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.

 

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