The Bucket Approach to Retirement Allocation

A diversified portfolio with various time frames can help you meet your income needs during retirement

Christine Benz 30 September, 2014 | 9:14AM
Facebook Twitter LinkedIn

Those who lived through the 1970s and '80s no doubt find their photographs from those decades to be cringe-worthy. But while few may wish to repeat a fashion era marked by pastel-coloured suits and big hair, one aspect of those bygone decades is appealing—substantially higher interest rates than those that prevail today. The average interest rate on a six-month certificate of deposit was 9.1% in 1970 and 13.4% in 1980. Of course, inflation was high then, too, but those higher rates, plus the prevalence of pensions, allowed many retirees to generate liveable income streams without invading their principal or taking risks in stocks.

But two decades' worth of declining interest rates have dragged yields way down, dramatically compounding the challenge for retirees. With infinitesimal yields on money market accounts and high-quality bonds, retirees' choices are stark: To be able to afford retirement, they can plan to delay the date, save more, reduce their standards of living, or take more risks with their portfolios.

The bucket approach to retirement-portfolio management, pioneered by financial planning guru Harold Evensky, aims to meet those challenges, effectively helping retirees create a paycheque from their investment assets. Whereas some retirees have stuck with an income-centric approach but have been forced into ever-riskier securities, the bucket concept is anchored on the basic premise that assets needed to fund near-term living expenses ought to remain in cash, dinky yields and all. Assets that won't be needed for several years or more can be parked in a diversified pool of long-term holdings, with the cash buffer providing the peace of mind to ride out periodic downturns in the long-term portfolio.

I've written extensively about bucketed portfolios during the past year, and have also developed mutual fund and exchange-traded fund portfolios based on this concept.

The All-Important Bucket 1

The linchpin of any bucket framework is a highly liquid component to meet near-term living expenses for one year or more. With cash yields close to zero currently, bucket 1 is close to dead money, but the goal of this portfolio sleeve is to stabilise principal to meet income needs not covered by other income sources. To arrive at the amount of money to hold in bucket 1, start by sketching out spending needs on an annual basis. Subtract from that amount any certain, non-portfolio sources of income such as State Pension payments. The amount left over is the starting point for bucket 1: That's the amount of annual income bucket 1 will need to supply.

More conservative investors will want to multiply that figure by 2 or more to determine their cash holdings. Alternatively, investors concerned about the opportunity cost of so much cash might consider building a two-part liquidity pool—one year's worth of living expenses in true cash and one or more years’ worth of living expenses in a slightly higher-yielding alternative holding, such as a short-term bond fund. A retiree might also consider including an emergency fund within bucket 1 to defray unanticipated expenses such as car repairs, additional healthcare costs, and so on.

Bucket 2 and Beyond

Although retirees may customise different frameworks for the number of buckets they hold, and the types of assets in each, my model bucket portfolios include two additional buckets, as follows.

Bucket 2: Under my framework, this portfolio segment contains five or more years' worth of living expenses, with a goal of income production and stability. Thus, it's dominated by high-quality fixed-income exposure, though it might also include a small share of high-quality dividend-paying equities and other yield-rich securities such as master limited partnerships. Balanced or conservative- and moderate-allocation funds would also be appropriate in this part of the portfolio.

Income distributions from this portion of the portfolio can be used to refill bucket 1 as those assets are depleted. Why not simply spend the income proceeds directly and skip bucket 1 altogether? Because most retirees desire a reasonably consistent income stream to help meet their income needs. If yields are low—as they are now—the retiree can maintain a consistent standard of living by looking to other portfolio sources, such as rebalancing proceeds from buckets 2 and 3, to refill bucket 1.

Bucket 3: The longest-term portion of the portfolio, bucket 3 is dominated by stocks and more volatile bond types like junk bonds. Because this portion of the portfolio is likely to deliver the best long-term performance, it will require periodic trimming to keep the total portfolio from becoming too equity-heavy. By the same token, this portion of the portfolio will also have much greater loss potential than buckets 1 and 2. Those portfolio components are in place to prevent the investor from tapping bucket 3 when it's in a slump, which would otherwise turn paper losses into real ones.

Bucket Maintenance

The bucket structure calls for adding assets back to bucket 1 as the cash is spent down. Yet investors can exercise a lot of leeway to determine the logistics of that necessary bucket maintenance.

The following sequence will make sense in many situations:

  • Income from cash holdings in bucket 1. These will be of limited help in the current yield-starved environment, but they could become more meaningful if yields rise.
  • Income from bonds and dividend-paying stocks from buckets 2 and possibly even 3. (Income-focused investors might decide that their bucket maintenance starts and stops with these distributions.)
  • Rebalancing proceeds from buckets 2 and especially 3.
  • Principal withdrawals from bucket 2, provided the above methods have been exhausted. Such a scenario would tend to be most likely in a 2008-style environment, when bond and dividend yields dropped and equities slumped, thereby making it an inopportune time to unload equities. (Such a scenario would generally be a decent time to engage in tax-loss selling, but the proceeds from that would be best deployed back into equities.)

For more details on bucketed portfolios, see this article.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Christine Benz

Christine Benz  is director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy        Modern Slavery Statement        Cookie Settings        Disclosures