Retirement Bucket Portfolios Made Simple

Jason Stipp: I'm Jason Stipp for Morningstar. The bucket approach to portfolio management has been garnering interest among retired and soon-to-be-retired Morningstar.com readers, but a few of those readers have told us it might be a little bit involved for them. Here to talk about how you can make a bucket approach in your portfolio with fewer moving parts is Christine Benz, our director of personal finance.

Christine, thanks for joining me.

Christine Benz: Jason, it's great to be here.

Stipp: You've written a lot of articles about the bucket approach, and you put together some model portfolios. It's a very sensible approach, but there are some moving parts. Before we talk about streamlining it, though, let's just cover the basics; what is the bucket approach?

Benz: I always like to be sure to attribute it to Harold Evensky, the financial planner in Florida--kind of the dean of financial planning. This is really his brainchild. And the key idea is that retirees need to segregate their near-term living expenses in cash accounts and keep them separate from their long-term portfolios. So, the idea is that if they have their near-term cash needs covered--it's safe and secure--the longer-term assets can be invested in longer-term securities. And they might experience some volatility, but retirees can probably put up with that, knowing that their near-term cash needs are covered. That's the central idea.

Stipp: So, there are behavioral benefits in the sense that you don't have to worry about those longer-term assets because you have the short term covered?

Benz: Exactly.

Stipp: This is a very sensible approach, but some readers would say, "Yeah, but it's maybe not quite as easy as it looks"--because you have different types of accounts: IRAs, as well as taxable accounts, for instance. You also have to maintain the bucket, which involves moving money from one to another. Understanding this, you have a few ideas regarding how you might streamline that approach. Your first idea is to limit the number of buckets you have to just two.

Benz: That's right. In my model portfolios, I've used three buckets. So, I've used a cash bucket, I've used a bucket two for intermediate-term assets, and a bucket three for long-term assets.

When Harold Evensky implements this concept, he simply has the cash bucket and then has a long-term total-return portfolio that he uses. I think retirees could reasonably do that--just have two buckets--and then periodically spill money over from that long-term bucket into bucket one as it becomes depleted. That seems like a perfectly reasonable idea and a great way to streamline, if you were so inclined.

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Stipp: Another idea you have involves reducing the number of accounts you have. So, you may have accounts with lots of different providers or different types; what's your thought there?

Benz: The thinking is that if you do have, say, multiple IRAs in your name, you can collapse them into a single IRA. If you have 401(k)s with former employers, you can roll those over into IRAs. And then even if you have, say, taxable accounts as well as tax-sheltered accounts like IRAs, you can hold them with a single provider--a single mutual fund company or brokerage firm.

The advantage of that--and this is something that I like to do with my personal accounts--is that you can see all of those accounts on a single statement. You can see your asset allocation for that total portfolio; you can see your balance for that total portfolio. So, that can be a helpful way to streamline the number of accounts.

Unfortunately, because the IRS is what it is, most of us will come into retirement with multiple account types. So, we'll have taxable assets; we'll have tax-sheltered assets; maybe Roth assets as well. And unfortunately, there's no way to further combine those account types, but there is a way to at least make sure that you don't have too many providers in the mix.

Stipp: Now, some of your model portfolios have as many as 11 holdings, but you say that you could have some smaller buckets and you might also get some cost benefits as well.

Benz: Absolutely. One idea is to simply use broadly diversified index funds in place of some of the funds and more specialized exchange-traded funds that I've used in my portfolios. So, the core here is that as long as you have that cash sleeve in the portfolio, if you have fixed-income instruments, you could potentially house those in just a total bond market index tracker, equity holdings in a U.S. total stock market index fund as well as perhaps an international index fund.

So, I think you could get away with as few as three or four individual holdings. You might not have all of the nuances that I have in my model portfolio; so, you might be missing out on, say, inflation-protected bonds, or emerging markets or aggressive bond types that hold junk bonds, for example. But I think you'll have the general flavor of the bucket strategy, and you'll have it with fewer holdings. And if you have index funds, you'll be able to reduce the overall costs associated with that portfolio, which is also a good thing.

Stipp: Let's talk a little bit about bucket maintenance, or how money might need to move from one bucket to another bucket to fund those living needs. First of all, why would you and why do you and when do you need to do that bucket maintenance?

Benz: Bucket maintenance really means that bucket one, as you're spending the money that's in it, is going to become depleted at some point. So, on an ongoing basis, you need to make sure that it is getting refilled. What I want to clarify, though, is that some people think that, if you're using this bucket strategy, you're constantly moving money from bucket three to two and two to one; it doesn't have to be that way.

So, if you are, say, an income-centric investor, you could simply have your dividend distributions--your income distributions from your bond holdings--distributed directly into your cash account. For a lot of investors, those yields may be sufficient to meet their living expenses for the year ahead. For some investors, [those distributions] might not quite get them there, so they might need to do a little bit of rebalancing; they might need to trim their most highly appreciated holdings to further increase their income distributions from the portfolio. But for a lot of investors, just simply setting that up and having those distributions automatically routed into bucket one is a way to greatly simplify this process of refilling that bucket one.

Stipp: We know readers are very fond of taking an income approach, but we also know it's been tough to take an income approach. Recently, you've been talking about taking a total-return approach; how would that intersect with the bucket approach and bucket maintenance in this case?

Benz: You absolutely can use the bucket strategy if you're a total-return investor. In that case, what you would be doing is that you would be reinvesting all of your dividend and income distributions back into your holdings and then, periodically--I would say once a year--taking a look at that portfolio and seeing where it stands in terms of its allocation versus your target and using rebalancing proceeds to refill that bucket one.

So, chances are, if you've come through a year like 2013, for example, it's your equity holdings that you want to be trimming. Those proceeds, in order to get your asset allocation back in to whack, would have been in most cases more than enough to refill bucket one. So, there are a few different ways to do it, but it needn't be especially time-consuming. You absolutely want to limit your amount of oversight because chances are you've got more things to do.

Stipp: Christine, the bucket approach is very sensible and, as you show here, it's also potentially very simple for investors to follow or it's at least a very streamlined approach they can take. Thanks for joining me today.

Benz: Thank you, Jason.

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