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Bucket Portfolio Maintenance: There's More Than One Way to Get It Done

The best strategies allow investors to be strategic when tapping long-term assets.

Note: This article is part of Morningstar's September 2016 Retirement Matters Week special report.

The bucket strategy for retirement income appears to be a model of simplicity, at least on the surface. Simply segment your investment portfolio based on when you expect to need the money, slot in the appropriate investments for each segment, then happily harvest living expenses from your portfolio for the rest of your life (provided your withdrawal rate is sustainable, of course). The key premise of bucketing is that by maintaining a liquid pool of assets at all times--consisting of one to two years' worth of living expenses--a retiree can maintain a stable standard of living while also holding a diversified pool of assets that may undergo short-term fluctuations.

That sounds straightforward enough. But things start to get somewhat more complicated when it comes to "bucket maintenance"--where to go for cash when, or ideally before, the cash bucket runs dry. Should you simply transfer money from bucket three (stocks) to two (bonds) to one (cash) on a regular, preset basis? Or should you take a more eclectic, opportunistic approach, refilling your cash bucket (bucket one) with income and dividends from bonds and stocks, rebalancing proceeds, tax-loss harvesting, and so forth? Alternatively, you could take a truly total-return- or income-oriented approach to bucket maintenance.

Each of these strategies has its pros and cons, as outlined below. Ultimately, a few of these approaches run counter to the central premises of bucketing and are, therefore, less than optimal. What I call the "strict constructionist total return" and "opportunistic" approaches will generally make the most sense for retirees wishing to employ a bucket strategy.

The Mechanical Approach Under such a strategy, a retiree would move assets from bucket two (bonds) to one (cash), and from bucket three (stocks) to two on an annual basis (on some other time-period-based frequency). The entire portfolio would become progressively more conservative as the assets in bucket three are depleted.

Pros: The strategy is simple to understand. And because the equity portion (bucket three) is apt to decline as a percentage of the portfolio over time, it reduces risk in the portfolio as the investor's time horizon grows shorter. That's something some--but not all--retirees may find desirable.

Cons: The big drawback to mechanically selling stocks and bonds on a calendar-year basis is that it doesn't take into account whether it's an opportune time to sell a given asset class. For example, someone adhering to a strictly mechanical approach to bucket maintenance would have been selling stocks and bonds throughout the 2007-09 bear market and moving them into cash, thereby leaving fewer long-term securities in place to rebound in the subsequent bull market. In this respect, such a maintenance strategy undermines one of the central attractions of bucketing: The cash sleeve is there to keep the investor from selling long-term assets at the wrong time. For that reason, such a mechanical approach to bucket maintenance isn't advisable.

The Income-Only Approach Using this strategy, bucket one is refilled with whatever income the cash, bond, and stock holdings kick off.

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.

The 'Strict Constructionist Total Return' Approach 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 the total-return approach, in contrast with the one 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 two to three years' worth of living expenses in bucket one, thereby giving the retiree more discretion over when to sell assets for rebalancing.

The Opportunistic Approach Under this strategy, a retiree takes a catholic approach to refilling 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 is apt to be less than is the case with the above-mentioned "strict constructionist total return" approach.

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