhaps sub-classes like small cap stocks or short term bonds, but it could as easily be organized as a TS portfolio with cash categorized as assets meant to cover immediate spending, bonds categorized as assets meant for intermediate spending, and the remainder listed as stocks for long term spending. The following diagram provides an example of a portfolio organized as a SWR portfolio and the same assets organized as a TS portfolio.

TS strategies also recommend spending first from cash, then from bonds, then from equities, but as the Kitces article explains, that is pretty much what happens when we rebalance a SWR portfolio. Rebalancing results in selling assets that have recently experienced the highest growth. If stock prices have fallen, rebalancing insures that it is other asset classes that will be sold. With rebalancing, stocks are sold after their price goes up, not down.

TS strategies use cash for near-term expenses, bonds for intermediate spending and stocks for growth to cover more distant expenses in a form of duration-matching, though less exact. But, so does an SWR strategy, although the common view of an SWR portfolio doesn't typically categorize its assets in that way.

In a paper entitled, "Sustainable Withdrawal Rates: The Historical Evidence on Buffer Zone Strategies", authors Walter Woerheide and David Nanigan showed that the drag on portfolio returns from holding large amounts of cash can be significant. In other words, the comfort of a large cash bucket can come with a heavy cost. According to the authors, the performance drag imposed by a large cash bucket actually leaves the typical portfolio less sustainable. Large cash holdings mean lower expected portfolio returns, and lower expected returns mean a higher probability of ruin.

As Kitces points out, a retiree with a 4% spending rate would need to hold nearly a sixth of her portfolio in cash to cover four years of spending and that has to be a drag on portfolio returns.

Having lots of money, as usual, helps with this problem. With a low withdrawal rate in the 1.5% to 2% range, a retiree can set aside four years of spending and still have a reasonable cash allocation. The performance penalty only comes when withdrawal rates exceed these.

It has also been argued that TS strategies reduce sequence of returns risk, but Moshe Milevsky showed in "Can Buckets Bail Out a Poor Sequence of Investment Returns?" that this strategy cannot always avoid sequence risk. When a retiree spends all his cash in a market downturn he can be left with an extremely risky all-equity portfolio, possibly before the bear market ends.

(The Milevsky paper is sometimes interpreted as saying that cash buckets cannot avoid a poor sequence of returns. Milevsky, however, simply offers a counterexample argument that shows the strategy doesn't always work.)

You could turn most SWR portfolios into a Time Segmentation portfolio simply by over-allocating cash. But, Woerheide and Nanigan tell us that we would actually hurt portfolio sustainability, not improve it, due to the performance drag of a large cash bucket. Milevsky showed that we can't depend on cash buckets to avoid a poor sequence of returns. This leaves only the behavioral benefit of a Time Segmentation strategy to distinguish it, so it becomes more of a different perspective on a SWR strategy than a unique approach, to my thinking.

If you have a lot of money and a low spending rate, you can hold a cash buffer that covers four or five years of spending without much damage to expected portfolio returns. The benefits will be largely psychological, but will have little or no financial cost. Retirees with a withdrawal rate of 3% or more may find the psychological benefits of this mental accounting worth the financial cost, but need to understand that it comes at a price.

I'm crossing Time Segmentation off my list of sound retirement income strategies, not because it is flawed or dominated, but because I don't believe it is distinct enough from SWR strategies to warrant separate consideration. In the end, it is largely a SWR strategy with perhaps too large an allocation to cash for its own good.

I believe Time Segmentation will provide a useful way for many retirees to view their finances, so just look at your portfolio from both perspectives. And, again, I don't want to minimize the value of making retirees comfortable, even if there are more efficient financial strategies. Over-withholding one's taxes, for example, isn't an efficient way to save money, but some people have trouble saving any other way.

I think a sub-optimal strategy is better than no strategy. Or, as my friend Peter is fond of saying, bad breath is better than no breath at all.

Please note the sidebar has been updated with a link to a recent New York Times column by Jeff Sommer on how often mutual fund managers beat the market.


  1. Kitces article is great in that it points to the importance of rebalancing even in spending down. i did my personal simulation and it see to me that the cash reserve only weathers one crisis, and it doesn't get replenished well.

  2. Amen Dirk! They are indifferent mathematically.

    This said, there are a couple of nuances:

    1) Math angle: The conservative bucket needs to be periodically refilled to replace what was spent (which is why, on the surface the two are identical in the LONG RUN). So what does happen during continually declining prices is that MORE SHARES are sold to net the same dollar amount (hint: when you run out of shares, you run out of money). So ... the conservative bucket allows for stopping the refill and conserving more shares. In practical application, most of my clients are refilling from their 401k or IRA ... and thus stopping the refill also stops taxation; which saves selling more shares. Shares are not sold into continually depressed prices.

    2) Behavioral angle: Also in practical application - once the refill of the conservative bucket stops, the balance starts shrinking. Since this bucket is the one that feeds into the retiree's checking account, the behavior to cut spending in order to help preserve the conservative bucket kicks in.

    A properly diversified portfolio (e.g., indexed all around) would follow the markets down, bottom out, and then recover. When markets have healed a bit, then the conservative bucket (I call it the Distribution Reservoir) may be refilled and the periodic refill may be restarted too.

    In the end, this is a dynamic spending approach with a layer of number of shares preservation during stressed markets. The real benefit come from behavioral aspects that encourage a slight reduction in spending for a short period of time on top of share management.

    With spending unchanged the results would be as you've pointed out. Behavior drives the differences.

    A great post Dirk, in that it does point out that buckets alone, or no buckets, makes little difference (in the end it is all about Total Return effects). Flexible spending does make the difference. There are methods to measure and monitor when spending may be in need of a tweak as we've discussed recently and over time.

    1. Thanks for the comments, Larry. Your spending "flexibility" issue is a very basic concept of retirement income strategies that I hope isn't lost on readers. Stock and bond portfolios have variable returns and if you try to spend a constant amount from a volatile portfolio, you run the very real risk of outliving your savings. If your spending adapts to changes in your portfolio balance, you are far less likely to go broke.


  3. After years of living paycheck to paycheck, I am finally starting to save and consider the years when I will truly be unable to work, even part-time. This is an interesting way to look at it. My conclusions are I have to control my spending and diversify my savings and investments.