The Buckets in the Bucket Approach

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The Buckets in the Bucket Approach

The all-important bucket 1

The linchpin of any bucket framework is a highly liquid component to meet near-term living expenses for one year or more. When cash yields are close to zero, bucket 1 is close to dead money, but the goal of this portfolio sleeve is to stabilize principal to meet income needs not covered by other income sources.

To arrive at the amount of money to hold in bucket 1, start by sketching out spending needs on an annual basis. Subtract from that amount any certain, non-portfolio sources of income such as Social Security or pension payments. The amount left over is the starting point for bucket 1: That’s the amount of annual income bucket 1 will need to supply.

More conservative investors will want to multiply that figure by 2 or more to determine their cash holdings. Alternatively, investors concerned about the opportunity cost of so much cash might consider building a two-part liquidity pool—one year’s worth of living expenses in true cash and one or more year’s worth of living expenses in a slightly higher-yielding alternative holding, such as a short-term bond fund. A retiree might also consider including an emergency fund within bucket 1 to defray unanticipated expenses such as car repairs, additional health-care costs, and so on.

Bucket 2 and beyond

Although retirees may customize different frameworks for the number of buckets they hold, and the types of assets in each, consider two additional buckets, as follows.

Bucket 2: This portfolio segment contains five or more years’ worth of living expenses, with a goal of income production and stability. Thus, it’s dominated by high-quality fixed-income exposure, though it might also include a small share of high-quality dividend-paying equities and other yield-rich securities such as master limited partnerships. Balanced or conservative- and moderate-allocation funds would also be appropriate in this part of the portfolio.

Income distributions from this portion of the portfolio can be used to refill bucket 1 as those assets are depleted. Why not simply spend the income proceeds directly and skip bucket 1 altogether? Because most retirees desire a reasonably consistent income stream to help meet their income needs. If yields are low, the retiree can maintain a consistent standard of living by looking to other portfolio sources, such as rebalancing proceeds from buckets 2 and 3, to refill bucket 1.

Bucket 3: The longest-term portion of the portfolio, bucket 3 is dominated by stocks and more volatile bond types like junk bonds. Because this portion of the portfolio is likely to deliver the best long-term performance, it will require periodic trimming to keep the total portfolio from becoming too equity-heavy. By the same token, this portion of the portfolio will also have much greater loss potential than buckets 1 and 2. Those portfolio components are in place to prevent the investor from tapping bucket 3 when it’s in a slump, which would otherwise turn paper losses into real ones.