Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

As interest rates have hovered near historic lows for the better part of a decade, producing sufficient investment income in retirement has become a significant challenge. For those approaching retirement, the choices are stark: To be able to afford retirement, they can plan to delay the date, save more, reduce their standards of living, or take more risks with their portfolios.

The bucket approach to retirement-portfolio management, pioneered by financial-planning guru Harold Evensky, aims to meet those challenges, effectively helping retirees create a paycheck from their investment assets. Whereas some retirees have stuck with an income-centric approach, but have been forced into ever-riskier securities, the bucket concept is anchored on the basic premise that assets needed to fund near-term living expenses ought to remain in cash, regardless of yield. Assets that will not 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.

The All-Important First Bucket
The linchpin of any bucket framework is a highly liquid component to meet near-term living expenses for one year or more. With cash yields close to zero currently, bucket one is close to dead money, but the goal of this portfolio sleeve is to stabilize principal to meet income needs not covered by other income sources. To arrive at the amount of money to hold in bucket one, start by sketching out spending needs on an annual basis. Subtract from that amount any certain, non-portfolio sources of income such as Social Security or pension payments. The amount left over is the starting point for bucket one: The amount of annual income required of bucket one.

More conservative investors will want to multiply that figure by two or more to determine their cash holdings. Alternatively, investors concerned about the opportunity cost of so much cash might consider building a two-part liquidity pool—one year's worth of living expenses in true cash and at least one year's worth of living expenses in a slightly higher-yielding alternative holding, such as a short-term bond fund. A retiree might also consider including an emergency fund within bucket one to defray unanticipated expenses such as car repairs, additional health-care costs, and so on.

Bucket Two
This portfolio segment contains five or more years' worth of living expenses, with a goal of income production and stability. Thus, it is 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. Balanced or conservative- and moderate-allocation funds would also be appropriate in this part of the portfolio.

Income distributions from this portion of the portfolio can be used to refill bucket one as those assets are depleted. Why not simply spend the income proceeds directly and skip bucket one altogether? Because most retirees desire a reasonably consistent income stream to help meet their income needs. If yields are low—as they are now—the retiree can maintain a consistent standard of living by looking to other portfolio sources, such as rebalancing proceeds from buckets two and three, to refill bucket one.

Bucket Three
The longest-term portion of the portfolio, bucket three is dominated by stocks and more volatile fixed income investments 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 one and two. Those portfolio components are in place to protect the investor from needing to bucket three when it is in a slump, which would otherwise turn paper losses into real ones.

Bucket Maintenance
The bucket structure calls for adding assets back to bucket one as the cash is spent down. There are two approaches to bucket maintenance that are generally recommended. The first is for the investor to reinvest all income, dividends, and capital gains back into his or her holdings. The retiree refills bucket one with the proceeds from rebalancing, periodically scaling back on those holdings that have performed the best, whether stocks or bonds, to bring the total portfolio's asset-class exposures back in line with targets. Those targets may gradually grow more conservative over time, depending on the asset-allocation glide path the retiree is using.

The big advantage to this approach is that it is attuned to market movements and valuation, forcing the investor to sell appreciated assets on a regular basis while leaving the underperforming assets in place or even adding to them. An investor using this strategy during a bear market, for example, would be trimming high-quality bond holdings to refill bucket one, leaving potentially undervalued equity assets intact. However, rebalancing too often may prompt a retiree to prematurely scale back on an asset class, thus reducing the portfolio's total return potential. That argues for holding at least two to three years' worth of living expenses in bucket one when using this maintenance approach, thereby giving the retiree more discretion over when to sell assets for rebalancing.

The second widely accepted approach to bucket maintenance calls for income distributions from cash holdings, bonds, and dividend-paying stocks to be automatically transferred to bucket one. If those distributions are insufficient to refill bucket one, the retiree can look to rebalancing proceeds, tax-loss harvesting, and required minimum distributions from buckets two and three to top up depleted cash stakes. By directing income and dividend distributions into bucket one, this approach provides a baseline of income for living expenses. Those income distributions may also trend up in periods of market distress, as yields often move in the inverse direction of prices. That extra income, in turn, could help the retiree avoid tapping principal during a market downturn. However, because income and dividend distributions are not reinvested when following this approach, the long-term total return potential for the portfolio will be reduced.

To learn more about retirement income strategies and if the bucket approach is right for you, meet with your Financial Advisor.