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

The bucket approach to building a retirement portfolio

Those who lived through the 1970s and 1980s undoubtedly find their photographs from those decades to be credible. But while few want to repeat a fashion era marked by pastel-colored suits and big hair, one aspect of those decades past is appealing: significantly higher interest rates than prevail today.

The average interest rate on a six-month certificate of deposit was 9.1% in 1970 and 13.4% in 1980. Of course, inflation was also high back then, but these higher rates , as well as the prevalence of pensions, have enabled many retirees to earn a living. stream of income without encroaching on their capital or taking stock risks.

But two decades of falling interest rates have pulled yields down, making the challenge much worse for retirees. With low yields on money market accounts and high-quality bonds, retirees’ choices are difficult: to be able to afford to retire, they may plan to delay the date, save more, reduce their life or take more risk with their portfolios. .

The Bucket approach to retirement portfolio management, pioneered by financial planning guru Harold Evensky, aims to address these challenges, effectively helping retirees create a paycheck from their investment assets. While some retirees have stuck with an income-centric approach but have been forced into increasingly risky securities, the Bucket concept is rooted in the basic principle that the assets needed to fund short-term living expenses term have to stay in cash, minimal returns and all. Assets that won’t be needed for several years or more can be parked in a diversified pool of long-term holdings, with the cash buffer providing the peace of mind needed to weather periodic long-term portfolio declines.

The very important bucket 1

The keystone of any Bucket framework is a highly liquid component to meet short-term living expenses for a year or more. Cash returns are extremely low, so Bucket 1 is by no means a yield driver. But the purpose of this wallet pocket is to stabilize capital to meet income needs not covered by other sources of income. To arrive at the amount of money to hold in compartment 1, start by sketching the spending needs on an annual basis. Subtract certain non-portfolio sources of income such as Social Security or pension payments from this amount. The remaining amount is the starting point for bucket 1: it is the amount of annual income that bucket 1 will have to provide.

More conservative investors will want to double that number to determine their cash flow. Alternatively, investors concerned about the opportunity cost of so much cash might consider building a two-part cash pool – one year of living expenses in real money and one or more years of living expenses in an alternative portfolio at slightly higher yield, like a short-term bond fund. A retiree might also consider including an emergency fund in Compartment 1 to cover unexpected expenses such as car repairs, additional health costs, etc.

Bucket 2 and beyond

Although retirees can customize different frames for the number of compartments they hold and the types of assets in each, my model compartment portfolios include two additional compartments, as follows.

Bucket 2:In my framework, this portfolio segment contains five or more years of living expenses, with a focus on production and income stability. Thus, it is dominated by exposure to high-quality fixed income securities, although it may also include a small portion of high-quality dividend-paying stocks and other high-yielding securities such as limited partnerships. main. Balanced funds or funds with a conservative and moderate allocation would also be appropriate in this part of the portfolio.

Income distributions from this part of the portfolio can be used to fill Compartment 1 when these assets are depleted. Why not just spend the income proceeds directly and skip bucket 1 altogether? Because most retirees want a reasonably constant stream of income to meet their income needs. If returns are low, the retiree can maintain a constant standard of living by turning to other portfolio sources, such as proceeds from the rebalancing of Tranches 2 and 3, to fill Tranche 1.

Bucket 3: The longest part of the portfolio, Bucket 3, is dominated by equities and more volatile types of bonds such as junk bonds. Since this part of the portfolio is likely to provide the best long-term performance, periodic adjustments will need to be made to prevent the overall portfolio from becoming too stock-heavy. In the same way, this part of the portfolio will also have a much greater loss potential than Compartments 1 and 2. These components of the portfolio are in place to prevent the investor from exploiting Compartment 3 when in crisis, which would otherwise turn paper losses into real ones.

Bucket maintenance

The bucket structure calls for adding assets to bucket 1 as money is spent. Yet investors can exercise wide latitude in determining the logistics of this necessary bucket maintenance.

The following sequence will make sense in many situations:

1) Cash income from Bucket 1.

2) Income from bonds and stocks paying tranche 2 and maybe even 3 dividends. (Income-oriented investors might decide that their tranche maintenance starts and stops with these distributions.)

3) The product of the rebalancing of Buckets 2 and especially 3.

4) Main Bucket 2 withdrawals, provided the above methods have been exhausted. Such a scenario would tend to be more likely in a market environment like 2022, when bonds and stocks crashed at the same time, making it an inopportune time to unload equities. (Such a scenario would generally be a decent time to engage in a tax-loss sale, but the proceeds from that sale would be better reinvested in stocks.)

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