Profit booking in the buckets

The bucket strategy splits a retirement corpus by when the money will be needed. Bucket 1 is spent soon and holds very low risk products. Bucket 3 is not needed for twenty years and can take real risk.

Bucket 3 doing well creates a problem nobody expects. As the risky assets grow, they become a large component of the portfolio. A retiree who set out with a modest share in growth assets can drift into a much riskier position simply by being right.

Profit booking in the buckets is the rule that prevents that drift. Set a target return. When the riskier bucket beats it, take the excess out and move it down to a safer bucket.

The workbook is upfront about the cost. The growth assets lose out on compounding from reinvestment. It accepts that cost, because in retirement most people would rather minimise risk than maximise returns.

The rule. Section 7.4, under Maintenance of the Buckets: it is prudent to be conservative with the riskier assets held, whether in bucket 2 or bucket 3, and book profits periodically. One way to do it is to set a target return, say 12 percent per annum, and if there is a higher return, book profits and move the excess from bucket 3 to bucket 2, or from bucket 2 to bucket 1, so that the risky asset does not grow to become a large component of the portfolio.

The direction of travel, which is not negotiable. The workbook states the refill logic and then states it as a prohibition:

• Bucket 2 refills bucket 1. Bucket 3 refills bucket 2.
• The lower risk bucket will be refilled from a higher risk bucket and never the other way.
• If there is a stock market crash, the fall in value in bucket 3 is not made up from the safer assets in bucket 2. The funds in bucket 3 are needed 15 to 20 years in the future, if not more, so there is time for a market recovery.

Profit booking rides on the same one-way street. Money moves down the risk ladder, never up.

What each bucket holds, so you can see what is being booked out of what.

The other replenishment methods it sits alongside. The workbook gives several: refill on a prefixed schedule, say annually; refill whenever funds fall below a pre-defined level; refill on an ad hoc basis; use a maturing bucket 2 investment to top up bucket 1; or refill bucket 1 from the dividends and interest received in buckets 2 and 3 and redeem capital only for the shortfall. A target-return trigger is the profit-booking variant of the same idea.

And the honest drawback. Booking profits removes money from the compounding engine. The workbook names this as the drawback of the strategy, then explains why retirees accept it: retirees typically prefer that their portfolios should be managed to minimize risk rather than maximizing returns.

Mr Rege retires with Rs 1,20,00,000 and fills three buckets. His rule, following the workbook, is a target return of 12 percent a year on buckets 2 and 3, with anything above it booked and moved down one bucket.

Start of the year

End of the year. Bucket 3, which holds hybrid and large-cap equity funds, returns 19 percent. Bucket 2 returns 9 percent.

Bucket 3 value      = 45,00,000 x 1.19 = Rs 53,55,000
Value at target 12% = 45,00,000 x 1.12 = Rs 50,40,000
Excess to book      = Rs 3,15,000   -> moved into bucket 2

Bucket 2 returned 9 percent, below the 12 percent target. Nothing is booked out of it.

After the transfer

Without the rule, bucket 3 would be sitting at Rs 53,55,000 and rising as a share of the portfolio every good year. With it, the growth bucket is held near its intended size and Rs 3,15,000 of market gain has been converted into money he will actually be able to spend in year 5 onwards.

Now the crash, the following year. Equity falls and bucket 3 drops to Rs 38,00,000. His instinct is to move Rs 12,00,000 from bucket 2 to restore it. The workbook forbids exactly this: the lower-risk bucket is refilled from the higher-risk bucket and never the other way. Bucket 3's money is not needed for 15 to 20 years, so it is left to recover — and the Rs 3,15,000 he booked out the year before is safely in bucket 2, which is the part of that year's gain he got to keep.

The cost, stated fairly. Had he left the Rs 3,15,000 in bucket 3 and had equity compounded at 12 percent for the next 15 years, it would have grown to roughly Rs 17,24,000. In bucket 2, earning less, it will grow to considerably less. That forgone compounding is the price of not being exposed to a 19-percent-sized equity bet he never chose.

Chapter 7, section 7.4 (Bucket Strategy), under Maintenance of the Buckets, is the whole source: the target-return trigger with its 12 percent illustration, the one-way refill rule, and the stated drawback of forgone compounding. Section 7.6 lists booking profits periodically to manage risks among the reasons portfolio monitoring is mandatory in both the accumulation and the distribution stages.

Expect a which direction question — a lower-risk bucket is refilled from a higher-risk bucket, never the reverse — and a scenario in which a market crash in bucket 3 tempts a transfer from bucket 2 (the answer is to leave it, because those funds are 15 to 20 years away). The drawback question is also set: profit booking costs the growth assets their compounding from reinvestment. The chapter's printed sample question on the maximum holding period in bucket 1 for a risk-averse investor belongs to the same section.

• Profits move down the risk ladder only. Bucket 3 to bucket 2, bucket 2 to bucket 1. Refilling a riskier bucket from a safer one is expressly ruled out, including after a crash.
• 12 percent is the workbook's illustration of a target, not a prescribed threshold. The rule is to set a target; the number is an example.
• Book the excess over the target, not the whole gain. The purpose is to hold the risky bucket near its intended size, not to empty it.
• The drawback is real and examinable. Booked profits stop compounding in the growth asset. The workbook states this and then justifies it by the retiree's preference for lower risk.
• This is maintenance, not the bucket strategy itself. The bucket strategy is the division of the corpus by time horizon; profit booking is one of several ways to keep the buckets at their intended sizes.
• Equity in bucket 2 is capped at 20 percent of the portfolio in the workbook's description, and it should be lower-risk equity. Bucket 2 is the safety cushion, not a second growth bucket.
• Buckets can be filled before retirement. The workbook suggests starting in the pre-retirement stage to lock in high interest rates and good entry prices, so profit booking may begin before the first withdrawal ever happens.