FAQs About Retirement Portfolio Bucketing

Investing prior to retirement is a walk in the park compared with investing in the so-called decumulation phase. In the accumulation phase, the tried-and-true mantras of saving early and often and maintaining a diversified portfolio will get you 95% of the way there (and maybe even further).

But managing your portfolio in retirement requires you to sort through many more complex variables, including whether you've saved enough to retire, how much you can safely withdraw without running out of money, and what your in-retirement asset allocation should look like. Add in the current headwinds of low bond yields and worries about future volatility in bonds, and it's no wonder so many retirees are worried about their futures.

The bucket strategy I've been writing about during the past few years creates a simple framework for addressing at least some of these challenges. At its most basic, the bucket approach as envisioned by financial-planning guru Harold Evensky includes two major buckets--one holding liquid assets for living expenses and the other holding longer-term assets such as stocks and bonds. By carving out an adequate pool of liquid reserves for living expenses, the thinking goes, a retired investor can readily ride out the volatility inherent in his or her long-term assets.

In previous columns I've supplied sample "bucket" portfolios composed of Morningstar's mutual fund and exchange-traded fund picks, but those articles have also sparked questions about the logistics and specifics of bucket portfolios. I'll address some of them here.

Your bucket portfolios include one to two years' worth of living expenses in cash, but cash yields are nonexistent. Can I reduce the cash stake and use bonds instead?
While maintaining a dedicated liquidity pool (bucket 1) is central to the bucket approach, cash has been close to "dead money" during the past few years while bonds have performed much better. Nonetheless, those who leave cash in search of higher yields should do so with extreme care. Yields on cash alternatives like short-term bonds are pretty skimpy, too, yet such vehicles could be somewhat vulnerable to interest-rate and credit-related shocks--in contrast with true cash vehicles.

In lieu of holding two years' worth of living expenses in cash, you might instead consider building a two-part liquidity pool: one year's worth of true cash (certificates of deposit, money market funds, checking and savings account assets, and so on) and another year's worth of living expenses in a high-quality short-term bond fund like  T. Rowe Price Short-Term Bond (PRWBX), where volatility has historically been pretty low and management has the latitude to range across different bond market sectors.

How do I reconcile the cash stakes in the bucket approach with the cash stakes that appear in many asset-allocation frameworks such as Morningstar's Lifetime Allocation Indexes?
The bucket strategy aims to address the fact that the amount of cash you hold in retirement is a personal decision, driven first and foremost by your income needs. To determine how much to hold in cash, start by totaling your annual income needs, then subtract your expected income from other sources such as Social Security or a pension. The amount left over is what you'll need your portfolio to replace each year and should drive the amount of cash you hold in bucket 1. For example, let's say a retiree needs $42,000 in income per year, $18,000 of which is coming from Social Security and the remainder from her portfolio. On day 1 of retirement, she'll want to have between $24,000 (one year's living expenses) and $48,000 (two years) of her portfolio in cash.

Morningstar's Lifetime Allocation Indexes also include cash, even for younger investors, but those stakes are there to improve the risk/reward characteristics of the long-term portfolio, not to serve as liquid assets to meet spending needs. If you hold actively managed funds in your portfolio, chances are your long-term portfolio includes some cash already; you probably don't need to carve out a separate stake in your long-term holdings.

I'm an income-focused investor and want to avoid invading my principal. How do income-producing securities fit into the bucket framework?
One common source of confusion with total-return-oriented strategies like bucketing is that you're ignoring income producers and instead constantly digging into your principal to meet your living expenses. However, the bucket approach gives you a lot of leeway about how you refill bucket 1. One of the main ways to do so is to have income from your bonds and dividend-paying stocks flow directly into that bucket. If, after a year of taking in dividend and bond payments, bucket 1 is full, you're all set. But if that amount isn't sufficient to meet your living expenses for the year ahead, you can sell securities. Such periodic selling might be desirable to restore your portfolio to its asset-allocation targets. The past three years provide a good example of a period when such rebalancing-related selling would be desirable: Bucketers may have found the income from their bond and dividend payers insufficient to meet their income needs, but strong equity performance could mean that it's necessary to trim long-term holdings. This article provides more color on how income and total-return approaches can peacefully coexist.

I have multiple retirement accounts, including a 401(k), Roth and traditional IRAs, and taxable monies. Do I have to create multiple buckets within each account type?
No. Once you've arrived at your bucket framework--how much and what you'll hold in bucket 1 as well as your longer-term buckets--you can then think about which account types you'll use to fund each bucket.

The sequencing-of-withdrawal guidelines outlined in this article can help you marry your bucketed portfolio with your various account types. The overarching idea is that you'd want to liquidate the least tax-efficient account types first, while saving the most tax-efficient assets for your later retirement years. Generally speaking, that would call for holding taxable assets and anything with required minimum distributions in bucket 1, which is cash/cashlike, because those accounts will be among the first to be liquidated. Roth assets, by contrast, would belong in longer-term buckets and therefore would be among the most aggressively positioned holdings in the portfolio. Assets that will be taxed upon withdrawal--such as traditional IRAs and 401(k)s--could go in the middle of the bucket queue--and might hold a mixture of bonds and balanced investments. However, these are just guidelines; the proper sequencing of withdrawals is a highly individualized set of decisions. A tax professional can help you make sure you're thinking through all of the proper variables.

I have long held a REIT fund because a lot of asset-allocation research points to the value of REITs as diversifiers. Why don't your sample bucket portfolios include REITs?
Holding a small stake in REITs (say, 5% or 10% of your portfolio) can be a reasonable strategy, but I didn't include them in these portfolios for a couple of reasons. The key one is that many diversified mutual funds, such as the stock funds in both my ETF and traditional mutual fund model portfolios, have at least a small amount of real estate exposure. Thus, the sample bucket portfolios all have about 2% of their equity assets in REITs, even if there's no dedicated fund. In addition, REITs have historically had a fairly high correlation with the small-cap value sector. During the past five years, for example, the correlation between the two categories has generally ranged from 0.75 to 1.00. (A correlation score of 1.0 indicates that two assets move in lock step.) So if you have small-cap value exposure in your portfolio, owning a small real estate stake isn't likely to provide a lot of diversification. Finally, it's worth noting that REITs have had a very good performance run and the valuations are currently on the high side, according to Morningstar's equity research team. That wasn't a big consideration in my construction of these portfolios, which are strategic rather than tactical, but it's something to bear in mind if you're considering adding to REITs now.

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