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Take This Simple Step As You Approach Retirement

Don’t wait until the last minute to fill your cash ‘bucket.’

An illustrative image of Christine Benz, director of personal finance and retirement planning of Morningstar.

I often write about the Bucket approach to retirement portfolio planning. In a basic Bucket portfolio, a retiree holds one to two years’ worth of anticipated portfolio withdrawals in cash investments, another five to eight years’ worth in high-quality bonds, and the remainder in investments with growth potential, mainly a globally diversified basket of equities.

The virtue of that setup is that the retiree should always be able to draw living expenses from an asset class that’s in the black. After last year’s rally, US stocks were ripe for pruning in many portfolios. When rising interest rates roiled stocks and bonds in 2022, tapping cash allowed bucketed retirees to leave their longer-term investments alone. As we noted in our recent white paper on diversification and correlations, cash and high-quality bonds have been superb diversifiers for equities over the past several decades. In years when stocks are down, one or both of those asset classes will typically hold their ground.

While most retirement portfolios will include allocations to stocks and bonds in the years leading up to retirement, most retirement savers don’t hold much more than an emergency cushion in cash. Thus, an important job in the two or so years leading up to retirement—right up there with figuring out your healthcare coverage and winding down your work activities—is building up that cash cushion. In addition to being there as a source of funding when you eventually retire, cash has the salutary effect of providing a buffer if you retire earlier than you expected due to unforeseen circumstances.

The good news on building cash today is that yields are up, meaning cash holdings aren’t the “dead money” they were a few years ago. And equity investments have performed well, too. That means that most investors can build their cash stakes, at least in part, by pruning appreciated holdings.

As you build out your Bucket portfolio, here’s some guidance on the amount, source, and location of those liquid reserves.

Rightsizing Bucket 1

I always take pains to say that your cash bucket should consist of one to two years’ worth of portfolio withdrawals, not living expenses. That’s because at least some of your living expenses will likely be coming from outside your portfolio—from Social Security or a pension, for example. And the composition of those cash flow sources may well change throughout your retirement.

In order to set up your Bucket 1 initially, think through your cash flow sources for the first few years of retirement. For example, let’s say a 66-year-old wants to retire in two years and expects that he’ll need to spend $80,000 per year, in total, from his $1.5 million portfolio, at that time. He wants to delay filing for Social Security until age 70, so all of his spending will come from his portfolio in those first few years of retirement. After that, roughly half of his spending needs will come from Social Security.

If he wanted to be conservative, he could build a cash cushion consisting of $160,000—his years 1 and 2 portfolio withdrawals. His Bucket 2—high-quality bonds—would consist of eight years’ worth of portfolio withdrawals, which at that point will be $40,000 per year (his $80,000 total spending less Social Security income). The remaining $1 million and change could go into a globally diversified equity portfolio.

Where to Put the Money?

In addition to thinking through the size of your liquid reserves bucket, it’s also worth considering the “where” of it. Will you hold cash in your taxable accounts, tax-sheltered accounts, or some in both? To help answer that question, you need to consider your sequence of withdrawals in retirement. Taxable accounts are often first in the queue for retirement withdrawals because their ongoing tax costs are higher than tax-sheltered accounts. (In a taxable account, you enjoy long-term capital gains tax treatment on the sale of appreciated winners you’ve held for more than a year, but ordinary income is dunned at your higher ordinary income tax rate.) But some retirees may benefit from spending from their tax-deferred accounts early in retirement, with an eye toward reducing future required minimum distributions and tax bills. Financial planners often use sophisticated software programs to model out decumulation strategies to reduce taxes over the whole of your retirement, so this is a good spot to get some advice from a financial or tax advisor. Armed with the knowledge of where you’ll turn for your spending in the first part of your retirement, you can then figure out where best to hold your liquid reserves.

Where to Get the Money?

Once you’ve determined how much of a cash bucket you plan to set aside and where you’ll hold it, the next step is figuring out how to build it up. Ideally, you’d give yourself a couple of years to enlarge your cash position rather than having to find the money just before retirement. Many people moving into retirement will have a few options for enlarging their cash positions, including the following.

Additional savings: For preretirees who are still saving for retirement, a logical way to begin bulking up cash is to direct new contributions into cash. Say, for example, the aforementioned retiree is making the maximum allowable 401(k) contribution of $30,500 and putting another $8,000 into an IRA. By directing two years’ worth of contributions to cash in those two accounts, he could arrive at nearly half of his target cash allocation ($77,000 of his $160,000 target) by the time he reaches his retirement.

Bonuses and inheritances: Not everyone is lucky enough to receive a windfall in the years leading up to retirement. But if you’ve recently received a surprise cash injection, the assets are a logical source for bulking up cash reserves. They’re probably already in cash and in a taxable account.

Rebalancing: Another solid option is to build up cash by peeling back on highly appreciated asset classes, especially US stocks. After all, a portfolio that was 60% equity/40% bond five years ago would be more than 70% equity today, and you’re also five years closer to retirement! Trimming equities and adding those assets to cash and bonds provides a twofer for people who are closing in on retirement: It reduces risk and also helps cover cash flows for the first few years of retirement. Of course, this kind of selling can trigger a tax bill, so get some tax advice and/or concentrate rebalancing in tax-sheltered accounts to lessen the impact.

Reducing risky positions: Even if your portfolio’s asset allocation doesn’t need adjusting, you may still have problematic holdings in your portfolio: the employer stock you know you should scale back on, the individual-stock portfolio that’s duplicative of what’s in your mutual funds, or the costly active fund that hasn’t earned its keep relative to an inexpensive exchange-traded fund. Such holdings can be ideal sources when building up your cash reserves, but just be sure to mind the tax consequences if you’re selling them from a taxable account.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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About the Author

Christine Benz

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Christine Benz is director of personal finance and retirement planning for Morningstar, Inc. In that role, she focuses on retirement and portfolio planning for individual investors. She also co-hosts a podcast for Morningstar, The Long View, which features in-depth interviews with thought leaders in investing and personal finance.

Benz joined Morningstar in 1993. Before assuming her current role she served as a mutual fund analyst and headed up Morningstar’s team of fund researchers in the U.S. She also served as editor of Morningstar Mutual Funds and Morningstar FundInvestor.

She is a frequent public speaker and is widely quoted in the media, including The New York Times, The Wall Street Journal, Barron’s, CNBC, and PBS. In 2020, Barron’s named her to its inaugural list of the 100 most influential women in finance; she appeared on the 2021 list as well. In 2021, Barron’s named her as one of the 10 most influential women in wealth management.

She holds a bachelor’s degree in political science and Russian language from the University of Illinois at Urbana-Champaign.

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