Financial planners and advisors are always talking about buckets, but what are they talking about?
Having a “Bucket Strategy” has become a routine and generally necessary step for retirees who must keep the bills paid when the paychecks disappear. Investing becomes a bifurcated task, generating income from a portion of your portfolio while preserving assets and creating growth with the rest of it. The bucket strategy places different types of assets in separate buckets, based largely on asset class risk, time, and when the assets will be required to meet living expenses.
Bucket strategy pioneer, fellow CFP Harold Evensky, uses a two-bucket approach, because having more than two, according to him, becomes harder to effectively implement and monitor. He promotes maintaining a cash reserve to meet liquidity needs over a five-year period in one bucket, and invests the remainder of client assets in longer-term assets in another.
And while some people may always operate out of a single bucket, others may find they need a dozen, which is overkill, but if you have the time, temperament and skill to manage a dozen buckets, you are undoubtedly unique.
With all due praise and deep respect for Mr. Evensky, WealthKeep believes three is probably the prime number for most investors. And unlike a Sleep Number bed, which offers a wide range of personalized settings to ensure a good night’s sleep, with buckets, three seems to get the job done, so lets flesh out the strategy.
Bucket 1: The Today Bucket
First, let’s define “today” as every day for the next 365 days.
In order to cover your day-to-day variable expenses, and your month-to-month fixed expenses, you need the reliability of cash. The downside, of course, is that you earn next to nothing in terms of current yield or return. But the big upside is that cash is there when you need it. Today. And for the next 365 days!
Cash is not subject to stock and bond market declines, and therein lies the tradeoff: You should happily accept a meaningless return for access to your dependable, reliable cash when you need it. And if, along the way, recession should rear its ugly head, cash will be king, and in a stock market downturn you will be less likely to sell off long term growth assets just to make the monthly bills. And this is when your decision to park money in cash, sacrificing yield and return, will look like utter genius!
So, how much do you put in your bucket today? How do you determine what you need in the first place? You will have to do some yellow pad analysis to determine if you have a shortfall. Just as it says, a shortfall means you ran out of cash to pay the bills. Start with the amount you think you need for one year of living expenses, and do some ciphering.
Suppose you need $50K a year to make the turnstiles turn, but between pension and social security you only receive $40K a year. That leaves a shortfall of $10K to cover. So, pop quiz: How much goes into your Today Bucket? If you said $10K, go to the head of the class! Easy peasy, right?
To take it a step further, let’s say you have $500K in total investable assets (not including your primary residence). With $10K parked in cash, you have $490K to park in your “tomorrow” buckets.
There are no commandments etched in stone regarding buckets. If you feel more comfortable with two years or three years of cash in bucket one, then do it. It’s about comfort level, but you already know that the more you have in cash, the lower your overall returns will be. And like that Sleep Number bed, everyone has a different number.
And to refine that concept a bit more, “cash” can take many forms. Current one year money should be in a money market fund for instant liquidity, but two or three year “cash” can be in laddered certificates of deposit. So, when you have depleted your one year’s worth of cash, a two year CD matures and becomes your one year money, the three year CD becomes a two year CD, and so forth.
With cash need covered, for most retirees, two more buckets of higher risk asset classes–stocks, bonds, annuities and a diversified pool of long-term holdings–will be necessary, a “Near Term Tomorrow” bucket and a “Long Term Tomorrow” bucket.
Bucket 2: For Near Term Tomorrows
This is essentially a five year bucket, and should be invested in assets with a risk and return profile matched to five years.
Fixed income securities that earn good rates of interest that can compound for the five year period. The job of Bucket 2 is to provide predictable and reliable returns that are higher than cash.
The job of Bucket 2 is to replenish Bucket 1 when necessary, so risk assets are generally not appropriate here. Just decent fixed returns from asset classes that provide a guarantee of principal (the return of every dollar you originally put in), a guaranteed rate (earning interest on principal) and compounding (earning interest on interest).
In the shortfall scenario we started above, you still have $490K to invest. How much should go into Bucket 2? There is no standard answer, but let’s say five times the amount of Bucket 1, in this case $50K, which leaves $440K for long term investing. (But there is no right or wrong answer here, only relevant answers. Relevant to your goals and circumstances.).
In this bucket, quality of assets is still more important than rate of return, so short, high quality bonds, long certificates of deposit, and fixed annuities all can get the job done.
In some cases, based on your own appetite for risk, market outlook and personal financial circumstances, preferred stock and dividend paying common stock can also be part of this bucket, and for more seasoned investors, REITs or master limited partnerships that invest in solid, income producing real estate may be another option. While situations and circumstances differ from person to person, WealthKeep believes these assets are better suited for Bucket 3.
Bucket 3: For Long Term Tomorrows
Growth is necessary in retirement. Prices go up, inflation never stops. It will cost more to live tomorrow than it does today. You need growth.
Bucket 3 is where you put risk-on assets; stocks, bonds, real estate, and physical assets or commodities. Preferably you will hold these asset classes in the form of quality no-load mutual funds, or better yet, ETFs composed of the aforementioned asset classes, to achieve proper diversification, and expense and tax management.
…three buckets is probably the prime number for most retired investors…
This is the bucket that you expect to deliver greater performance. Because you have two other buckets to take care of shorter term needs, you need to adopt the attitude that you will not tinker with Bucket 3 every day. Sure, you will modify and rebalance at given intervals, but here is where you play the long game, setting out on a strategic plan of allowing the markets to work in your favor, in context of your personal game plan. Knowing history, and holding quality diversified assets should bring you the peace of mind to not be spooked by market downturns and coerced into selling assets at the wrong time.
“At given intervals” is a key point,and like every good gardener you will need to do some maintenance. “Buy and hold’ does not mean “set and forget.” Weeding and feeding are still necessary, which is why you need to establish an allocation and rebalancing strategy right up front.
Unlike the other two buckets, this bucket has the chance of creating losses, but it is those other two buckets that will allow you to stay the course in Bucket 3 when the market growls like a bear.
…Growth is necessary in retirement. Prices go up, inflation never stops…
As time goes by, you will need to adjust assets but not necessarily your overall strategy, in all of your buckets. Bucket management is a fluid task, forcing you to pay attention to your plan and your assets on a regular basis. This is a very good thing.
At the end of year one, for instance, Bucket 1 will likely be empty, so you need to refill it by taking accumulated returns and maturing short-term assets from Bucket 2. And at some point, some long term assets from Bucket 3 will need to be liquidated, cascading the sale proceeds down to the other two.
…quality of assets is still more important than rate of return…
If Buckets are a new concept to you, it may seem confusing, but in practice it is anything but.
Also, the timing of income payments and qualified retirement plan distributions are key determinants of overall financial success, because the tax bogeyman is always lurking around the corner. Short- and long-term capital gains, ordinary income taxation, tax deferral and tax free sources must all be coordinated to generate tax-alpha, the extra amount of money you keep through smart location management.
You must understand, that the buckets can be in either taxable qualified retirement accounts (IRAs), tax free qualified retirement accounts (ROTH), or is personal taxable banking and brokerage accounts, so along with a solid allocation and rebalancing strategy, you will also need to follow a smart LOCATION strategy. (click here to read more about Asset Location.)
And it should not go without saying, a qualified investment advisor or certified financial planner can help you build and maintain a bucket strategy that will serve you for many years to come.
Good luck, and let us know how bucketing works for you!