By Christine Benz
Here's your assignment: Gather up all of your retirement accounts and shape them into a portfolio that will supply you with the income you'll need during your retirement years.
Oh, and one other tiny to-do: You'll also need to make sure you never run out of money, even though you don't know exactly how long you'll need it.
In the past, one simple and elegant solution to the above problem was to buy an immediate annuity that would pay you a stream of income for the rest of your life. But many investors don't like the loss of control that accompanies annuities. A more temporal problem is that today's ultra-low interest rates mean payouts from such annuities are lousy right now.
One other intuitively appealing idea is to sink your portfolio into income-producing investments, such as bonds and dividend-paying stocks, and live off whatever yield they generate. That way you might never have to tap your principal at all. The big drawback, however, is that you're buffeted around by whatever the interest-rate gods serve up. When yields are up, you're living high off the hog; when they're miserly, as they have been for the better part of a decade, you have the unappetizing choice of scaling your spending way back or venturing into riskier income-producing securities to get the yield you need.
Given that each of those approaches has become more challenging in the current low-interest-rate environment, it's no wonder that so many retirees and pre-retirees have been receptive to another strategy: "bucketing" their portfolio for retirement. Originally conceived by financial-planning guru Harold Evensky, bucketing is a total-return approach in which you segment your portfolio based on when you expect to need your money. Money for near-term income needs is parked in cash and short-term bonds, while money needed for longer-range income needs remains in bonds and stocks.
Why has bucketing become so popular? First, it bows to reality by acknowledging that all but very wealthy investors will need to tap their principal during retirement; second, it provides a sensible and easy-to-use framework for doing so. And given that many retirees will live for 25 or more years in retirement, the bucket approach provides a necessary dose of long-term growth potential, enabling a retiree to hold stocks as well as safer securities for nearer-term income needs.
Bucketing also helps address some of retirees' key psychological roadblocks. By carving out a cash position in their portfolios and automating withdrawals from that account, a retiree can receive a steady paycheck, month in and month out, just like they received when they were still working. Knowing that a predictable stream of income is coming in the door can provide great peace of mind.
Moreover, holding a cash component (Bucket 1) can help retirees ride out periodic downturns in their long-term portfolios without panicking. If they know their near-term income needs are covered in the cash bucket—and, in a worst-case scenario, in their bond bucket as the next-line reserve—they're likely to be less rattled the next time stocks plunge.
Bucketing also helps retirees get away from the income-only mindset, which may not lead to an optimal outcome. 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 never touching principal might lead a retiree to underspend, forsaking quality-of-life considerations and leaving more to heirs than would be optimal.
Six Steps To Bucketing Your Retirement
Perhaps even more significantly, as yields on safe securities have shrunk to lower than 2% to 3% during the past few years, income-only investors have found themselves with a stark choice: Either stick with cash and high-quality bonds and reduce their standard of living, or venture into securities that promise a higher payout with higher volatility to boot.
Instead of relying on dividends and bond income to supply living expenses, a retiree using a bucket approach can be unrestrictive 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 fulfill some of his living expenses, but also use rebalancing proceeds, tax-loss harvesting proceeds, and so forth.
Finally, bucketing is compelling because it's flexible. A bucket portfolio can incorporate many of a retiree or pre-retiree's existing holdings, and a bucket plan can be readily customized to suit a retiree's own specifications.
For example, an older retiree with an expected 10-year time horizon might have just two buckets—one for very short-term needs and another bucket earmarked for the medium term. A younger retiree with a longer time horizon, meanwhile, might have similarly positioned short- and intermediate-term buckets as well as a sizable equity bucket for long-term growth.
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