How to Get the Most From Bucket 1

Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. Retirees using the Bucket system probably put a lot of thought in how they invest their long-term buckets, but the cash bucket, Bucket 1, may get less attention. Joining me to share some tips for getting the most out of bucket one is Christine Benz, our director of personal finance at Morningstar.

Christine, thank you for joining us today.

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

Dziubinski: Now, let's review why Bucket 1 is there in the first place.

Benz: It's really there to serve as your spending money in case your long-term assets, your bond and your stock assets, for whatever reason are not cooperating. So, maybe your bonds aren't delivering the yield you are looking for, maybe your stocks are down, so it's not a good time to sell any pieces of those to meet your living expenses, your cash is there to meet your ongoing living expenses.

Dziubinski: And you think it's important for retirees who may not be using a Bucket system in retirement to have some cash on hand?

Benz: I do. And it's really for the same reason that I recommend it for people who are using a Bucket approach. The idea is that your long-term portfolio may be volatile at various points in time. Oftentimes or sometimes your best course is just to leave those assets undisturbed. A couple of other reasons you'd want to have at least some liquid assets in retirement would be, if you have just unanticipated expenses and those come up in retirement just as they did when you were working. And you would also want to think about whether you're an opportunistic investor. So, maybe you are someone who likes to put money to work in long-term investments when they're down. In that case, you might want to have a little bit of extra cash sitting around as well.

Dziubinski: So, then investors who are using the Bucket system, how do they figure out how much cash they need in that first bucket?

Benz: I always say it's wise to take a step back, think about your total spending needs in each year of retirement, and subtract out any of amount of those income needs that will be met through nonportfolio sources, so pension, Social Security, rental income perhaps. Any other certain sources of income that aren't coming from your portfolio, subtract those out. The amount that's left over is that you will be needing your portfolio to supply each year. I usually say retirees who are using a Bucket strategy should think about holding one to two years' worth of portfolio withdrawals in true cash instruments.

The reason I lean a little bit more toward two years versus just one would be a year like 2018 where it wasn't a great year for bonds. Intermediate-term bonds were pretty much flat, some were even a little bit down for the year. And toward the end of 2018, it wasn't a great year for stocks either. So, the idea of having two years' worth of living expenses set aside in cash would be, well, even if 2019 isn't such a great year, you can still leave your long-term portfolio undisturbed.

Dziubinski: Now, once a retiree has figured out, OK, this is how much cash I should have in Bucket 1, how does he or she decide how to deploy that cash, what to invest it in?

Benz: It's a really great point right now, Susan, because I think a lot of us had gotten used to this period where all of our cash was dead money, nothing was yielding anything, so why even bother. Well, now, if you haven't looked at it for a while, it's a good time to take a look because yields have really popped up. And so, you want to bear in mind that for most people will have a little bit of patchwork of different cash vehicles. So, you might have some money in your checking account just to meet your liquid expenses, but you might be willing to lock up your money a little bit longer in, say, a CD where you have less liquidity, but you have the chance to earn a higher yield. So, it's worth getting to know the different types of cash instruments.

Money market mutual funds right now and CDs tend to be the sources of the best yields on the market today. With money market mutual funds, you just need to bear in mind that they are not FDIC-insured, in contrast with a lot of bank-type accounts. So, bear in mind that potential risk factor, albeit very small. With CDs, bear in mind the liquidity constraints that come along with holding CDs. I often talk to retirees who build laddered CD portfolios and that can certainly be an effective strategy for wringing out more income from your cash securities. I think the key thing is to not be complacent and to not assume that you'll not earn anything on your cash because if you shop around, you can.

Dziubinski: Now, what shouldn't you be putting in that Bucket 1? Why shouldn't you be considering "cash" and what are some of the risks to look out for?

Benz: One of the key things to keep in mind is if you are someone who uses our X-ray functionality within Portfolio Manager on Morningstar.com, you can see the cash allocation, but that's taking into account residual cash holdings that might be in your mutual funds, so you might have like a large-cap growth fund, for example, that has a 10% cash holding. Well, that's going to show up in your X-ray, but that's not your money really to say to the fund manager, I want just my cash back. Unfortunately, that's not how it works. So, bear in mind that you are looking at your true cash allocations when gauging how much you have in cash.

And then another point I would make is that sometimes I talk to investors who want to nudge out on the risk spectrum a little bit in an effort to capture a higher yield. That's not really my vision of what bucket one should look like. My view would be to keep it very safe, very simple, invest in true cash instruments there and save even high-quality short-term bond funds for bucket two where you are willing to tolerate a little bit of volatility.

Dziubinski: Now, assuming a retiree has his or her Bucket system up and running, how do you go about maintaining it? What are the steps they take?

Benz: This is one thing that I think is really important to think through before you get started with a Bucket system. How are you refilling bucket one because you are spending from it on an ongoing basis? There are a few ways to go about it. One would be to rely largely on current income distributions, whether income from bonds that you hold or dividends from dividend-paying stocks. The risk is, as we saw in the wake of the financial crisis, there will be periods where yields secularly drop very, very low. So, that's a trade-off.

Another strategy would be to just use a pure total return strategy where you are reinvesting your income distributions back into the portfolio, then periodically taking a step back and reviewing are there appreciated portions in this portfolio that I could lighten up on, potentially reduce risk in this portfolio while also sending money over to bucket one because I've been spending from it. That's the pure total return strategy.

A strategy that I've come to like more and more is kind of a hybrid of the two where you build a portfolio, but you are not stretching for income production. You are just building a well-diversified portfolio and you are sending income distributions as they occur into bucket one as you spend from it, but you are also maybe once annually taking a look at that portfolio and seeing whether there's some rebalancing that you might do to meet additional cash flow needs. So, that hybrid strategy, I think, can be appealing because psychologically you are getting some cash flows through the income distributions and so, you are not relying totally on rebalancing.

Dziubinski: Yeah. Christine, thank you for joining us today. A lot of great information about how to manage cash in retirement.

Benz: Susan, my pleasure.

Dziubinski: Thank you. For Morningstar, I'm Susan Dziubinski. Thank you for watching.