Author: Dave Carboni

The Bucket Approach for Retirement Portfolio and Income Management

     The Bucket Approach divides a retiree’s assets into buckets for retirement portfolio management to serve retirement income needs. Pioneered by Harold Evensky in the 1980s, this approach originally used only two Buckets: a Cash Bucket (CB) and a diversified total return bucket. The purpose of the CB is to protect the retiree from having to make withdrawals from equity funds in down markets. This will allow equity funds sufficient time to recover from down markets without harming the cash flow needs of the retiree. Evensky’s CB always has two years of income available to withdraw to pay bills. Ideally, this income will supplement Social Security benefits and other guaranteed incomes the retiree may have.

     In contrast, the Total Return Bucket (TRB) consists of a diversified portfolio of Stock funds, Stock funds, real estate funds, and perhaps funds of other asset classes. Its purpose is to provide portfolio growth over time. This will allow the retiree to make increasing withdrawals from this account to cover rising expenses. In practice, the retiree will be feeding funds from the TRB to assure that the two-year Cash always has two years worth of inflation increasing expenses covered.

     “Feeding” the CB will occur at least quarterly. The retiree has a great deal of discretion in transferring funds from the TRB to CB. Typically, all income (dividends, interest, etc.) are transferred. Furthermore, quarterly rebalancing can provide additional transfers to CB, especially when growth assets move the portfolio significantly beyond its prescribed allocation. Accordingly, the “excess growth” can be added to the CB. For example, if the TRB’s prescribed allocation is 40% fixed and 60% Stock, and a market rise transforms the TRB’s portfolio to 70% Stock and 30% fixed, the 10% “excess” of Stock value may be transferred to the CB. This will provide additional cash to the CB while also serving to return the TRB’s portfolio to its prescribed asset allocation of 40% fixed and 60% Stock.

     The Bucket Approach assumes that the retiree has already calculated and assembled the following information:

  1. monthly income need,
  2. the value of the portfolio,
  3. guaranteed incomes from Social Security, pensions, and other income sources
  4. prescribed asset allocation to meet income needs (adjusted for inflation) until age 100

These values will help the retire identify:

  1. the income shortfall needed to fund the CB (two year’s worth of needed income)
  2. the minimum risk profile for the portfolio for the TRB (prescribed asset allocation)

   The retiree will need all this information to identify the amount necessary to fund the CB, and to identify the least risky asset allocation (distributed among the remaining buckets) to provide inflation adjusted purchasing power to meet the retiree’s income needs until age 100.

     Since Evensky’s initial suggestions, others have developed variations of the bucket approach. Most enhance the CB and add buckets and spread them in time segments over a 30 year period. The CB still contains guaranteed investments but generally have enough funds to cover 3 to 5 years of income not met by the retiree’s guaranteed income sources. Since there has never been a bear market exceeding three years since World War II, many suggest 3-5 years is sufficient. More conservative retirees extend the income shortfall beyond 3-5 years for added income protection.

     A Second Bucket (SB) contains investments with modest risk to principal. This will allow the retiree to generate growth greater than offered by short-term investments, while limiting downside risk. Intermediate bonds and conservative real estate funds populate the second bucket. Over time, the second will gradually meld with the first bucket providing an additional source of guaranteed funds for income. 

     The Third Bucket (TB)  contains stock funds that will rise and fall with the stock market. The retiree will need the growth this bucket provides to increase the CB as the retiree’s income needs rise to keep pace with inflation.

   As gains occur in the TB, they can be distributed to the CB to maintain it’s income cushion for the retiree’s guaranteed incomes. In down market years, the retiree can “cannabalize” the CB (draw down the principal) to meet current income needs. As noted, the presence of the CB protects the retiree from drawing down from a depleted TB in episodic stock market swoons. This will serve to preserve TB by allowing it to recover from market lows to provide the long-term inflation protection is was designed to do.

    During the first decade or so of retirement, the SB will split, adding additional guaranteed incomes to the CB. thereby adding years of income protection. The remaining assets in the SB will be distributed to the TB, thereby enhancing the amount available for inflation protection. The retiree will revisit his asset allocation at this point as a guide for how to best divide assets from the SB between the CB and the TB.

    Finally, as the retiree reaches his mid 80s he will need a late retirement income strategy. Generally, he’ll reduce the  CB to three years of income protection, and then consider annuitizing some or most of the assets remaining in the TB. At his then advanced age, annuitization will greatly increase his income while protecting him from outliving his portfolio. Health considerations, assets remaining, current income need, and legacy goals will drive the decision on how much of his portfolio (if any) to annuitize.


