Note: This article is part of Morningstar's January 2016 5-Point Retirement-Portfolio Assessment Week special report. A version of this article appeared on Sept. 14, 2015.
The linchpin concept of the bucket approach to retirement-portfolio planning is that a retiree holds a cash bucket alongside his or her long-term investments. That way, cash flows for a few years are assured, even though the value of the long-term portfolio may ebb and flow.
But how best to replenish those cash flows when the cash bucket begins to run dry? That's the subject of a fair amount of confusion. Some investors assume the retiree would move on to bucket two--primarily bonds, in my model bucket portfolios--and begin spending through that. When bucket two is gone, it's on to bucket three (and stocks). But that strategy is not optimal because it could leave a retiree with a big bucket of stocks (and no safer assets to tap) when they're at a low ebb. An all-equity portfolio isn't necessarily going to jibe with an older retiree's risk tolerance, either.
Constantly moving money from bucket three to two and two to one might seem like the alternative, and would supply ongoing cash flows into bucket one. The trouble with that constant-maintenance approach, however, is that it's too labor-intensive. Moreover, there may be years in which it doesn't make sense to pull from one of the longer-term buckets because they've lost value; it would be better to leave the assets in place to recover.
So, how should retirees use the bucket approach to supply ongoing cash flows, not just in the first few years of retirement when the cash bucket is full, but throughout retirement, too? What follows are some reasonable ways to do so; the method that's right for you will depend on your preferences as an investor.
Strategy 1: Generate Cash Flow With Income-Producing Investments
This is the most straightforward method, with the retiree regularly refilling bucket one with whatever income the cash, bond, and stock holdings kick off. The virtue of retaining bucket one even though income-producing securities are supplying needed cash flows is that it can serve as a buffer if the income production is disrupted for whatever reason--for example, if prevailing interest rates decline, a bond is called away, or a dividend-paying firm cuts its dividend.
Pros: Because it doesn't involve tapping principal, this approach guarantees not only that a retiree won't outlive his or her assets, but also that there will be principal left over for heirs or for in-retirement splurges. In addition, an income-centric approach is the lowest-maintenance, as it's easy to automate the income distributions into bucket one.
Cons: One of the central attractions of the bucket approach is that it helps a retiree smooth his or her income stream by holding a static amount in bucket one, based on real-life living expenses. But by relying only on income distributions to refill bucket one, a retiree is apt to find that income stream is buffeted around by the prevailing yield environment. Moreover, given how low yields are currently, the income-generating securities in a portfolio may not generate a livable yield at various points in time (like right now), leaving the retiree with no choice but to withdraw principal.
Best for: Investors who prefer income-producing strategies and don't mind modest volatility in their cash flows.
Strategy 2: Use Rebalancing Proceeds to Supply Cash Flows
Under this strategy, a retiree reinvests all income, dividends, and capital gains back into his or her holdings. The retiree refills bucket one with rebalancing proceeds, periodically scaling back on those holdings that have performed the best, whether stocks or bonds, to bring the total portfolio's asset-class exposures back in line with targets. (Those targets may gradually grow more conservative over time, depending on the asset-allocation glide path the retiree is using.)
Pros: The big advantage to using rebalancing proceeds to supply cash flows, in contrast with the income-centric approach outlined above, is that it's extremely plugged into market movements and valuation, forcing the investor to sell appreciated assets on a regular basis while leaving the underperforming assets in place or even adding to them. An investor using this strategy during the bear market, for example, would have been trimming high-quality bond holdings to refill bucket one, leaving potentially undervalued equity assets intact.
Cons: Rebalancing too often may prompt a retiree to prematurely scale back on an asset class, thus reducing the portfolio's total return potential. That argues for holding at least a few years' worth of living expenses in bucket one, thereby giving the retiree more discretion over when to sell assets for rebalancing.
Best for: Investors who would like to maintain tight control over their portfolios' asset allocations.
Strategy 3: Use Current Income and Rebalancing Proceeds
Under this strategy, a retiree takes a catholic approach to generating cash to refill bucket one. Income distributions from cash holdings, bonds, and dividend-paying stocks are automatically transferred to bucket one. If those distributions are insufficient to refill bucket one, the retiree can look to rebalancing proceeds, tax-loss harvesting, and required minimum distributions from buckets two and three to top up depleted cash stakes.
Pros: By directing income and dividend distributions into bucket one, this approach provides a baseline of income for living expenses. Those income distributions may also trend up in periods of market distress, as yields often move in the inverse direction of prices. That extra income, in turn, could help the retiree avoid tapping principal during a market downturn.
Cons: Because income and dividend distributions aren't being reinvested, the long-term portfolio's total return potential may be less than is the case with the above-mentioned total-return approach.
Best for: Investors who would like to receive a baseline of annual income while also ensuring steady cash flows (rebalancing picks up where income leaves off).