The bucket approach to retirement allocation

By Christine Benz |  02-12-19 | 

Harold Evensky, President of Evensky & Katz Wealth Management, is a pioneer in terms of what has now been called the bucketing concept for managing retirement income.

When I spoke to him a decade ago, when some advisers were advocating almost 8 buckets for their clients, he felt two was sufficient.

I personally recommend three buckets.

Before I explain further, I would like to clarify that when I speak of model retirement portfolios, I divide them into two key groups:

  • Retirement Saver Portfolios: Geared toward people accumulating assets for retirement
  • Retirement Bucket Portfolios: Designed for people who are already retired

Here are some basics on the bucket approach.

What is the logic of a Retirement Bucket Portfolio?

The bucket concept is anchored on the basic premise that assets needed to fund near-term living expenses ought to remain in cash or liquid funds. 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.

Hence, my Retirement Bucket portfolios are segmented by time horizons:

  • Bucket 1: A very short-term horizon
  • Bucket 2: An intermediate-term horizon
  • Bucket 3: A long-term holding period

I sometimes see the Bucket approach referred to as a time segmentation approach, and I think that's a nice way of putting it. The basic idea is that you are thinking about your spending horizon from your portfolio and using that to structure the portfolio.

For assets that I'm going to need to spend right away, I want to keep that money very safe. I'd keep 6 to 24 months' worth of my portfolio expenditures in cash. From there I can step out on the risk spectrum.

If I have a time horizon of at least 3 years, up to 8 or 10 years, I can take a little bit more risk with that portion of the portfolio in the hope of earning higher return, and I can venture into bonds, maybe focus on high-quality short and intermediate-term bonds.

If I have a very long-term spending horizon for a component of my portfolio, I can think about venturing into higher-returning assets that have this potential for significant volatility along the way. But I wouldn't want to earmark them for near-term spending.

Does the spending have to happen from a particular bucket?

Retirees won't necessarily spend their money from the buckets in that sequence. For example, I'd argue that Bucket 3 is ripe for spending, given that higher-risk long-term assets have performed so well over the past decade. But holding an adequate amount in safer, shorter-term assets can help ensure that a retiree never has to raid those longer-term, higher-volatility assets when they're in a downturn.

How are the rules for deciding on each bucket?

Bucket 1

The linchpin of any bucket framework is a highly liquid component to meet near-term living expenses for 12 months or more. 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 this bucket, start by sketching out spending needs on an annual basis. Subtract from that amount any certain, non-portfolio sources of income such as rental income 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.

Bucket 2

Under my framework, this portfolio segment contains at least 5 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. 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.

Bucket 3

The longest-term portion of the portfolio is dominated by stocks and more volatile bond types such as credit funds. 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 the other buckets. 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.

Why do the Retirement Saver Portfolios forgo the bucketed setup?

That is because accumulators aren't yet spending from their portfolios. Without an imminent spending need, holding a dedicated cash component, which is a linchpin for the bucket approach, is too big a drag on the portfolio's results.

People in accumulation mode need to emphasize investments that can grow--or at least that will keep up with inflation--in the years leading up to retirement. They can't afford to park their retirement assets in cash, which is likely to lose money on a real basis over time. Nor do they need as much in bonds as is the case for retirees who are actively spending from their portfolios.

Only as retirement draws close does it make sense to begin raising cash or even earmarking significant shares of the portfolio for bonds, provided the retirement saver can sit tight through an equity-heavy portfolio through periods of market volatility.

But that assumes investors who are still earning paycheques are focused entirely on retirement with their portfolios, which of course isn't always the case. Just as retirees expect that they'll spend from their portfolios as the years go by, so may working people want and need to deploy investment assets to fund short- and intermediate-term goals. They don't always have a single-minded focus on investing for retirement. From that standpoint, the bucket concept can be helpful to them, too, in that it can show the way to an appropriate asset allocation for a particular goal given the proximity to spending.

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