The Bucket Approach to Retirement Allocation

If you’ve lived through the ’70s and ’80s, you’d likely wince at seeing your pictures from those decades. Most people don’t exactly revel in its fashion era, defined by big, teased hair and loud make-up. There was also the craze for muted harvest colors, which was later replaced by a neon glow. But if there’s one appealing aspect from those olden years, it would be the remarkably higher interest rates than those that predominate these days. 

There was a 9.1% and 13.4% average interest rate on a six-month deposit certificate in 1970 and 1980, respectively. Yes, inflation was soaring back then, too. But these higher interest rates, along with the prevalence of pensions, enabled a lot of retirees to create a livable steady flow of money. This was possible without them having to overrun their principal nor take risks in the stock market. 

But more than two decades of waning interest rates pushed the yields down. This severely compounded the challenge for the retirees. The serious decline in the yield on money market accounts as well as high-quality bonds resulted in dreary choices for retirees. Only two options made sense to afford retirement: Either they delay the date to save more or take more risks with stocks. 

Fortunately, there’s the bucket strategy to help you with your retirement portfolio management. This personal finance concept was pioneered by Harold Evensky, a financial planning expert, in the ’80s. His goal was to help people who are planning their retirement get the cash to live on from their investment assets. The idea is to keep assets required to fund your near-term living expenses in cash. 

On the other hand, you need to park those assets that won’t be necessary for several years or more in a diversified pool of long-term holdings. During periodic downturns in your long-term portfolio, you’ve still got cash that will serve as a buffer. Thus, you will have peace of mind as you ride out the losses.

Bucket #1

The cornerstone of the bucket framework is having a high liquid component in order to meet living expenses for a year or two. The cash here will be used to pay your day-to-day living expenses for near-term. It also serves as an emergency fund to defray any unexpected expenses like car repairs. So, you’d want to be able to access it quickly with little to no fees or penalties. Bucket #1 aims to stabilize principal to satisfy income needs that your other income sources don’t cover. 

Are you wondering how to determine how much to hold in this bucket? Just list down your annual spending needs. Then, subtract from that amount any fixed, non-portfolio income sources, like pension payments. The remaining amount will be the starting point for Bucket #1. It’s essentially the amount of annual income that Bucket #1 will have to supply.

Bucket #2

You may use different frameworks according to the number of buckets you have and the kinds of assets in each. For some people, their Bucket #2 holds five or more years’ worth of living expenses. In this portfolio sleeve, the goal is income production as well as stability. So, it’s mostly composed of high-quality fixed-income exposure. But it might also include a little bit of high-yield securities and high-quality dividend-paying equities. You may also place into this bucket a conservative to moderate, or balanced, allocation of funds. 

Bucket #3

This is the longest-term part of the portfolio. It’s dominated by stocks as well as more volatile bond types. This bucket will likely give you the best long-term performance. So, you need to perform periodic trimming to avoid turning your total portfolio into something too equity-heavy. In the same way, Bucket #3 will also have greater loss potential compared to the first two buckets. As you may have noticed, Buckets #1 and #2 are there to keep you from tapping the third bucket when it’s in a nosedive. Nobody wants their paper losses to turn into real ones. 

Tips to Maintain Your Bucket

The bucket approach encourages investors to refill the first bucket as cash is drained. Nevertheless, you can always exercise some leeway when determining the logistics for maintaining your buckets. The flow below will be sensible in various scenarios:

  • Place income derived from cash holdings into Bucket #1.
  • Take income from dividend-paying bonds and stocks from Bucket #2, and if possible, even in #3.
  • Rebalance the proceeds from Buckets #2 and #3. 
  • Once the above-mentioned strategies have been used, principal withdrawals may be taken from Bucket #2. 

Make sure you are monitoring your buckets and that you can run cash flow projections on your withdrawals so you can see if it all makes sense. Use retirement software to do this or hire a financial planner. Not all retirement and financial planning applications allow you to drill down on projections for each bucket, but the consumer-friendly retirement application called WealthTrace does. Not only can you set up your buckets, you can view the projected withdrawals every year from each account. This can help you figure out how much risk to take with each bucket and each investment account.

The bucket approach covers various risks. You get to decide how much of your assets go into each bucket. Of course, this is based on your need for financial growth matched with your risk tolerance level. Having different buckets to hold your low, medium, and high-risk investments in their correct allocations is essential for growing and protecting your wealth. 

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