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“There's a hole in my bucket, dear Liza, dear Liza,
There's a hole in my bucket, dear Liza, a hole.”
- classic children’s folk song
We have the privilege of guiding many of our clients through their final working years into retirement. It’s a major life transition for most people. Beyond answering the pivotal question of how their time will now be spent, retirees must ensure their retirement portfolio strategy can support leaving the workforce.
Once retirement begins and paychecks are replaced by portfolio income, the financial stakes become higher. Careful planning improves the likelihood that your retirement savings last for your lifetime and provide for your loved ones.
There are many different approaches to creating a retirement portfolio to achieve that goal. There is no single method that applies to everyone. In my view, the best strategies can be consistently adhered to and bring you peace of mind.
Speaking of that, we all know that in investing there are times when peace of mind is priceless. The cyclical nature of stock markets means that downturns are inevitable. Historically, it has recovered and reached new heights, but it still pains us to see the damage in the moment. Your retirement years should be focused on your family and passions, not concerns about money.
One approach stands out in the financial planning world as a popular way to manage retirement savings. As we’ll see, the 3 Bucket approach is a simple way to create a portfolio that addresses asset allocation, withdrawal strategy in retirement, and rebalancing.
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Bucket 1: Cash, High-Yield Savings, CDs, Treasuries
Many consider Bucket 1 to be the most important of the 3 Bucket Strategy.
Christine Benz, Director of Personal Finance at Morningstar, calls Bucket 1 the “linchpin of any Bucket framework… a highly liquid component to meet near-term living expenses for one year or more.”
Bucket 1 is comprised of only the most conservative investments. Cash and other low volatility holdings are appropriate. I also include high-yield savings accounts, CDs, treasuries, and short duration bond funds with high credit quality in this mix.
The goal with this bucket is to include enough to cover at least two years of annual spending. If you’re receiving non-portfolio income from Social Security or pension, you can reduce the amount needed in Bucket 1 by the amount of guaranteed income.
You’ll also want to be sure you’ve included your emergency fund in Bucket 1. Together, this reserve stabilizes your portfolio principal during market downturns. It will carry you through a rough patch in equities and allows your portfolio time to recover before needing to sell stocks and income-producing bonds to meet your spending needs.
Bucket 2: High-quality Fixed Income
After ensuring short-term cash needs are met through Bucket 1, you can move onto filling Bucket 2 with investments that provide principal stability and income generation.
My approach to Bucket 2 uses fixed income bonds. I’ve seen others include real estate investment trusts and dividend paying stocks in their Bucket 2 holdings.
The idea behind having Bucket 2 is to hold enough to cover spending needs beyond the short term with a goal of income production.
After the first two years, you will eventually deplete your Bucket 1 assets through withdrawals. While you draw assets from Bucket 1, your investments in Bucket 2 are earning income. Maintaining this Bucket Strategy involves rebalancing occasionally, replenishing assets in Bucket 1 by trimming from Buckets 2 and 3.
The amount to keep in Bucket 2 varies from person to person based on their risk tolerance. Many of my retired clients keep between three to eight years of expenses in Bucket 2. Similar to Bucket 1, investments in Bucket 2 are intended to provide some stability when equity markets are volatile. We might take slightly more duration or credit risk in this second bucket to generate more income than the CDs and treasuries do. Importantly, it’s an intermediate position in terms of volatility and return as we aim for higher returns than cash but lower drawdowns than equities. As the investments in this bucket pay interest and dividends, it can be used to refill Bucket 1.
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Bucket 3: Equities for the Long-Term
In the third bucket we include assets that we intend to invest in for the long term. This usually includes equities, such as individual stocks and index funds.
Bucket 3 provides an opportunity to grow your portfolio principal. This segment of your holdings is expected to generate greater returns but with the trade-off of more volatility.
Since inflation poses a great risk to a conservative portfolio, Bucket 3 includes investments that are expected to generate returns that outpace inflation.
While this bucket targets higher returns, it’s important to remain true to the basics. Diversifying your Bucket 3 holdings across various sectors and companies will reduce the danger of being overconcentrated in one area.
Similar to Bucket 2, this bucket should be regularly rebalanced to hold an appropriate amount of assets. If the stock market delivers strong equity performance for a few years, the amount you hold in Bucket 3 may need to be trimmed to replenish the amounts in Buckets 1 and 2.
Have you ever said a word over and over again until it didn’t sound like a real word? That’s how I feel after typing “bucket” 43 times in this post!
Ask your fiduciary advisor about the 3 Bucket approach to retirement income.
Travis
Investment advisory services offered through Andrews Advisory Associates LLC, a registered investment advisor. This blog is not meant to give investment advice. Before investing in any advisory product please carefully read any disclosure documents, including without limitation, the firm’s Form ADVs. The information herein is provided for informational purposes only, and does not constitute an offer, solicitation or recommendation to sell or an offer to buy securities, investment products or investment advisory services. Nothing contained herein constitutes financial, legal, tax, or other advice. These opinions may not fit your financial status, risk and return profile or preferences. Investment recommendations may change, and readers are urged to check with their investment adviser before making any investment decisions.
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