Bucketing your retirement portfolio—or segmenting it by time horizon—won't necessarily yield the very best investment result, as financial-planning guru Michael Kitces argued in this video.
Most bucket frameworks call for keeping near-term income needs in cash. But if the cash component of the portfolio—bucket 1 in most bucket constructs—is too large, it can drag on the portfolio's returns. The opportunity cost of holding too much cash is particularly high right now, given how low certificate of deposit and money market yields are. Simply maintaining a total-return portfolio, consisting of bonds and stocks, then periodically peeling off living expenses from either asset class when rebalancing will tend to generate a higher return than a portfolio with a dedicated cash bucket. Underperforming a pure stock/bond portfolio is a particular problem for retired people who like to keep their cash cushions large—holding more than one or two years' worth of living expenses.
Using a bucket strategy also doesn't guarantee a successful retirement plan. If your withdrawal rate is too high, you choose poor investments to populate the portfolio, or you live to be 110 and your retirement kitty will only last you to age 90, a bucket strategy isn't going to save you.
Instead, the main advantages of the bucketing strategy are psychological. Although retirement brings many joys—namely, time to pursue enjoyable pastimes that you couldn't while working—the financial component can bring some angst. It's a scary mental adjustment to transition from earning a pay cheque to tapping a portfolio for living expenses. And the process of creating a portfolio that balances near-term income needs with long-term growth for your later years—and figuring out how much you can safely take out of it to ensure that you don't run out of money prematurely—is overwhelming to say the least.
Enter the bucket system. Financial planner Harold Evensky originated the bucket concept, and I've written extensively about it during the past few years. Along the way, I've heard from a lot of retirees who have said that it helps address their key concerns in a straightforward and intuitive way.
Here are some of the key psychological benefits of using a bucket portfolio.
Benefit 1: Helps Simulate the Security of a Steady Paycheque
One of the reasons retirees like social security benefits is that the government programme delivers a steady pay check, month in and month out, just like they received when they were still working. The same goes for pensions. Knowing that a predictable stream of income is coming in the door, no matter what, can provide great peace of mind.
The trouble is your State Pension won't cover all of the income needs in many retiree households, and a shrinking share of the population has a pension. A properly implemented bucket portfolio can pick up where those two income sources leave off, however. The key idea behind bucketing is that you hold a cash bucket—bucket 1—that you can tap for living expenses on an ongoing basis. You can even put those withdrawals from bucket 1 on autopilot, asking your bank or brokerage firm to send you a fixed disbursement each month. Combined with social security or any other certain sources of income you can rely upon, your pay cheque from bucket 1 can provide you with a stable cash flow to cover your living expenses.
By contrast, relying on the income distributions from your assets—whether cash, bonds or stocks—means that your pay cheque could get buffeted around depending on what the interest-rate gods are serving up. When yields are high, you can spend more, and when they're miserly, as they are at present, you have to get by on less. Chances are you'd rather not deal with that uncertainty.
There are a few keys to making this whole system work, however. One is that your cash bucket is just that; it's not invested in volatile securities where selling could force you to unload those securities when they are down. Moreover, the amount you're withdrawing from bucket 1 each year must be sustainable, passing the 4% sniff test or some other sustainable withdrawal-rate method.
Benefit 2: Helps You Ride Out Volatility in More Aggressive Assets
The length of the average retirement has been extending during the past several decades, to an average of 19 years in the UK, though it can be much longer for many retirees. That's both because rates of longevity have been increasing and because people are retiring earlier. All happy news. But longer retirements necessitate that you come into retirement with a larger nest egg than you would have needed in the past. Moreover, a longer time horizon calls for investing that money in a well-diversified portfolio that includes aggressive assets such as stocks and higher-risk bonds for long-term growth potential.
The presence of those assets can lift your portfolio's return potential and give it a much better shot at beating inflation over time, but it also increases the potential for volatility, which can create angst for retirees when things are looking bad. When the market drops and you're still working, you know that you won't be tapping your portfolio imminently, so the downturn won't hurt your standard of living. If you're thinking clearly, staying the course will seem logical.
By contrast, retirees often experience declining markets with thoughts of reining in planned travel and having to move in with their kids. That, in turn, may cause them to get defensive at precisely the wrong time, thereby damaging their portfolios' long-term return potential.
But here again, holding the cash component of a retirement portfolio—as the bucket system requires you to do—can help you ride out periodic downturns in your long-term portfolio without panicking. If you know your near-term income needs are covered in the cash bucket—and in a worst-case scenario, in your bond bucket as the next-line reserves—you're likely to be less rattled the next time stocks plunge.
Benefit 3: Gets You Away From an Unhealthy Form of Mental Accounting
Many retired investors make a strict distinction between their principal and the interest it kicks off. The former is sacrosanct, never to be touched and, ideally, left to heirs. The latter is what they must rely on to meet their living expenses.
Yet such a strategy—often classified as a behavioural finance pitfall called "mental accounting"—can be problematic from a couple of angles. For one thing, never touching principal might lead a retiree to underspend, forsaking quality-of-life considerations and leaving more to heirs than would be optimal.
Perhaps even more significantly, as yields on safe securities have shrunk to lower than 2%-3% during the past few years, income-only investors have found themselves with a stark choice: They could either stick with cash and high-quality bonds and reduce their standards of living, or they could venture into securities that promise a higher payout with higher volatility to boot.
The bucket strategy is also a form of mental accounting, but arguably a healthier one than income/principal segmentation. Instead of relying on dividends and bond income to supply living expenses, a retiree using a bucket approach can be catholic about how he replenishes the cash in bucket 1 once it becomes depleted. Such a retiree could rely on bond and dividend income from his portfolio to fulfil some of his living expenses, but also use rebalancing proceeds, tax-loss harvesting proceeds, and so forth. For example, in recent years bond income sharply decreased while the stock market has been performing well. A bucket investor would refill bucket 1 primarily by rebalancing out of stocks, meeting both income needs and employing a sound portfolio practice all at once.
