Questions About Bucket Retirement Portfolio Logistics? We Have Answers

05/24/15 07:00 AM EDT
Questions About Bucket Retirement Portfolio Logistics? We Have Answers 5/24/2015 6:00:00 AM 5/24/2015 6:00:00 AM Christine Benz christine.benz@morningstar.com Christine Benz Director of Personal Finance Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz. WMT MORN SLADX VWIGX OTCFX HACAX NEWFX AVFIX OAKLX TMGFX VPCCX VTMGX TBGVX LLPFX VMSXX VWITX VTRIX RIO 690198 1 The effect of Social Security, whether target-date funds make sense, and more.

In a recent column, I tackled reader questions about my model bucket portfolios: whether they'd be vulnerable in the face of interest-rate changes, for example, and whether I've made any changes to the portfolios since the first one made its debut in late 2012. 

But readers who are using the bucket approach to managing their portfolios also have questions about bucketing in general--how they can use the strategy to both generate cash from their portfolios while also maintaining a well-balanced portfolio (and their own peace of mind). 

This week, I'll address some of those questions. 

Q: How does Social Security affect my buckets?

A: It doesn't, at least not directly. My version of bucketing involves segmenting your investment portfolio by your anticipated spending time horizon for that pot of money. However, other sources of income that you'll be able to rely on during retirement, such as Social Security or a pension, may indirectly affect the size of the buckets. 

Say, for example, you think you need $80,000 per year in total income in retirement, $30,000 of which will be supplied by Social Security. You would need your portfolio to supply the additional $50,000 of living expenses. Of course, you'd first want to check that a $50,000 annual withdrawal is a sustainable withdrawal rate. Assuming it is, your bucket one would consist of $50,000 to $100,000 worth of cash (one to two years' worth of living expenses). Bucket two, under the framework I've used in my model portfolios, would be another $400,000 ($50,000 times eight years, for years three through 10 of retirement). The remainder of the portfolio, for years 11 and beyond, would go in bucket three--assets that supply long-term growth. 

If you're one of the lucky retirees for whom a pension and Social Security supply most of your annual living expenses and you're only sipping from your portfolio, your buckets one and two would obviously be much smaller, and your bucket three would be, by far, the largest segment of your total portfolio. In this way, the large Social Security and pension payments indirectly push the portfolio into a more aggressive asset allocation. I find this to be a more helpful and intuitive way to factor Social Security and pensions into asset allocation than treating Social Security as a bond, as some pundits have suggested. 

Q: Maintaining a multibucket approach seems too complicated for many retirees. Could I use a target-date fund in place of buckets two and three? 

A: While streamlining your portfolio is a worthwhile goal, and I love target-date funds for people who are accumulating money for retirement, the retirement-income versions of many target-date funds fall short, in my opinion. That's because the retiree loses control over the portfolio's asset allocation and can't be strategic about which assets gets sold to meet any desired distributions. 

Say, for example, we're in the midst of the 2008 financial crisis and a retiree's bucket one (cash) has run dry. If her only long-term investment is a target-date fund, taking a withdrawal from that fund would mean, effectively, selling pieces of both her stock and bond portfolios. From an investment standpoint, it would be much better if she could pull her distributions from her bond holdings and leave the equity holdings in place to heal. 

By contrast, a retiree today should consider pulling any money needed to refill bucket one from her stock portfolio; that way she can reduce the risk in her total portfolio--important given that stocks aren't especially cheap today--while also harvesting cash for living expenses.

Yet, even though I wouldn't advise using all-in-one funds in lieu of buckets two and three, there are other good ways to run a simplified bucket system. A minimalist retiree could get away with bucket one (cash), bucket two (an intermediate-term bond fund), and bucket three (a U.S. stock index fund and a smaller stake in a foreign-stock index fund). I discussed the pros and cons of various bucket-streamlining ideas in this article. Of course, the fact that most of us will come into retirement with investments silo-ed across various accounts--tax-deferred, Roth, and taxable--necessarily makes bucketing more complicated than it might appear, as discussed here

Q: I hold preferred stocks in my portfolio. Should they be part of bucket two or three? 

A: As hybrid securities, preferred stocks don't fall neatly into bucket two--primarily bonds--or bucket three, which is predominantly stock. 

Although it has "stock" in its name, preferred stock has some bondlike characteristics, too. In particular, preferred-stock yields are typically much higher than the dividend yields on common stock. Preferred-stock shareholders are also higher up in the capital structure than holders of common stock, meaning that in a forced liquidation of a company's assets, preferred holders would get their share before equity owners and after bond owners. From that standpoint, preferreds are safer than stocks. 

But preferred stocks can be accompanied by substantial volatility, especially in a rising-interest-rate environment. During the past five years, for example, the standard deviation of preferred-stock funds has been twice as high as the Barclays U.S. Aggregate Bond Index; senior analyst Cara Esser warns that volatility could pick up in a rising-interest-rate environment, too. From that standpoint, it seems reasonable to use preferreds to help supply the income you need to refill bucket one, but you'd also want to make sure you have a nice long holding period in mind for them. I'd use them in bucket three or at the tail end of bucket two. And if I held them as part of bucket two, I'd make sure to hold them in addition to larger positions in high-quality short- and intermediate-term bond funds. 

Q: Where does real estate fit into my buckets? 

A: It depends on the type of real estate. If you're talking about the home that you live in, it wouldn't factor into your buckets at all. If you own property that supplies you with income you use to fund in-retirement living expenses, the amount of that income would indirectly affect your buckets. (See my answer on how Social Security affects buckets, above. If your rental income could be streaky--and income from properties is surely less certain than income from Social Security or a pension--enlarge buckets one and two accordingly.) 

If you're talking about investing in real estate securities--either individual REITs or a REIT fund or ETF--I'd use them as part of bucket three because they're stocks. You can still have their income distributions paid right into your cash bucket, however.

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