How Pre-Retirees Can Transition to a Bucket Strategy

My model "bucket" portfolios are designed to help investors visualize how a bucket strategy would work with actual holdings; my bucket portfolio "stress tests" are meant to model the logistics of extracting cash flow from a bucketed portfolio. (This article delves into the basic idea behind bucketing.)

But the percentage allocations in my model portfolios won’t make sense for every retiree. At least some customization is crucial. Because bucketing revolves around setting aside your near-term cash in something pretty liquid, your own portfolio withdrawal amounts are the big determinant of how much to put in each bucket. A retiree with a higher spending rate will necessarily have more in safe securities than one who’s taking extremely modest withdrawals.

Moreover, the tax character of your investments--and the sequence with which you’ll tap those various pools of assets in retirement--will play a big role in how you asset-allocate those subportfolios. The account(s) that you’ll tap for your ongoing cash needs should hold a healthy component of cash (that’s what the bucket strategy is about, after all), whereas assets you’ll hold later should be positioned more aggressively.

Finally, you shouldn’t need to reinvent the wheel when it comes to your holdings in order to implement a bucket strategy. Unless you’re planning a major overhaul of your portfolio for some other reason--for example, you’d like to switch from actively managed funds to index funds and exchange-traded funds--you shouldn’t need to start from scratch when adopting a bucket approach. Making changes can be costly and trigger a tax bill, so it’s healthy to view bucketing as a gradual transition rather than a radical transformation.

If you’re getting ready to retire or already retired and in drawdown mode, here are the key steps to take when transitioning your own pre-retirement portfolio to a bucket strategy.

(1) Take stock of starting allocations. Start the process by getting a baseline read of all of your assets in aggregate. What's the asset allocation of your total portfolio? What are the asset allocations of each of your subportfolios? And crucially, if you're implementing a bucket strategy, how much cash do you have on hand?

You can view your long-term portfolio's asset allocation using the X-Ray view within Portfolio Manager. If you don't have a portfolio saved on the site, Morningstar Instant X-Ray is a quick way to get a read on your starting portfolio's actual asset allocation; you can then click "Save Instant X-Ray as a Portfolio" to refer to your portfolio on an ongoing basis.

My preferred method of monitoring portfolios on Morningstar.com is to maintain discrete portfolios for each major account type--for example, create separate portfolios for your traditional IRA, Roth IRA, and taxable holdings. That enables you to view the asset allocation of each of these subportfolios, which is important when you’re in drawdown mode and withdrawing from some of your asset pools while leaving other assets for later. You can then use the "Combine" feature (under the "Create" tab in the main navigation bar of Portfolio Manager) to create an aggregate view of your portfolio. That step saves each of your subportfolios rather than overrides them.

X-Ray will show you how much cash you have on hand, but it combines any stand-alone cash holdings you’ve entered with residual cash in your long-term holdings. For that reason, it makes sense to hand-calculate your starting cash values, thereby removing any residual cash holdings in your long-term mutual funds from the equation. Total up all cash assets that you hold in money market funds, online savings accounts, CDs, and checking and savings accounts.

(2) Set a target for your asset allocation based on your spending needs. Armed with your starting asset allocation, the next step is to think through what your asset allocation should look like, based on your proximity to spending from your portfolio. Assets that you expect to spend soon should go into investments where you have a high probability of earning a positive return over your short time horizon; for my money, that's cash. Assets for which you have a slightly longer horizon can go into high-quality bonds, and assets that you won't need to touch for many years can go into stocks. (You could take money out of stocks earlier, especially if they've appreciated a lot, but having such a long time horizon helps ensure that you'd never have to sell any stocks under duress.)

To arrive at a target allocation based on your expected spending horizon, start with your total annual in-retirement income needs (on a take-home, aftertax basis). Then subtract any nonportfolio income (Social Security, a pension) that you expect to receive in retirement. The amount that’s left over is your Year 1 portfolio withdrawal. If you’ll be withdrawing most of your portfolio spending from your tax-deferred accounts, you’ll need to "gross up" your desired spending by your tax rate. For example, if you’ll need $36,000 a year on an aftertax basis, you’re in the 22% tax bracket, and you’ll be taking that whole withdrawal from a traditional IRA, you’d need to withdraw about $46,000 to arrive at your income needs on an aftertax basis ($36,000 X (1 / 0.78) = $46,153).

