Making your cash work harder - re-thinking the buckets strategy
With short-term cash rates hovering just above zero, and unlikely to move higher for at least three years, expectations are that returns on short-term cash investments are likely to remain negative after inflation for some time. This is uncharted territory for many, posing a major challenge for investors relying on low risk cash investments to fund their lifestyle. The bottom line is that today’s cash investments are unlikely to generate the income required to fund the short-term needs of investors. In particular, retirees relying on their investment income to fund day-to-day expenses will suffer a shortfall. In this unprecedented environment we need to take a different approach to cash investments.
The bucket strategy
Not a new concept to most advisers, the bucket strategy for retirement planning was pioneered by US financial planning expert Harold Evensky in 1985. The strategy was designed to balance the need for income stability with capital growth during retirement. The aim was to make retirement savings last, while enabling lump sums to be withdrawn to fund lifestyle expenses.
The bucket strategy divides a retirement portfolio into three buckets with different time horizons –
- Cash Bucket: less than 3-year horizon, containing up to 3 years’ worth of savings to cover short-term expenses; all held in cash or short-term term deposits.
- Defensive Bucket: 3 to 7-year horizon, invested in defensive assets such as fixed income/bonds.
- Equity (shares) Bucket: 7-year+ horizon, invested in assets expected to grow over the longer term.
Today’s Cash Bucket has been hit by a double whammy – negligible interest rates combined with increasing household expenses.
Income generated in the Defensive Bucket and the Equity Bucket is fed back into the Cash Bucket as time passes. This strategy works well when cash investments are paying reasonable rates. Those with long memories will remember a different world in 1989 - the Australian overnight cash rate was 18%, while 3-month bank bill/certificate of deposits paid an annualised interest rate of 18.3%. Even with high inflation, investors were being rewarded with high real returns for very low risk assets. Fast forward to 2020: a cash rate of 0.1%, term deposit rates of up to 0.8% for 3 years; the problem is obvious. Today’s Cash Bucket has been hit by a double whammy – negligible interest rates combined with increasing household expenses (inflation of 0.7% in 2020) - effectively dragging the bucket backwards.
Cash buckets 2.0
We expect rates to stay low for the foreseeable future, and certainly for the three years a typical cash bucket strategy is designed to last. This is based on the long-term trends that have driven inflation down and the signals from central banks of their desire to keep rates low to spur growth, as evidenced by interest rates for durations of 3 years and less. Unfortunately, this means that savers and cash investors will earn virtually no income on this portion of their portfolio. It therefore makes sense for investors to rethink their Cash Bucket in order to generate more income to cover expenses. Introducing Cash Buckets 2.0.
The original Cash Bucket can be divided into two buckets, one for expenses in Year 1 and the other for expenses in Years 2 and 3.
- ‘Now Bucket: Designed to meet income needs now and for the next 12 months. Over this time period investors want the greatest certainty and the ability to access cash if they need it. We suggest this bucket is invested in cash investments such as bank accounts which can be immediately accessed at no cost, and short-term term deposits. The term of any term deposit should be carefully considered as redemption penalties apply for withdrawals made before the applicable maturity date.
- ‘Later Bucket: With a 3-year time horizon, more investment risk can be taken in this bucket. This is where it may make sense to fully invest in higher income-generating options such as a broad portfolio of debt instruments, for example Australian investment-grade corporate bonds, global investment-grade corporate bonds and other securities across the credit risk spectrum. Managed funds and ETFs offer access to a vast universe of debt instruments, with different risk profiles, which enables them to achieve substantial diversification and exhibit defensive properties. We have used the Schroder Absolute Return Income Fund as an example of how this strategy can be implemented.
We can't forget risk
While the goal is to increase income through the Cash Bucket 2.0 strategy, risk cannot be ignored. As the old adage goes, to achieve a greater return, you must be prepared to accept more risk.
In the debt markets the key risks are credit risk – the possibility of a loss resulting from a borrower’s failure to repay a loan or meet a contractual obligation; and duration risk – the risk that market interest rates will increase (resulting in a decrease in the market value of debt instruments with fixed coupons).
Diversification can be used to significantly dilute credit risk. Holding a broad portfolio of securities spreads the credit risk across many borrowers. An actively managed income fund invests in hundreds, or thousands of different borrowers, thereby reducing the risk of any one borrower defaulting on their loan. For example, the Schroder Absolute Return Income Fund currently holds approximately 2,000 different securities. Investing in this style of managed fund or ETF offers the potential for a higher yield, and while it brings a commensurate level of risk, this is mitigated by broad diversification. With market interest rates low, income funds, like the Schroder Absolute Return Income Fund, can reduce duration risk by holding fewer securities with fixed coupons that are susceptible to increases in market interest rates.
How do I set up the new buckets?
The ‘Now’ Bucket is simply the Cash Bucket from the original strategy. The money is invested in cash and term deposits that are easily accessible and without the risk of penalties or break costs. Funds for the first half of the year are sourced from bank accounts and once the term deposit/s has matured this will fund expenses in the second half of Year 1.
In the ‘Later’ Bucket, we propose investing the full amount in an absolute return income fund and have used the Schroder Absolute Return Income Fund as an example. Investing in an actively managed fund with a broad investment strategy allows investors to benefit from opportunities to enhance the yield when appropriate opportunities emerge.
In Cash Buckets 2.0 strategies should be actively managed, well diversified and investors should be able to access their money reasonably easily.
An active management approach refers to investing in actively managed funds where the professional managers can take advantage of new opportunities caused by changes in the economic and market outlook while avoiding possible risks. They are highly skilled and have access to extensive research into debt instruments, enabling them to create a well-diversified portfolio of global investments with the potential to deliver consistent returns, generally with high liquidity but with much lower risk than equity investments. When the conditions are favourable, they can invest in new opportunities. See Figure 3 for a comparison of the income generated for the ‘Later Bucket.
The Cash Buckets 2.0 approach is based on our belief that investors can increase income with some additional risk by putting a portion of their money into high quality, actively managed income strategies. As noted earlier, risk management is also crucial.
Case Study: what impact will this have on income?
To demonstrate the impact the Cash Buckets 2.0 approach can deliver, we have compared two self-funded retiree investors’ portfolios. Both have set aside $60,000 per year for three years of their retirement. This is approximately equivalent to the ASFA Retirement Standard – Comfortable lifestyle for couples ($62,083 in September 2020).
Jack adopts the traditional approach to Cash Buckets, investing three years of expenses in cash and term deposits, generating a first-year return of 0.55%, or $975.
Jill adopts the Cash Buckets 2.0 approach, investing in a combination of Cash and term deposits for Year 1 and the Schroder Absolute Return Income Fund in Years 2 and 3. She has been able to increase her yield in Year 1 by 0.83%, representing an additional $1,500 in income for the year.
For the purposes of this example, we have assumed that the Schroder Absolute Return Income Fund delivered a return, after fees of 2.00% p.a. based on the Fund’s after-fees performance target of 2.00% over the RBA cash target. The Fund’s return, after fees, for the 1-year period to 30 November 2020 was 2.96%. You should be aware that past performance is not a reliable indicator of future performance and there is no assurance that the Schroder Absolute Return Income Fund will be able to achieve its performance target.
 Australian Bureau of Statistics: Selected Living Cost Indexes, Australia, Consumer Price Index, September 2020
There’s no doubt that achieving a satisfactory yield in the current environment is challenging, however there are strategies to help boost the yield on a portfolio without materially increasing the risk.
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