Getting Your Buckets in a Row

Jason Stipp: I'm Jason Stipp for Morningstar.

Our director of personal finance, Christine Benz, has often discussed the "bucket approach" for retirement planning on Morningstar.com. Some readers may wonder how to actually execute this plan. She is here to offer some details around some specific strategies that retirees can take implementing that bucket approach.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So before we get started, let's review the bucket approach to investing. This is something popularized by Harold Evensky. We've talked about it before, but just give us a quick refresher: What does that mean?

Benz: Well, essentially it means, at the most basic level, you are carving out a portion of your total assets before retirement and those are the assets that you will use to cover your near-term living expenses--a lot of people say one to two years' worth of living expenses--that you hold separate from your long-term assets. And the idea is that you're drawing your living expenses there, and you don't have to worry so much about fluctuations in your longer-term assets because you know that your near-term income needs are covered.

What we found in talking to our Morningstar.com users is that people find this to be a really helpful concept in constructing their portfolios. The other thing is that they, rather than using a strictly income-centric approach, where they're drawing dividends or income from their bonds, the bucket approach lets them withdraw a stable stream of income. So, you're not buffeted around by what the interest rate environment is like, and that's a particularly important consideration given how low bond yields are right now.

Stipp: If you have that bucket for your immediate living expenses, you can put your mind at rest a little bit knowing that that's covered, and so you can let those longer-term assets fluctuate day-to-day, month-to-month as they might, but knowing that probably over time, they'll work harder for you.

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Benz: Right, and that's what planners like Harold Evensky say they have observed in their practices. They have inculcated their clients on the fact that they do have those near-term living expenses set aside, so they don't have to freak out when we're going through a 2008 type market environment.

Stipp: So there are a few different ways to implement a bucket approach, and since you mentioned Harold Evensky, he has a specific way that he implements it. What's his way, as a starting point for the discussion of bucket strategies?

Benz: Well, his is quite minimalist, and that is that you've got bucket number one, near-term cash needs, and then you've got a long-term portfolio that is set up and asset allocated just like you would any other long-term portfolio. That's pretty minimalist, pretty simple. I think that that's a decent way to go about it, if you don't want to be spending too much time on "bucket maintenance." So, I think there are advantages to that sort of minimalist approach.

Stipp: So with those two buckets, what kinds of assets would you have in that near-term bucket, that bucket that you'd be drawing from in the very near future?

Benz: So that would be truly safe investments: cash, CDs, money market funds, money market accounts. Possibly, I think you could complement those true cash holdings with a short-term bond fund, but you wouldn't want to keep it any more aggressive than that.

Stipp: And in the case of a two-bucket, it sounds like the second longer-term bucket might be more diversified?

Benz: Balanced perhaps.

Stipp: So, it could be a mix of assets?

Benz: It is. So, it's bonds and stocks and commodities and whatever else you hold for intermediate and long-term cash needs.

Stipp: So, in that longer-term bucket, in the two-bucket system, how would you calculate how much you should have in stocks and how much you should have in bonds in that more diversified piece?

Benz: Well, it's pretty individualized. It would depend on your time horizon, how long you need that money to last. Certainly, the longer the time horizon, the bigger the equity component would be. It would also depend on other stable sources of income that you have that you're able to draw on. So, if you have a pension plus other sources of income, you may be able to keep that portfolio more stock heavy too, because you don't expect to tap those assets in the near term.

Stipp: But the main point about that second bucket is that it is a somewhat longer-term portfolio, it's not something that you would be tapping for your immediate needs in the next one to two or three years?

Benz: Right. You could set it up so that you do have obviously some intermediate-term assets. Those could be next in the queue; once bucket number one is depleted, those could be your go-to assets at that point.

Stipp: You have been advocating a plan that uses one more bucket, one that's sort of in between there, and more explicit for those intermediate-term needs. How do you think about the bucket strategy?

