Four bucket strategy misconceptions

It's an intuitive way to organize your in-retirement portfolio, but it's not a miracle worker.

Christine Benz 19 October, 2018 | 5:00PM

Setting an asset allocation and figuring out a mechanism for drawing cash flow from your portfolio is a daunting exercise. That's why the Bucket strategy can be so useful: It can help you visualize an appropriate portfolio structure based on your spending needs.

Starting with the amount you need to draw from your portfolio each year, you can then position your portfolio based on your expected spending horizon. Money for the next year or two should go in cash (Bucket 1), the only asset class where your principal is guaranteed. Assets for which you have a slightly longer horizon can go into high-quality bonds (Bucket 2), which have historically returned more than cash while holding principal fairly steady for time horizons of five years or longer. The remaining assets can go into stocks and other higher-risk/higher-returning assets (Bucket 3).

That seems really straightforward, but implementation can be a bit messy. How does that cash bucket get refilled, anyway? What role, if any, do nonportfolio assets like government pension benefits play in the Bucket approach? Investors have lots of questions, and there's a fair amount of confusion over how to make a Bucket approach work. Here are some of the key misconceptions I hear bandied about in relation to the Bucket approach.

Misconception 1: Government and employer pensions should be part of your buckets.

There are different ways to implement a Bucket approach. But I think the strategy is the most useful for organizing assets that you can invest and spend--that is, your investment portfolio. Nonportfolio sources of cash flow such as government retirement benefits and/or pensions are, of course, integral components of most retirees' plans, and they should influence the positioning of their investment portfolios. But I think it makes the most sense to factor them in at the beginning of the retirement-planning exercise rather than into the buckets themselves. To do otherwise is to risk getting bogged down in abstractions that ultimately aren't that useful.

Start the process by considering your total anticipated spending needs in retirement. After that, take a look at how much you'll have from certain, nonportfolio sources of income: government benefits (CPP/QPP, OAS), a pension or a fixed annuity. (In this group I would put anything that offers a guaranteed source of lifetime income and is out of your control in terms of its management.) The amount that's left over is the amount that your portfolio will need to replace annually. Armed with that figure--your annual portfolio spending--you can then segment your portfolio by time horizon. One to two years' worth of living expenses can go into cash, eight or so years in high-quality bonds and balanced/allocation funds, and the remainder can go into stocks.

To illustrate how certain sources of income have an impact on buckets, and in turn asset allocation, let's say that Brenda needs $60,000 in annual income, and she'll be getting $32,000 of that from a combination of government and employer pensions. In that case, her annual portfolio spending is $28,000. She'll need to check whether that amount is sustainable, of course, as discussed here. She can then bucket her investment portfolio using that $28,000 annual portfolio spend to guide her--$28,000 to $56,000 in Bucket 1, $224,000 or thereabouts in Bucket 2, and the remainder of her portfolio in Bucket 3, stocks.

By contrast, a retiree with a larger share of her cash-flow needs coming from certain sources of income, say a retired college professor with a full pension, would have a lower spending rate and, in turn, a lower allocation to safe assets. Let's say Karen also needs $60,000 per year but is retiring with a pension that's supplying $50,000 of her annual income needs. In that case, she'd stake between $10,000 and $20,000 in cash, $80,000 in bonds, and the rest in stocks. Assuming both portfolios were the same size, Karen's portfolio would be a lot more aggressive. (Of course, that also assumes that Karen is OK with the swings that will inevitably accompany her aggressive portfolio; that may or may not be the case.)

Misconception 2: You spend from the buckets sequentially.

Once you've segmented your portfolio by your anticipated spending horizon, you need to have a system for maintaining those allocations an ongoing basis. One common point of confusion on this front is that you'll "spend through" the buckets sequentially--that is, you'll spend your cash first, then move onto short- and intermediate-term bonds, while saving stocks for last. That makes a certain amount of sense, in that cash is the safest asset for very short time horizons, bonds have historically been quite safe assuming you have a time horizon of at least five years, and stocks have been pretty reliable for time horizons of 10 years or longer.

But the "spend-through" strategy is not desirable for a few reasons. First, such a strategy would leave a retiree with an increasingly aggressive portfolio. True, research conducted by financial planning experts Michael Kitces and Wade Pfau suggested that an asset allocation that grows more aggressive with time can help retirees avoid "sequence of return risk"--encountering a bum market early in retirement. But an increasingly aggressive portfolio might create behavioural challenges, as many older retirees prioritize being able to sleep easily over growing their nest eggs. Perhaps more important, spending down cash and bonds first has the potential to leave an investor with a very aggressive, stock-heavy portfolio at a time when it's not opportune to draw from it because stocks are depressed. For that reason, I like the idea of using income and rebalancing proceeds to help supply liquidity to the portfolio on an ongoing basis. Rebalancing to a target allocation also serves to keep the portfolio from skewing to a single asset class over time, as depleting the buckets sequentially would tend to do. It also allows you to be opportunistic in terms of where you turn for cash flow in a given year.

Misconception 3: Income-centric retirees won't benefit from buckets.

Another misconception is that buckets are only for total-return-oriented retirees, and the strategy won't work for more income-focused investors. Personally, I prefer to use a pure total return approach, reinvesting dividends and capital gains back into the portfolio and refilling Bucket 1 with the proceeds from rebalancing appreciated positions. But the Bucket strategy doesn't have to be interpreted so narrowly; I would urge investors to apply their own investment philosophies when implementing the bucket approach, as discussed here.

For income-focused retirees, one possible strategy would be to have income from your bonds and dividend-paying stocks flow directly into the cash bucket. If, after a year of taking in dividend and bond payments, Bucket 1 is full, you're all set. But if that amount isn't sufficient to meet your living expenses for the year ahead, you can sell securities. Such periodic selling might be desirable to restore your portfolio to its asset-allocation targets. The past three years provide a good example of a period when such rebalancing-related selling would be desirable: Bucketers may have found the income from their bonds and dividend-payers insufficient to meet their income needs, but strong equity performance could mean that trimming long-term holdings fulfills additional cash-flow needs.

Alternatively, there may be years in which income production from the portfolio is insufficient to meet living expenses and the market is also down--that is, there is no choice but to draw from Bucket 1. In such an instance, bucket 1 is there to serve as a buffer--to tide the investor through a 2008-style environment.

Misconception 4: A Bucket strategy can help address a savings shortfall.

The Bucket approach is an easy-to-understand way to organize your portfolio based on your anticipated time horizon, but it's not a miracle worker. In this sense it's a lot like target-date mutual funds: It's a helpful innovation, but it won't save you if you haven't saved enough yourself. The same guidelines related to portfolio sustainability relate to Bucket portfolios; even a sensibly crafted Bucket portfolio will be of no help if the portfolio expenditures exceed what's sustainable given the size of the portfolio. This article takes a closer look at how to make sure that your portfolio withdrawals pass the sniff test on the sustainability front; that's one of the first steps to take before implementing a Bucket approach.

About Author

Christine Benz

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.