Assuming your desired withdrawals are sustainable (and be sure to quadruple-check that; read this if you’re not sure), you can use that annual spending amount to structure your portfolio. I’ve typically recommended six months’ to two years’ worth of living expenses in cash investments, but the opportunity cost of cash seems incredibly low right now. If retirees would like to nudge their cash holdings up to three years’ worth of portfolio withdrawals, I wouldn’t quibble. Compare your target cash holdings with your current cash holdings to see if you need to add or subtract there. For most pre-retirees, this is the key area where portfolios will need adjusting in order to conform to a bucket strategy. If it turns out you need to add to cash, selling highly appreciated equity securities is a logical place to start.

For bond holdings, I’ve typically recommended eight or so years’ worth of portfolio withdrawals in high-quality bonds (Bucket 2) and the remainder in Bucket 3 (stocks). You can then compare your long-term portfolio’s current positioning with those targets.

As you do so, bear in mind that you’re juggling two sets of considerations--risk capacity and risk tolerance--and they can be in conflict. The aforementioned portfolio format relates strictly to risk capacity: You’re structuring your portfolio based on the amount of risk you can afford to take without having to sell out of an asset class, especially stocks, when it’s in a trough. Risk tolerance relates to your comfort level with your portfolio’s positioning; you may be taking an appropriate amount of risk given your expected spending horizon, but it’s possible that your asset allocation could lead to more portfolio gyrations than you’re comfortable with. If you adjust your portfolio to make it more conservative than you really need to be, bear in mind the interplay between asset allocation and spending rate, as discussed here.

(3) Identify the sequence of withdrawals to arrive at an asset allocation for subportfolios. If you have a single account geared toward retirement--say, a traditional IRA--organizing that portfolio into three buckets is straightforward. But most retirees bring multiple accounts into retirement--traditional and Roth IRAs and 401(k)s as well as taxable (nonretirement) accounts.

If you have multiple accounts, it’s usually a mistake to asset-allocate each of those subportfolios identically. For example, if you’ve identified an overall target allocation of 8% in cash, 40% in bonds, and 52% in stocks, you’d rarely want to allocate each of your subportfolios in precisely that same way. That’s because you probably won’t be drawing from those portfolios simultaneously; rather, you’d ideally factor in tax consequences when deciding which accounts to tap when. Financial advisors often espouse the following sequence of withdrawals to maximize the tax-saving features of tax-sheltered retirement savings vehicles: required minimum distributions if age 70 1/2, followed by taxable accounts, followed by traditional tax-deferred assets, with Roth IRA accounts bringing up the rear.

From a practical standpoint, that sequence of withdrawals means that RMD-subject IRA investors should hold at least some of their IRAs in cash, to address the fact that they’re actively drawing upon them. Non-RMD-subject investors, by contrast, could position their taxable accounts more conservatively, to address the fact that they’ll be drawing from those accounts most heavily at first. This article does a deeper dive into the relationship between the bucket portfolio and multiple accounts.

(4) Address other goals. So far we've focused primarily on asset allocation and tax considerations when transitioning to a bucket portfolio. But if you're positioning your portfolio for retirement, it's also a good time to think about any other goals you'd like to achieve. Would you like to reduce your number of accounts and the holdings within them, for example? Are you transitioning away from individual stocks and into more managed products such as ETFs? Do you need to make your taxable portfolio more tax-friendly, so that it's not kicking off frequent capital gains distributions? If you're adjusting your portfolio's asset allocation as you transition to a bucket strategy, it's a good time to see if you can achieve other goals as well.

(5) Develop an implementation strategy. Once you've identified the asset allocation you'd like to use for each of your subportfolios, it's time to formulate an implementation plan that factors in tax and transaction costs. Rejiggering your tax-sheltered accounts to align with your asset-allocation targets is straightforward; you won't incur a tax bill to give those accounts a makeover.

But taxable accounts are another story, especially if the preceding steps led you to conclude that your taxable account is too stock-heavy, given your proximity to spending from it. If you need to lighten up on appreciated assets in your taxable account and retirement is close at hand, getting your asset allocation in line should take precedence over tax considerations. That's particularly true when you consider that capital gains taxes are currently low and even zero for some taxpayers.

If you're not retiring imminently, however, you can be more artful in building up your cash position at the expense of equities. For example, you could bulk up cash by steering new contributions into that portion of your portfolio, or by directing income and dividend distributions directly to your cash account. You might also find that a more opportune time to realize capital gains/sell stocks is the year you retire; you'll have more latitude to keep your taxable income down than when you were working.

(6) Articulate your bucket-maintenance regimen. In addition to getting your buckets up and running, it's crucial to outline what maintenance regimen you'll use to maintain your buckets on an ongoing basis. Where will you go for cash? Will you spend your income distributions or reinvest them and live on rebalancing proceeds? This article coaches you on creating a retirement policy statement that articulates your approach to these and other important issues.