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Buckets: Not Just for Retirees

Accumulators with short- and intermediate-term financial goals can employ the concept, too.

My model retirement portfolios are divided into two key groups: Saver Portfolios, geared toward people accumulating assets for retirement, and Bucket Portfolios designed for people who are already retired.

The Retirement Bucket portfolios are segmented by time horizon: Bucket 1 with a very short-term horizon, Bucket 2 with an intermediate-term horizon in mind, and Bucket 3 with a long-term holding period. Retirees won't necessarily spend their money from the buckets in that sequence: Right now, for example, I'd argue that Bucket 3 is ripe for spending, given that higher-risk long-term assets have performed so well over the past decade. But holding an adequate amount in safer, shorter-term assets can help ensure that a retiree never has to raid those longer-term, higher-volatility assets when they're in a downturn. The bucket concept can also help a retiree back into an appropriate asset allocation based on his or her spending horizon, as discussed here.

The Retirement Saver portfolios forego that bucketed setup, however, because accumulators aren't yet spending from their portfolios. Without an imminent spending need, holding a dedicated cash component, which is a linchpin for the bucket approach, is too big a drag on the portfolio's results. People in accumulation mode need to emphasize investments that can grow--or at least that will keep up with inflation--in the years leading up to retirement. They can't afford to park their retirement assets in cash, which is likely to lose money on a real basis over time. Nor do they need as much in bonds as is the case for retirees who are actively spending from their portfolios. Only as retirement draws close does it make sense to begin raising cash or even earmarking significant shares of the portfolio for bonds, provided the retirement saver can sit tight through an equity-heavy portfolio through periods of market volatility.

But that assumes investors who are still earning paychecks are focused entirely on retirement with their portfolios, which of course isn't always the case. Just as retirees expect that they'll spend from their portfolios as the years go by, so may working people want and need to deploy investment assets to fund short- and intermediate-term goals. They don't always have a single-minded focus on investing for retirement. From that standpoint, the bucket concept can be helpful to them, too, in that it can show the way to an appropriate asset allocation for a particular goal given the proximity to spending.

Starting Point: Evaluate Viability The first step for accumulators who have near- and intermediate-term nonretirement goals (stuff they want to pay for within the next two to 10 years) is to articulate the "when" and "how much" associated with those goals. Ideally you'd look even further out into the future, and if you think you can do so, go for it. But from a practical standpoint, it can be difficult to predict what your spending priorities will be 10 years from now. At the other extreme, I'd argue that assets for financial goals for the next one to two years shouldn't be invested in anything but cash; the risk of loss is greater than the potential upside of venturing into investments with greater return potential.

This worksheet can help you enumerate and quantify your goals. It's easy to ponder some of these goals in the abstract ("I'd love to own a vacation home that my kids and grandkids could visit…"), but committing this information to an document (either physical or electronic) makes it much more tangible. The trade-offs between must-dos and want-to-dos also become clearer: Realistically, replacing your 12-year-old Toyota that has 250,000 miles on it is going to have to take precedence over a down payment on a vacation home.

Armed with a basic outlook for your short- and intermediate-term financial goals and what they'll cost you, you can also explore their implications for your retirement plan. If paying for a home addition will require you to pull $100,000 from your portfolio, will that expenditure hobble your ability to retire when you expected to with the income you would like to have? In short, a key step before earmarking any investment assets for short- and intermediate-term goals--and in turn bucketing them in a way that suits the shorter spending horizon--is assessing whether it's financially prudent to do that given the state of your retirement account.

Identify Where You'll Invest Assuming you've determined that some of your short- and intermediate-term spending goals are financially tenable, the next step is to identify where you'll invest for those goals. Ideally, you'd do so in a taxable (nonretirement) account that won't carry any taxes, penalties, or strictures on withdrawals prior to retirement. It's also a worthwhile practice to reserve your tax-sheltered receptacles (401(k)s, IRAs, etc.) for your longest-term goals (retirement), the better to stretch out their tax benefits. The downside of investing inside a taxable account, however, is that those investment assets will be fully taxable on a year-by-year basis and you'll also be taxed on your gains when you pull the money out in retirement. There's not much you can do about taxes on your gains when you withdraw, but you can invest tax-efficiently to reduce the ongoing drag of income and capital gains distributions.

Sample Bucket Portfolio for a Goal That's Five Years Away Assuming you're investing for a very short-term goal that's just five years away, you can use the bucket construct to set your allocations. The key is to match your time horizon to investments that have a probability of having a positive return over that time horizon.

Stocks are out; while they've been extraordinarily reliable over periods of 10 years or longer, they're too volatile for time frames of less than that. Bonds have a much higher probability of holding their ground over shorter time periods. For example, from February 1993 through January 2018, which was admittedly strong for bonds, the Bloomberg Barclays U.S. Aggregate Bond Index had a positive return in every rolling three-year time period and in 91% of rolling 12-month periods. Of course, past is not prologue. In a sustained period of rising interest rates, bond losses could be higher and more frequent than they have been in the recent past. That's why it's prudent to employ cash and short-term bonds in addition to intermediate-term bond when investing for a short-term goal.

A bucketed portfolio for a goal that's within five years could look something like the following:

Bucket 1 20%-40% cash (Checking and saving, money market, online savings accounts, etc.)

Bucket 2 40%-60% short-term bond fund 20% intermediate-term bond fund

Note that municipal bond funds will make sense for investors in higher tax brackets who are investing inside taxable accounts. And as the goal date approaches, the investor should transfer money from Bucket 2 to 1, effectively locking in any gains from that portion of the portfolio and battening down the hatches in Bucket 1.

Sample Bucket Portfolio for a Goal That's 10 Years Away Investors with spending horizons of between five and 10 years can afford to take more risk with their portfolios, but not too much risk. Thus, a bucketed portfolio for that time horizon would include a lower cash allocation and a higher weighting in intermediate-term bonds, which could incur some near-term volatility as yields trend up but are likely to return more than cash and short-term bonds over the 10-year time horizon.

Bucket 1 20% Cash

Bucket 2 20% Short-term bond fund 40% Intermediate-term bond fund 20% Equity fund

Here again, investors using taxable accounts will want to pay attention to tax efficiency; for many investors, municipal bond funds will offer a better tax-adjusted return than will taxable bond funds. A total stock market index fund or ETF would work well in the equity slot (though volatility-averse investors could forego equities altogether, too). And as with the short-term portfolio, the intermediate-term portfolio should be adjusted as the years go by and the goal date draws close, with assets being moved from Bucket 2 to 1 on a regular basis.

A version of this article originally ran on March 5, 2018.

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