Implementing a bucket system? There will need to be some rules

Your system for Bucket portfolio maintenance will have an impact on your portfolio's asset allocation and performance.

Christine Benz 21 September, 2018 | 5:00PM

On paper, the Bucket strategy seems so simple and elegant: Set up the buckets and then spend your way through a long and happy retirement. Done and done, right?

Uh, not quite. Keeping a Bucket strategy up and running requires some maintenance. Without a set of guidelines about how you’ll manage your bucket portfolio on an ongoing basis, it can quickly run off the rails. Your cash bucket might not get replenished--or grow too large. Your portfolio could tilt toward a perilous weighting in stocks, or it could end up holding more safe securities than you intended, exposing you to shortfall risk.

To maintain a Bucket portfolio and extract cash flow from it, you’ll need to make some decisions about how you'll do it. Once you've formulated some guidelines, you then append them to your broader retirement policy statement.

Decision 1: How will you extract cash from your portfolio on an ongoing basis?

With any retirement portfolio, bucket or otherwise, you'll need to wring cash out of it on an ongoing basis. Will you rely on organically generated income distributions, pure rebalancing (reinvesting dividends and selling appreciated positions to raise cash), or a combination of the two?

Spend income distributions: Any portfolio consisting of stocks and bonds is going to generate at least some current income, which can be used to provide a substantial share of a retiree's living expenses. Spending dividends rather than reinvesting them can also help ensure that you're not putting more money to work when the market is overheated. Right now, a 60% S&P/TSX Composite/40% FTSE TMX Canada Universe Bond portfolio kicks off about 2.7% in current income. That's a good start, but it's likely not enough cash flow for most retirees. To subsist on yield alone, they'll likely have to nudge it up by focusing on higher-yielders, which have the potential to increase the portfolio's volatility level. Moreover, spending income distributions in down markets rather than reinvesting them has the potential to reduce the portfolio's long-run performance.

Reinvest income distributions, rely on rebalancing: This is a pure total return approach. A retiree employing this strategy would reinvest all income distributions back into the portfolio and instead look to rebalancing to supply living expenses on an ongoing basis. There are a couple of benefits to this approach. The first is that regular rebalancing helps keep the portfolio's allocations in line with targets. The second benefit is that reinvesting all dividends can help ensure that no part of the portfolio gets spent during market downturns. In 2008, for example, a retiree using the pure total return approach would rely exclusively on cash (Bucket 1) to supply living expenses; income distributions reinvested back into the portfolio would increase the amount of the portfolio in place to recover with the market.

The drawback of this strategy is the opposite of the "spend income" strategy: In frothy market environments, it would actually be better to spend income distributions rather than reinvesting them back into expensive securities.

Rely on a combination of income distributions and rebalancing proceeds: You could employee this hybrid strategy mechanically or opportunistically. With the mechanical approach, you would spend current income distributions (or use them to refill Bucket 1). Then, once a year, you could also rebalance, trimming appreciated positions to meet additional cash needs.

With an opportunistic approach, which is admittedly more complicated, you could use your view of the market's relative valuation to guide next steps. When the market is expensive, you could spend those income distributions. When it seems inexpensive, income distributions could be reinvested back into the portfolio; you could instead rely on your cash bucket to supply cash for living expenses.

Decision 2: What kind of "glide path" are you targeting?

Do you want to maintain a more or less static asset allocation throughout your retirement years? Or are you targeting a portfolio that grows more conservative--or perhaps more aggressive--as the years go by? Having a view on what your asset allocation should look like over your retirement life cycle will have implications for how you rebalance your portfolio. Whatever your approach, Morningstar's X-Ray functionality can help you keep tabs on your asset allocation on an ongoing basis.

Target a static glide path: If steady asset-class exposure is your goal, you'll want to regularly rebalance back to your target asset allocation.

Target a progressively more conservative portfolio: If you're aiming for a heavier allocation to cash and/or bonds as the years go by, that calls for scaling back appreciated positions and redeploying the assets into cash or short-term bonds.

Target a progressively more aggressive portfolio: If you're concerned about sequence of return risk--encountering a lousy market environment early on in retirement--one way to mitigate that problem is to maintain a conservative asset mix at the outset of retirement and gradually ramp up the equity allocation. That's the approach put forth by retirement researchers Michael Kitces and Wade Pfau in this research paper; the pair advanced the argument that an upward-sloping glide path can help improve a portfolio's sustainability if a bear market occurs at the outset of retirement. Of course, you'd only want to undertake such a strategy if you know that you have nerves of steel, in that you'll be adding to equities after they've taken a beating.

Decision 3: How will you rebalance?

Rebalancing is a retirement portfolio's great multitasker. It can help you extract cash flows for spending money, meet RRIF withdrawal requirements, make charitable contributions and reduce risk in your portfolio. But how will you rebalance? Will you focus on your asset-class exposures/glide path, as discussed above? Or will you also rebalance at the securities level, stripping back individual securities once they've exceeded certain preordained thresholds? What thresholds will you use to trigger rebalancing? No matter what approach you take, it's best to concentrate your rebalancing activity in your tax-sheltered accounts, where you won't pay tax costs to harvest appreciated winners.

Rebalance at the asset class level: This is the classic version of rebalancing: periodically scaling back exposure to appreciated asset classes. Ultimately, your portfolio's asset-class exposures will be the main determinant of how it behaves; this type of rebalancing helps ensure that your portfolio's risk level doesn't get out of whack. On the downside, investors who are looking to shake cash flows out of their portfolios on an ongoing basis may not find enough rebalancing opportunities if they only make changes when their portfolios' asset-class exposures have veered from their targets. (It takes a big market move to shift asset-class exposures meaningfully in one direction or another.)

Rebalance at the securities level: This type of rebalancing, whereby you scale back individual positions once they exceed specific thresholds, can be useful for retirees who are relying heavily on rebalancing--rather than just current income--to meet their cash flow needs. It's important to remember that you can employ security-specific rebalancing at the same time you're employing asset-class rebalancing. For example, if you're stripping back on equities because your overall position is higher than you want it to be, you can also concentrate your rebalancing activity on your most highly appreciated large-growth fund.

Decision 4: How often will you tweak your portfolio?

This is a more mundane consideration. Assuming you've put in place some rules for managing your in-retirement portfolio, how often will you maintain it? Will you conduct a once-annual checkup/tuneup, or will you conduct maintenance more frequently? Keeping your portfolio management on a preset schedule--and documenting that in your retirement policy statement--may serve to inhibit ill-advised portfolio changes, such as bulking up your cash position during a period of volatility.

Check up annually: You can accomplish a lot with a single annual checkup in retirement, ideally as the year winds down. You can set aside your cash needs from the portfolio for the year ahead, conduct a year-end portfolio review and rebalance, and address tax issues, including taking your required minimum distributions. By limiting yourself to a single portfolio maintenance session per year, you'll be less inclined to engage in off-schedule portfolio changes that you may come to regret.

Check up with greater frequency: If you take a more hands-on approach to portfolio management--for example, because you hold individual stocks in your portfolio--you may want to check in more frequently than once a year. Even so, it's worthwhile to stick to a preset schedule for your portfolio review and maintenance, and clearly outline your triggers for making changes in your investment policy statement.

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.