5 Bucket-Portfolio Misconceptions

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The bucket approach to retirement income is designed to help retirees simplify their portfolio planning, but there are still plenty of misconceptions about what the bucket approach is and isn't. I'm here today with Christine Benz--she is our director of personal finance--to look at five misconceptions about the bucket approach. 

Christine, thanks for joining me.

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

Glaser: The first one that we hear a lot is that retirees think they need to have exactly three buckets and that it's a rigid formula. Is that the case?

Benz: No. So, in my bucket portfolios--I've created a lot of model portfolios on Morningstar.com--I have used three buckets. I've got that bucket one, which is the cash piece; bucket two, which is kind of an intermediate-term piece (primarily, high-quality bonds); and bucket three, which is the longer-term piece of the portfolio--for years, say, 10 and beyond of retirement (that's mainly stocks).

So, that's the construct that I've used for my model portfolios. But the only commonality that investors really need to have in mind if they want to implement this bucket approach is that you want to have that bucket one. Then, what you do with the other components of your portfolio is really up to you. You can use the three-bucket system that I talk about and work with, or you can use maybe a simplified version from financial planner  Harold Evensky--who is really the originator of this bucket strategy. He simply has the cash bucket for his clients, as well as sort of a long-term portfolio, which is bucket two.

I've also heard from retirees who are using this strategy and have four buckets. They've got buckets one, two, and three as I've kind of constructed them, and then they add a fourth bucket for long-term-care needs or possibly assets that they hope to pass to their children and grandchildren. They've segregated that money from their long-term portfolio, their spendable portfolio, because they want to make sure that they are not spending that money during their lifetimes.

So, there are different ways to think about doing this. As long as you are making sure that you have that cash bucket set aside--that bucket one--you can feel free to array the rest of your portfolio however it makes sense to you.

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Glaser: Speaking of that cash bucket, one of the misconceptions could be that if you have a lot of dividend-paying stocks or bonds that are throwing off lots of cash, then maybe you don't need that dedicated cash bucket. Are those dividend-payers a good substitute?

Benz: Not really. The key thing with that cash bucket is that this is stable money. It's not going to move around a lot in value. So, your standard of living wouldn't be disrupted in any way, even if there were some fluctuations in the longer-term portion of your portfolio. I often use 2008 as an example to illustrate why you want to have that bucket one: People who had been using dividend-payers to supply their income and cash flows in retirement saw dividend-payers--banks, in particular--slash their dividends. Those folks would be forced to regroup in the face of a very difficult market environment. By setting that cash bucket aside, you have a little bit more time to regroup and rethink your investment strategy if your cash flows have been disrupted in some way.

Glaser: The next misconception is about spending, and it has to do with withdrawals. Do you just deplete bucket one, then move to bucket two and deplete that, and then move to bucket three?

Benz: That's what people sometimes think when they look at this three-bucket system--that we're systematically depleting each bucket. That's really not how I think about maintaining these buckets on an ongoing basis. You are using bucket one to supply your spending needs, but you're periodically refilling it throughout the year. So, if you have income-producing securities, maybe you have those dividend checks sent directly to bucket one, and that will partially refill your bucket one as you spend out of it. Then, if you need to harvest additional proceeds from your portfolio, you can do some rebalancing perhaps at year-end and steer some more money into bucket one as you've spent it.

The problem with the sequential approach, where you would spend through your portfolio, is that you could imagine a situation where an 80-year-old would end up with a big bucket of stocks at the end, having spent through the cash and bonds in his or her portfolio. That's not the scenario that a lot of 80-year-olds would like to find themselves in. Most people would like to have a diversified portfolio throughout their retirement lifetimes.

Glaser: That maybe leads us to the next misconception. Do you have to be constantly rebalancing, constantly moving assets from the third bucket to the second and from the second to the first in order for this system to work?

Benz: No. Because that sounds like an awful lot of ongoing maintenance, probably more maintenance than most retirees would care to engage in. So, rather than constantly spilling money from one bucket to the next, I think it makes sense to use that basic strategy that I just talked about where you're having any income distributions sent automatically to bucket one and then just doing that once-annual rebalancing. In some years--if it's been a good year for bonds, for example--your rebalancing proceeds will come out of bucket two; in other years--like the recent past, for example, when the stock market has been especially strong--your rebalancing proceeds will come out of bucket three. But you don't constantly need to be moving money from one bucket to the next. Usually, in a given year, you'll be either tapping bucket two or bucket three for rebalancing--probably not both.

Glaser: The final misconception is about account types. Do these buckets need to fit neatly into different accounts--be it a Roth IRA or taxable account?

Benz: It would be great if it worked out that way. I sometimes hear from retirees who say, "If I have a long time horizon for my Roth IRA assets, can I put that all in bucket three?" In some cases, that might make sense; but I think retirees will want to use a general sequencing-of-withdrawal framework to guide which account types they put in which buckets.

And it's also worth keeping in mind that retirees probably want to stay flexible throughout their retirement years when determining where they go for cash. So, even though Roth assets generally are best saved for later in retirement or they're certainly great assets for your heirs to inherit from you, there might be times when you have a high tax year, where you actually need to tap those Roth assets because of the lack of tax consequences associated with tapping those accounts. So, for most retirees, they want to build in a little bit of flexibility rather than relegating an entire account to a single bucket.

Glaser: Christine, thanks for clearing up these misconceptions today.

Benz: Jeremy, it was great to be here.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.