Filed under: Musings-Articles, Uncategorized

Retirement Income Planning

    The main challenges of retirement income planning are to create an income that lasts a lifetime, keeps pace with inflation, and allows enough flexibility to cover emergencies. While there are countless strategies to meet these challenges, they boil down to two fundamentally different approaches: the Probability based approach  and the Safety first approach.

     The Probability based approach, favored by investment manager types, has you assemble a sizable portfolio during your career and systematically draw from it during retirement to underwrite your retirement life-style. This approach requires significant participation in the Stock Market, a sizable portfolio, and a plan to deal with inevitable stock market swoons. Some call this approach the “4% Solution” drawn from the work of Bill Bengen during the 1990s. Bengen examined rolling 30 year periods from 1926 and discovered that a Portfolio of 60% S&P 500 and 40% Intermediate Bonds could sustain an annual withdrawal rate of 4% (and each year upping the withdrawal by the inflation rate). For example, a $500,000 portfolio would prescribe a $20,000 withdrawal (in retirement’s first year ($500,000 X 4% = $20,000). If inflation was 3% in year two, the next withdrawal would be $20,600 ($20,000 X  3% = $600) and so on, each year raising the annual withdrawal amount by the preceding year’s inflation rate.

     Bengen found that there was never a 30 year period among the 100 or so he studied where a portfolio was fully depleted before 30 years expired. In some 30 periods, it was nearly fully depleted, where as in other 30 year periods, the retiree could have withdrawn 8% per year and still have funds left at the end of the period. It just depended on how the markets performed and the time sequencing of market downturns occurred during the 30 year periods. Bengen assumed 30 years as a proxy for a retirement life-time.

     Many variations of “the 4% rule” have appeared over recent decades. Vanguard’s iteration suggests setting “guard rails,” allowing somewhat greater withdrawals than 4% during Stock Market booms, while requiring withdrawals less than 4% in years when the Stock Market doesn’t deliver.

     The RMD variation follows the required distribution percentages the IRS mandates from most qualified plans. Here you make withdrawals somewhat less than 4% in retirement’s early years, and gradually increasing the withdrawal percentage each year as your life expectancy shortens. 

     Some 4% strategies suggest drawing 4% plus inflation “on a total return basis” each year, combining investment income along with capital gains (and investment principal, if necessary) from the entire portfolio. Other 4% withdrawal strategies exempt guaranteed buffer (emergency) assets from annual withdrawal considerations. 

     In contrast, The Safety first approach emphasizes guaranteed incomes as the centerpiece of retirement income planning. Payouts from defined benefit pension plans, Social Security’s retirement benefits, and commercial annuities with guaranteed incomes are used to implement this approach. Withdrawals from Investment assets, though present, are used primarily to “inflation hedge” fixed incomes and to provide emergency or buffer funds. 

   The (SFA) also employs commercial annuities to “risk pool” in generating life time, guaranteed incomes, virtually impossible to assure in any other way. Insurance companies can guarantee life-time incomes because their actuaries know everyone (as a group) dies at a predictable rate. This allows the insurance company to spread the risk among populations of annuitants to cover the life-time income needs of even the longest lived. Immediate annuities, deferred income annuities, and longevity insurance (advanced life deferred annuities) in various combinations are the insurance products used to implement the plan. Each provides life income either immediately, some time in the near or distant future.

   With payout annuities you exchange a lump sum of money to an insurance company for a promise to provide you with a life-time income. The life-time income can begin immediately, some time in the near future, or in decade or more hence. For a given monthly income, the longer you delay the income to commence, the lower the cost. For example, in 2021, a 65 year could buy a a life-time annual income of $6,340 for $100,000. In contrast, a 65 year old could buy the same life-time income to begin at age 65 (20 years in the future) for only $16,000 today.

   Because some buyers of these future income products do not live to receive the payments, these unused dollars are distributed among those who do to provide them with additional income. These enhancements to the incomes of the survivors are called “mortality credits” and provide additional income to survivors difficult to replicate in any other way. Also, the IRS waives required minimum distribution (RMDs) requirements for qualified retirement plans up to $130,000 if they use advanced life deferred annuities in this way. They’re called Qualified longevity annuity contracts (QLACs). Once the life-time income is initiated, the annuitant is subject to the RMD requirements.

     Every retiree has a retirement income plan. Often, the plan is by default where the retiree never actively creates a plan but simply withdraws funds from accounts randomly. Occasionally, a retiree’s pension and Social Security represent such a large portion of his/her retirement income that plan creates itself. We hope this discussion provides you with the impetus to be an active participant in creating your own plan. The two approaches described above (Probability based approach and the Safety Approach) provide templates to consider. Retirees need to take the best of each approach for themselves to create a plan they can live with. Successful retirees will combine portions of both to reflect their needs for certainty, willingness to take risks, and legacy considerations. Good luck on your journey!



Filed under: Musings-Articles