Forty years ago, many retirees could rely on pension income from a previous employer to cover most of their financial needs – with supplemental income coming from Social Security and personal savings. Back then, government bonds were yielding 10%, which mitigated the need to invest in riskier assets, such as equities. Those days are long gone.
Traditional Capital Allocation
There are two primary schools of thought when it comes to retirement investing: the total return approach and the bucket approach. The total return approach is the traditional strategy, with assets invested in a diversified portfolio. During the accumulation phase, the investor’s primary objective is capital appreciation. As he nears retirement, funds are shifted from equities to fixed income in order to reduce market risk. Once the client retires, assets are typically drawn down evenly from the entire portfolio.
The Bucket Approach
The bucket approach follows the total return approach throughout most of the accumulation period. However, once the client is about three years away from retirement, his assets are divided among several portfolios (or buckets) with differing time horizons, asset allocations, and objectives. The advantage of this approach lies in its simplicity. Dividing assets into smaller, more manageable pieces is less overwhelming than lumping everything together into a single account.
Today’s retirement portfolios typically have three requirements: capital preservation (cash), income (bonds), and growth (stocks). The bucket approach is well-suited to these objectives, with each bucket serving a unique purpose. The first bucket is conservatively designed to produce income while preserving capital over a short time period, and the second bucket takes on more risk in order to provide a higher income during retirement. The third bucket is the riskiest of all, with substantial long-term capital gains as the investment goal.
Due to an investment environment with historically low interest rates, these are particularly challenging times for investors looking for a dependable retirement income. With money market accounts and short-term bonds offering practically nonexistent yields, retirees are faced with a difficult decision. They must either delay their retirement, reduce their standards of living, save more, or take on greater investment risks.
The bucket strategy was developed as a way of dealing with these problems. It maintains a stable pool of assets—sufficient to cover two years’ worth of living expenses—and a diversified basket of investments geared toward long-term growth. In other words, you segment your total portfolio by your anticipated investment time horizon. Funds required to cover short-term living expenses remain in cash, regardless of yield. Assets that won’t be needed for at least a couple of years are invested in a diversified pool of long-term holdings in pursuit of higher returns.
Your first bucket is designed to provide immediate income and cash for emergencies. It contains sufficient funds to cover the first two years of retirement. To determine the amount of money you’ll need in bucket 1, start with your anticipated annual spending. Subtract any other sources of guaranteed income, such as pension payments or Social Security. The remaining amount is the annual income that bucket 1 must provide. Conservative investors may wish to include an extra cushion for unexpected expenses. Appropriate bucket 1 investments are stable, very conservative, and liquid in nature.
Funds invested in bucket 2 are waiting to be tapped for income when bucket 1 is depleted. This intermediate bucket contains sufficient assets to cover living expenses for retirement years three through 10. Investments in this bucket tend to be higher risk than those found in bucket 1, since there’s more time to ride out market swings. Funds are typically invested in quality fixed income assets—such as corporate and government bonds—with an eight-year time horizon. A small portion of this portfolio may be invested in dividend-paying equities and other higher-yielding securities such as master limited partnerships. Conservative or balanced mutual funds are also appropriate bucket 2 investments.
While it’s possible to spend the income from bucket 2 directly, it’s generally better to use these proceeds to refill bucket 1 instead. The yield from these investments can flow directly into bucket 1, replenishing it automatically throughout the year.
Bucket 3, which covers years 11 and beyond, represents the long-term, high-volatility, high-return portion of your portfolio. This bucket has the highest risk profile of them all, since it has the longest time horizon and the best chance of recovering from a market downturn. It’s invested in equities and higher-risk bonds—such as junk bonds—with a primary focus on capital appreciation. This portfolio has the potential to deliver the best long-term performance, but it also has greater risk of permanent loss of capital than do buckets 1 and 2. The first two buckets exist to prevent you from needing to dip into bucket 3 when markets are down, and these assets show paper losses. When your short-term living expenses are safely tucked away in bucket 1, you can psychologically endure the volatility that comes with bucket 3.
The bucket strategy is simple in principle, but managing this plan becomes more complicated when bucket 1 runs dry. You should add assets to bucket 1 as cash gets spent down, and there are different ways of doing this. This process works for many investors:
The retiree reinvests all income, dividends, and capital gains back into his holdings. He refills bucket 1 by rebalancing the other buckets – periodically selling holdings that have performed the best to bring the total portfolio’s asset class exposures back in line with asset allocation targets. Using this strategy, the investor sells appreciated assets on a regular basis, while leaving the underperforming assets in place.
Cash meets immediate income needs and preserves capital, bonds satisfy intermediate cash flow needs, and stocks provide growth. By linking asset buckets to specific time horizons and income goals—and investing in the appropriate vehicles—the bucket approach can potentially generate a more reliable retirement income.