FAQs about retirement portfolio bucketing

The bucket strategy I've been writing about during the past few years creates a simple framework for addressing at least some of these challenges. At its most basic, the bucket approach as envisioned by financial-planning guru Harold Evensky includes two major buckets--one holding liquid assets for living expenses and the other holding longer-term assets such as stocks and bonds. By carving out an adequate pool of liquid reserves for living expenses, the thinking goes, a retired investor can readily ride out the volatility inherent in his or her long-term assets.

Previous articles about bucketing have sparked questions about the logistics and specifics of bucket portfolios. I'll address some of them here.

Your bucket portfolios include one to two years' worth of living expenses in cash, but cash yields are nonexistent. Can I reduce the cash stake and use bonds instead?

While maintaining a dedicated liquidity pool (bucket one) is central to the bucket approach, cash has been close to "dead money" during the past few years while bonds have performed much better. Nonetheless, those who leave cash in search of higher yields should do so with extreme care. Yields on cash alternatives like short-term bonds are pretty skimpy, too, yet such vehicles could be somewhat vulnerable to interest-rate and credit-related shocks--in contrast with true cash vehicles.

In lieu of holding two years' worth of living expenses in cash, you might instead consider building a two-part liquidity pool: one year's worth of true cash (guaranteed investment certificates, money market funds, high-interest savings accounts, and so on) and another year's worth of living expenses in a high-quality short-term bond fund like PH&N Short Term Bond & Mortgage, where volatility will likely be pretty low and management has the latitude to range across different bond-market sectors.

How do I reconcile the cash stakes in the bucket approach with the cash stakes that appear in many asset-allocation frameworks such as those used by target-date funds?

The bucket strategy aims to address the fact that the amount of cash you hold in retirement is a personal decision, driven first and foremost by your income needs. To determine how much to hold in cash, start by totalling your annual income needs, then subtract your expected income from other sources such as government benefits or pensions. The amount left over is what you'll need your portfolio to replace each year and should drive the amount of cash you hold in bucket one. For example, let's say a retiree needs $42,000 in income per year, $18,000 of which is coming from the Canada/Quebec Pension Plan and the remainder from her portfolio. On day one of retirement, she'll want to have between $24,000 (one year's living expenses) and $48,000 (two years) of her portfolio in cash.

Target-date funds also include cash, even for younger investors, but those stakes are there to improve the risk/reward characteristics of the long-term portfolio, not to serve as liquid assets to meet spending needs. If you hold actively managed funds in your portfolio, chances are your long-term portfolio includes some cash already; you probably don't need to carve out a separate stake in your long-term holdings.

I'm an income-focused investor and want to avoid invading my principal. How do income-producing securities fit into the bucket framework?

One common source of confusion with total-return-oriented strategies like bucketing is that you're ignoring income-producers and instead constantly digging into your principal to meet your living expenses. However, the bucket approach gives you a lot of leeway about how you refill bucket one. One of the main ways to do so is to have income from your bonds and dividend-paying stocks flow directly into that bucket. If, after a year of taking in dividend and bond payments, bucket one 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 it's necessary to trim long-term holdings.

I have multiple retirement accounts, including a company pension, an RRSP and taxable monies. Do I have to create multiple buckets within each account type?

No. Once you've arrived at your bucket framework--how much and what you'll hold in bucket one as well as your longer-term buckets--you can then think about which account types you'll use to fund each bucket.

The sequencing-of-withdrawal guidelines outlined in this article can help you marry your bucketed portfolio with your various account types. This article takes an even deeper dive into the topic of bucketing across multiple accounts. The overarching idea is that you'd want to liquidate the least tax-efficient account types first, while saving the most tax-efficient assets for your later retirement years.

Generally speaking, that would call for holding taxable assets and anything with required minimum withdrawals (such as RRIFs and LIFs) in bucket one, because those accounts will be among the first to be liquidated. TFSA assets, by contrast, would belong in longer-term buckets and, therefore, would be among the most aggressively positioned holdings in the portfolio. Because their assets will be taxed upon withdrawal, RRSPs could go in the middle of the bucket queue and might hold a mixture of bonds and balanced investments.

However, these are just guidelines; the proper sequencing of withdrawals is a highly individualized set of decisions. A tax professional can help you make sure you're thinking through all of the proper variables.