Best Practices for Bucketed Retirement Portfolios

If the many comments below my recent sample retirement portfolios are any guide, the bucket strategy clicks with investors attempting to sort out what their in-retirement portfolios should look like. There are many variations of the bucket approach (including one espoused by wealth manager Ray Lucia, who recently found himself in trouble with the SEC). But in the simple format pioneered by financial-planning guru Harold Evensky, a bucketed retirement portfolio includes a safe component--consisting mainly or entirely of cash to meet near-term income needs--as well as segregated longer-term assets such as bonds and stocks to provide income and growth for the later retirement years.

My sample portfolios of exchange-traded funds and traditional mutual funds included three buckets--one in cash and very short-term bonds; the middle one, for the intermediate portion of retirement, primarily in bonds; and a longer-term component consisting largely of stocks to fuel growth for the retiree's later years.

Yet even though the sample portfolios are straightforward, retirees' real-life financial situations aren't typically as streamlined. They might bring nonportfolio assets like annuities and pensions to the table, for example. In addition, individuals might have multiple accounts, both tax-sheltered and taxable, and couples could have different retirement dates. Finally, retirees may have different goals and risk capacities than the hypothetical couple for whom I designed the ETF and traditional mutual fund bucket portfolios. They might have a greater appetite for income and security, for example, which would call for a larger cash and bond component, or they might consider leaving money to their kids a priority. (The hypothetical couple featured in my portfolios had a very high risk capacity and were using the "last breath, last dollar" approach.)

All of those variations in situations make it important to customize your bucket strategy to suit your own needs. For would-be bucketers, here are some best practices to keep in mind as you think about structuring your portfolio.

Start With Your True Income Needs
For retirement planning, the bucket portfolios I supplied were the equivalent of tuning into a movie already in progress: At least a few key steps precede putting the bucketed portfolios together. The first one is to determine income needs during retirement, either on a monthly or annual basis. Armed with that information, you can then figure out how much of that income your certain sources of in-retirement income--Social Security, a pension, or a fixed annuity--will replace. The amount that's left over is the amount that your portfolio will have to deliver. Bucket 1 contains living expenses for the first year or two of expenses that are not being covered by external (nonportfolio) income sources such as Social Security and/or pensions.

Customize Bucket Size
My sample portfolios were geared toward very aggressive retirees. Not only did my hypothetical couple have a time horizon of 25 years, but I was also assuming a very high risk capacity. But the end result, a portfolio with a higher stake in stocks than in bonds and cash, will be too volatile for many retirees. More conservative types with shorter time horizons might reasonably enlarge buckets 1 and 2 while scaling back on the equity slice of the portfolio, provided their portfolio plan could accommodate the lower expected return rate. For example, bucket 1 could cover years 1 through 5 of retirement and feature cash for years 1 and 2 and a high-quality short-term bond fund for years 3 through 5. Bucket 2, meanwhile, could cover living expenses for years 6 through 15 of retirement while maintaining a focus on high-quality bonds and balanced funds. Assets for years 16 and beyond could be parked in stocks in bucket 3.

Don't Reinvent the Wheel
In my two sample bucket portfolios, I favored broadly diversified funds and emphasized low-maintenance products, especially index funds, ETFs, and subadvised actively managed products. My goal was to reduce the number of moving parts and craft low-cost, simple portfolios that could run themselves for a time if need be. But adopting a bucket approach shouldn't require you to start from scratch. If you have favorite investments or would incur substantial tax or trading costs to make changes to your existing mix, you should be able to incorporate many of your current holdings, including individual stocks, into a bucket plan.

Get a Program for Keeping Them Up to Date
While a bucketed portfolio might beckon in its simplicity, there's a catch: It doesn't stand still. Because assets are being depleted from bucket 1 on an ongoing basis to meet spending needs, you'll need to put in place a system for moving assets from one bucket to the next. One starting point is to send any income or dividend distributions from buckets 2 and 3 into bucket 1; depending on how much income your portfolio's longer-term components kick off, that could go a long way toward refilling the cash reserves. For additional bucket maintenance, there are two key tacks to consider. You could employ a strictly mechanistic approach, moving money from bucket 2 to 1 and 3 to 2 on a quarterly or annual basis. Alternatively, you could weave in a tactical element, using rebalancing or taxable gain/loss harvesting as an impetus to move money from the more aggressive to conservative buckets. This article discusses the logistics and key strategies for refilling your portfolio's cash stake.

Weave in Tax Management
My sample portfolios assumed that all of the assets were held in tax-sheltered accounts, but most individuals come into retirement with multiple account types--some tax-deferred (traditional IRAs, 401(k)s, 403(b)s, and 457s), some Roth, and some taxable. The trick for those marrying a bucket approach to multiple accounts is to start by determining an appropriate sequence of withdrawals for retirement, then matching the asset allocation of each portfolio to its expected liquidation date. Accounts that will be tapped earlier in retirement will go into buckets 1 and 2, while longer-term assets, especially Roth IRAs or highly appreciated individual stocks you hold in taxable accounts and expect to pass to your heirs, belong in bucket 3. This article discusses the basics of sequencing withdrawals for retirement; a financial or tax advisor can also help you tackle this part of the planning process.

See More Articles by Christine Benz