Benz: It's pretty similar to the Evensky approach, but it is three buckets. So, like his, it would have that near-term cash bucket. It would have an intermediate-term bucket that would consist mainly of high-quality bonds, intermediate-term bond funds, maybe balanced funds or conservative allocation funds.

In the sample portfolios that I have produced in the past, I have said that maybe those are the assets that would cover you in years 3 through 10 of your retirement.

Then the last bucket, bucket number three, would be your truly long-term assets, so that would be equities, that could be perhaps riskier bond types, that could be alternative asset classes like commodities--so that would be assets that would cover you in years 10 and beyond of your retirement.

Stipp: So, certainly that longer-range one, you wouldn't expect to be tapping those for a while, but you would be doing some maintenance of those three buckets. So, how would that work? Because money eventually will have to move from bucket two to bucket one, from bucket three to bucket two.

Benz: Right. So, I think people who are employing this approach absolutely need to make sure that they have bucket maintenance on their to-do list. I think annually is probably fine. The other thing to keep in mind, Jason, is I think sometimes people assume that when we're talking about bucketing it means invading principal. To fill up bucket number one, you've got to sell stuff from buckets number two or three. Not necessarily. So, I think you can be opportunistic about how you fill bucket one. It could come from equity dividends, it could come from bond income, it could come from tax-loss selling or rebalancing proceeds. So, you can be pretty flexible in terms of where you draw the income from that gets spilled into bucket number one as you refill it.

Stipp: So this isn't saying don't do income, it's saying do income but do it in this broader context.

Benz: Exactly, I think we've seen people really fall into two camps where they're total return oriented in retirement, or they are income-only oriented. I think the bucket approach really gives you a way of splitting the difference and using the best of both approaches.

Stipp: Christine, you recently put a question to our readers on Morningstar's discussion forum about how they manage a bucket approach, and we got some interesting answers that might lead some people to have other kinds of buckets, too, that could be useful. What were some of the things that readers were telling you on that forum?

Benz: First, I'll say that I was completely heartened by the well-thought-out bucket approaches that investors were using. It was great to see not just how people had constructed their portfolios but how much comfort they seem to have taken from this approach--that it really made sense to them, and you could tell that people had build portfolios that they were going to buy and hold and live with for many years. So that was great.

In terms of the additional buckets that people talked about creating--one seemed really obvious and logical to me--that's an emergency fund bucket. So, the idea behind the traditional bucketing approach is that you are setting aside enough money to cover living expenses, not extraneous expenses, not leaky roofs or broken-down cars, and so people have said, we know these things happen in everyone's lives. Whether you're working or not working, you need to set aside cash to cover some of this stuff. So people had set up emergency fund buckets. For that piece of the portfolio I would say you probably want to keep the money in relatively safe securities, probably cash or maybe even high-quality short-term or intermediate-term bonds and bond funds.

Stipp: And there is another sort of bucket for folks who are estate planning minded. What was that and what would you put in that kind of a bucket?

Benz: Some of our readers told us that they had specifically targeted a legacy bucket for their children--that they identified that it was very important to them to leave money to their children and maybe grandchildren, and so they had set aside that money, and basically by doing that, they had said, we're willing to ratchet down our own living expenses in retirement because it's important for us to have these segregated assets that we know will go to our kids.

So, they had set up portfolios that did include maybe bucket number four, that legacy-planning bucket, and I think that makes sense for people who are in that mode, and for them I think you'd want to keep in mind that you'd want to have your very longest-term assets in that area, and maybe think about some tax/estate planning as you set up that bucket. And so that would call for maybe putting highly appreciated securities there, because your heirs will receive that step-up in basis, if you hold those assets in a taxable account and they inherit them.

So I think that there are some tax planning, estate planning things you can do around bucket number four, if legacy planning is a big deal for you.

Stipp: So, Christine, the bucketing approach sounds like certainly a very sensible approach, but also one that can be customized to your individual situation.

Benz: Absolutely.

Stipp: Thanks for offering some detail on that.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.