Advisers should rethink “bucket strategy” in low interest rate environment

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MEDIA RELEASE. Advisers need to rethink their “bucket strategy” in light of the historically low interest rate environment, and consider changes to cash buckets in order to generate more return for their clients, particularly retirees, says Stuart Dear, deputy head of fixed income at Schroders.

“Many retirees rely on their allocation to cash to meet their day-to-day expenses, but falling interest rates have made it difficult to generate income without taking excessive amounts of risk.

“With official interest rates remaining at a record low of 0.75 percent following the latest RBA board meeting, it is now a serious challenge for investors to generate income using traditional approaches. This problem is compounded further on platforms where the rate paid to investors for cash accounts is nearing zero after fees.

“A commonly used investing technique by advisers is the “bucket strategy”, where they allocate investments for their clients to three asset buckets: equities, diversified but defensive, and cash.  As the income and capital from the cash bucket is used for day-to-day expenses, the income generated by the riskier buckets flows down to top up the cash bucket.

“With significantly lower return on cash, there is clearly a problem with this model.

“Furthermore, while one percent has commonly been seen as an effective floor for the cash rate in Australia, we think rates can go lower still – even to zero, given the global experience.  And it’s likely that cash rates will be kept at low levels for a considerable period of time, exacerbating the challenges facing retirees, and indeed any investors, seeking the benefits of cash.”

Mr Dear says that in light of the prospect of low cash rates for the foreseeable future, it makes sense for advisers to consider making a change to the way they manage their clients’ cash buckets in order to generate more return.

“With very little return on cash, it makes sense to consider other alternatives.

“For example, a diversified, defensively oriented fixed income strategy that offers periodic income and daily liquidity could be a good substitute for part of the cash bucket.

“Of course, any alternative option must be considered in light of the trade-offs involved.  By investing in alternative options to cash, investors are likely to be taking on more risk.  As such, advisers should choose options that can generate higher returns while preserving the liquidity and relative certainty of return their clients require – both key features of cash.

“A fixed income strategy predominantly made up of high quality, liquid, publicly traded securities, can help with this,” Mr Dear says.

He adds that advisers could also consider dividing cash buckets into three further segments, based on timeframes, which vary according to their clients’ requirements for liquidity and certainty:

Figure 1: Segmenting the cash bucket

Segmenting_the_cash_bucket
Source: Schroders

Next 12 months – over this period, investors want the greatest certainty and liquidity, therefore may be best maintained as cash investments.

 1 – 2 years – in this segment, investors can take a little more risk to invest for slightly higher returns. However, this allocation away from cash should only be into defensively oriented strategies with high liquidity, and cash should still be a large part of this segment.

   2 – 3 years – this segment can take more risk again, and this is where it may make sense to blend some of the higher risk options, alongside cash and more defensive options.

“Based on this strategy, investors would still hold a little over half of their “cash bucket” in cash, but also utilise fixed income to lift their income generation without unnecessarily compromising the certainty of capital and liquidity requirements,” Mr Dear says.