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More than a decade ago now, Morningstar’s director of personal finance Christine Benz interviewed Harold Evensky, the president of Evensky & Katz Wealth Management. Evensky is a pioneer in the ‘bucketing’ concept for managing retirement income, though he believes the system makes sense for anyone.
Here’s how he defined the system in the interview.
“We call it our five-year mantra. It simply means we don't believe anyone should invest money that they are going to need in the next five years. If someone says, ‘I want to buy a second home three years from now’ we will carve that out of the investment portfolio and put it in short-term bonds or cash. When it comes to retirement income, someone says, ‘I got a million dollars, I need $50,000 in a year out’ In that case, carving five years' [worth] of cash flow has too much opportunity cost, so we experimented and came up with two years. So I said, ‘OK, put two years in cash, take the other $900,000 and invest it in a total return portfolio.’ You can take that cash and set it up to pay your check once a month like a payroll check. The market can be volatile, but you know where your grocery money is coming from, so you are not going to get panicked [about] what is going down.”
Additional Reading
What’s a Bucket Approach?
The Bucket Approach to Retirement
Getting the Most from Bucket 1
Bucket Strategy Misconceptions
“The Bucket concept is anchored on the basic premise that assets needed to fund near-term living expenses ought to remain in cash, dinky yields and all. 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,” Benz explains.
Her book 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances has a complete section on buckets. She recommends a three-bucket system.She says that to arrive at the amount of money to hold in Bucket 1, start by sketching out spending needs on an annual basis, subtract from that amount any certain, nonportfolio sources of income such as government or pension payments, and the amount left over is the starting point for Bucket 1: That's the amount of annual income Bucket 1 will need to supply.
Under Benz’s framework, the Bucket 2 portfolio segment contains five or more 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 and other yield-rich securities such as master limited partnerships. Income distributions from this portion of the portfolio can be used to refill Bucket 1 as those assets are depleted.
“The longest-term portion of the portfolio, Bucket 3 is dominated by stocks and more volatile bond types such as junk bonds. 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 Buckets 1 and 2. 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,” Benz says.
Additional Reading
Asset Allocation in Retirement
Bucket Stress Test
Maintaining Your Buckets
Bucket FAQs
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