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Course 509
The Bucket Approach to Retirement Allocation

Introduction

The bucket approach to retirement-portfolio management, pioneered by financial planning guru Harold Evensky, effectively helps retirees create a paycheck from their investment assets.

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.

Here’s how the bucket approach works and how to fill each bucket.

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. When cash yields are close to zero, bucket 1 is close to dead money, but the goal of this portfolio sleeve is to stabilize 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 Social Security or 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 year's 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 health-care costs, and so on.

Bucket 2 and Beyond

Although retirees may customize different frameworks for the number of buckets they hold, and the types of assets in each, Morningstar’s Director of Personal Finance, Christine Benz suggests two additional buckets, as follows.

Bucket 2: 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, 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 a yield-starved environment, but could become more meaningful when 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.)

Quiz 509
There is only one correct answer to each question.

1 What is the purpose of the bucket approach to retirement allocation?
a. It helps retirees leave a legacy
b. It helps retirees create a paycheck from their investment assets
c. It helps retirees manage their expenses
2 How do you determine how much money to hold in Bucket 1?
a. Estimate spending needs for at least the next 12 months
b. Calculate any certain, non-portfolio sources of income such as Social Security or pension payments
c. Subtract certain sources of income from estimated spending needs for at least the next 12 months
3 What is contained in Bucket 2?
a. Cash to meet living expenses for the next 12 months
b. Income-producing, stable investments
c. Stocks and bond types that maximize total return
4 Which bucket has the greatest potential for loss?
a. Bucket 1
b. Bucket 2
c. Bucket 3
5 Which statement about bucket maintenance is true?
a. The bucket structure calls for adding assets back to bucket 1 as the cash is spent down.
b. Principal withdrawals from bucket 3, no matter the market environment, should fill up bucket 1 as cash is depleted.
c. Bucket 3 never needs rebalancing.
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