Bucketing Your Retirement Portfolio? 5 Mistakes to Avoid

One of the most appealing aspects of the bucket approach to retirement portfolio planning is just how customizable it is. Retirees can readily rightsize the buckets to match their time horizons and levels of wealth. And while I've used a total-return-oriented approach to the ongoing maintenance of my model portfolios, income-oriented investors can use buckets, too. The virtue of having a cash bucket if you're an income-nik is if your portfolio's payout falls, either due to declines in prevailing interest rates or dividend cuts, you can rely on the portfolio's cash--bucket 1--to help provide a cushion as you rejigger your strategy. Having a cash bucket would've been particularly helpful to income-oriented investors in 2008, for example, as yields on high-quality bonds fell at the same time many banks were slashing their dividends.

Yet as flexible as the bucket approach is, there are also ways that investors can misuse it. One of the key points of misunderstanding is that you spend the buckets sequentially--cash first, bonds next, and stocks last. The big problem with that approach, however, is that it would leave you with a big bucket of stocks toward the end of your retirement. Not only would the whole portfolio be extraordinarily volatile at that point, but market conditions could be such that it wouldn't be a good time to take withdrawals from it, either. (I discussed various bucket-maintenance strategies in this article.)

Here are some of the other mistakes to avoid if you're adopting a bucket-portfolio approach.

1) Going overboard with the cash bucket. Last year wasn't a catastrophic year for the markets, but it did illustrate the merits of holding short-term assets as part of an in-retirement portfolio. Yields on high-quality securities, whether stocks or bonds, remain pretty underwhelming; retirees are apt to find it hard to subsist on income alone without venturing into higher-risk securities. Nor did high-quality stocks or bonds generate much in the way of capital appreciation last year, so rebalancing wouldn't have delivered much cash flow, either. In such environments, tapping a portfolio's short-term bucket can make sense. Meanwhile, having cash on hand to supply living expenses is downright essential in really beaten-down markets, because you can leave depressed portfolio holdings undisturbed.

However, that cash component doesn't come without a cost: When you factor in today's low cash yields, cash is a losing proposition on an inflation-adjusted basis. (One of my previous bucket "stress tests" showed that a portfolio with a cash component would have underperformed one that was fully invested in long-term stocks and bonds.) That means it's important not to go overboard with bucket 1, especially if you're a young retiree with a long anticipated time horizon. I've typically recommended six months to two years' worth of living expenses in cash (bucket 1) with the rest of the portfolio earmarked for stocks and bonds.

2) Getting "creative" with cash. At the opposite extreme, many retirees would, quite reasonably, rather not hold much cash at all. They'd prefer to hold bucket 1 in something with a realistic possibility of out-earning inflation--perhaps a short-term bond fund, floating-rate loan funds, or even dividend-paying stocks. The trouble is that even though all of those securities promise higher income streams than cash today, they also carry at least some risk of principal fluctuations, which could wreak havoc with your planned spending in the year or two ahead. That's one reason why my approach to bucket 1 has been to be safe rather than sorry; I'd recommend that bucket 1 assets go into true cash instruments (money market accounts, online savings accounts, etc.) rather than higher-yielding instruments.

3) Not factoring in the role of other in-retirement income sources. Would-be bucketers often struggle with how to handle non-portfolio sources of income, such as Social Security or pensions. Do they get housed in bucket 1, or…? In my version of the bucket system, the buckets house investment assets only, but non-portfolio income sources should shape the size of the buckets. For example, let's say a retiree is forecasting $80,000 of expenditures per year. If $30,000 of that will be supplied by Social Security, she'll be relying on her portfolio to deliver the additional $50,000 per year. Thus, her bucket 1 should include anywhere from $25,000 to $100,000 in cash/bucket 1 (to cover six months' to two years' worth of expenses unaccounted for by Social Security/pension).

For retirees who are lucky enough to have a very high percentage of their living expenses funded by pensions and/or Social Security, the net effect of using those non-portfolio income sources to inform bucket size is that buckets 1 and 2 are quite small, whereas bucket 3 (stocks) contains the lion's share of their portfolios. For example, let's say a retiree with a $1 million portfolio is practically sipping from his portfolio--he wants to take just $20,000 out of per year to save for his grandkids' college funds, but the rest of his income needs are covered by a pension. In that case, his bucket 1 would be anywhere from $10,000 to $40,000 (six months' to two years' worth of planned expenditures), plus any money he is holding as an emergency fund. Bucket 2 (mainly bonds)--assuming it contains five to eight years' worth of living expenses--would be anywhere from $100,000 to $160,000. The bulk of his portfolio would go into bucket 3 (stocks).

4) Not having a maintenance strategy that reflects your goals for your assets. Unless your plan is to buy an immediate annuity and call it a day, it's impossible to find a cash-flow-generating strategy for retirement that's truly hands-off. The bucket strategy is no exception. As my bucket portfolio simulations illustrate, it's essential to have an approach to "bucket maintenance"--for example, how you'll refill bucket 1 when it becomes depleted and whether and how you'll rebalance the portfolio if its allocations veer from your targets. Your approach to these issues should reflect your investment goals and philosophy. Successful bucketers will have asked (and answered) the following questions:

• How much will you hold in cash reserves on an ongoing basis?
• If you spend from bucket 1 for ongoing expenses, how often will you refill it?
• Will you refill bucket 1 with income distributions alone, rebalancing proceeds, or a combination of the two? (This article discusses that decision in greater detail.)
• Where will you go for cash if bucket 1 is depleted and your portfolio's income distributions and/or rebalancing proceeds are insufficient to meet your living expenses? What are your next-line reserves? (My simulation and all of my bucket portfolios rely on a high-quality short-term bond fund to fulfill this role.)
• What will you do if bucket 1 is in line with your targets?
• Will your asset allocation change over time--for example, become more conservative as you age? Or will you maintain a static asset allocation? How will you maintain/change your asset allocation?

5) Not factoring in tax considerations. The three-bucket approach seems so simple at first blush. And it needn't be complicated: As long as a retiree has some type of a cash account, a core bond fund, and global equity exposure, she has the key ingredients for a bucket portfolio. But most retirees' portfolios don't consist of a single account but rather several--Traditional tax-deferred, Roth, and taxable. Because each of these account types comes with different considerations regarding withdrawals, it's important to factor tax and withdrawal-sequencing issues into how the buckets are set up. This article discusses how a bucket strategy could overlay a retirement portfolio composed of several different accounts.

Mark your calendars for the 2016 Morningstar Individual Investment Conference, taking place on April 2 at 9:00 a.m. CDT. At this live-streamed event, we'll cover strategies to help you strengthen your investment plan, regardless of age or investing expertise. Register for free today.