• Evergreen Wealth Management

The Bucket Approach to Investing


Evergreen Wealth advocates a “bucket approach” for asset management. We utilize 3 main buckets based on your future cash flow needs. Short term (1-5 years), Medium term (5-10 years), Long term (10+ years) cash flow needs, plus we advocate a 3-6 month + cash savings account for needs under 1 year. We manage the short-term needs using cash and core bonds. We manage the medium term using strategic bonds and the long term using stocks (dividend, growth and inflationary). This portfolio management approach has proven to be very effective over many years and should allow a peace of mind around having cash available when you need it most without selling assets at depressed prices to meet needs regardless of market conditions.

A couple of our favorite analyst from Morningstar (one of our internal resources for planning and management) recently performed a fantastic interview around the details of such “bucket approach”. It was such a powerful summary of what we believe that I wanted to share first hand.

The Bucket Approach to Asset Allocation, Part 1 – Morningstar Interview

  • Matt Coffina, CFA, Morningstar Editor, Analyst and Portfolio manager is conducting the interview. Full text was provided through one of Morningstar’s many publications which we subscribe, Stock Investor.

  • Christine Benz, Morningstar’s director of personal finance, who has kindly agreed to answer some questions about this strategy. (Because of space constraints, this will be a two-part series).

Matt Coffina: Let’s start with the basics. What is the bucket approach and how does it differ from other common asset allocation philosophies?

Christine Benz: The bucket approach is mainly useful when setting up your retirement portfolio. It can be a helpful overlay, no matter what strategy you’re using for selecting individual securities. The basic concept, which was developed by financial planning guru Harold Evensky, is that retirees can benefit from holding a cash component (“bucket 1”) alongside their long-term stock and bond portfolios. Having those liquid assets—enough to supply one or two years’ worth of living expenses—can prevent retirees from being forced to sell any of their long-term portfolio holdings at depressed prices. And, of course, holding some cash can also provide peace of mind. In the model portfolios I’ve worked on, I include two “buckets” in addition to cash: One for bonds and other assets appropriate for intermediate-term horizons, and one for stocks and other truly long-term assets. The advantage of having three buckets—cash (bucket1), intermediate-term assets such as bonds (bucket 2), and long-term assets like stocks (bucket 3)—is that a retiree can readily see which parts of the portfolio have appreciated the most and could be pruned for living expenses.

MC: So how does this work in practice? If an investor withdraws her living expenses from bucket 1, how does that bucket get refilled?

CB: The devil is in the details! First, what you’re not doing is constantly moving money from bucket 3 (stocks) to 2 (bonds) to 1 (cash). That’s too complicated and too much work. Nor are you spending sequentially through the buckets—cash first, then bonds, then stocks. That could leave you with a stock-only portfolio when you’re 80, which is not what most retirees want. I recommend retirees spend from bucket 1 each year and then replenish the cash as it becomes depleted using a combination of income from stock dividends, interest on bonds, and rebalancing proceeds. In a good year for stocks, like 2013 or 2014, the retiree will be selling highly appreciated parts of the equity portfolio. If bonds have gained at the expense of stocks, the retiree would be lightening up on bonds. And if neither stocks nor bonds had appreciated, the retiree might allow bucket 1 to be drawn down, or even move into “next-line reserves” in the bond portfolio. In my bucket portfolios, for example, I’ve included a high-quality short-term bond fund to serve as next-line reserves, in case cash is depleted and it’s not a good time to pull funds from stocks or longer-term bonds.

There are certainly different ways to do it. For example, Evensky reinvests all of his clients’ income distributions back into the long-term portfolio and relies strictly on rebalancing to meet living expenses. He doesn’t spend his clients’ bucket 1 cash on an ongoing basis—he only taps cash in years when both the stock and bond components of the portfolio are depressed. If there’s a unifying theme among the

various approaches, it’s that the retiree always maintains a cash bucket. Having that liquidity can help

avoid the trap of selling depressed assets in a down market, improving a portfolio’s longevity.

MC: What about special buckets for specific large expenses, such as a child’s college tuition or a contingency fund in case of unexpected healthcare costs?

CB: You don’t want to overcomplicate by having 10 buckets, but you do want to think of the three-bucket system as supplying your cash-flow needs during your retirement. If you have additional goals besides

retirement funding, you may want to segregate those assets from your three-bucket retirement cash flow

system. An emergency fund bucket makes a lot of sense to me—as an add-on to the three main retirement buckets—since surprise expenses can occur in retirement, too. And retirees who are self funding long-term care expenses should put those assets in a distinct bucket, to ensure that money doesn’t get lumped in with spendable assets.

MC: The reason I like the bucket approach isn’t so much the outcomes it produces—which can be similar

to other asset allocation strategies—but rather the psychological support it can provide to investors. This is especially important when you actively manage a portion of your equity allocation; there’s no point in beating the S&P 500 if you are going to panic and sell in a bear market. How can the bucket approach encourage investor discipline?

CB: You’re right that there’s really no asset allocation magic going on here. The big advantage to the bucket approach is that it can provide the peace of mind needed to hold equities through volatile market environments. And nearly everyone—regardless of life stage—needs equities because they have better growth potential than bonds or cash. The bucket approach gives retirees confidence that even in a catastrophic scenario in which stocks endure a multiyear decline, they’ll have a couple years’ living expenses set aside in cash, and several additional years’ worth of living expenses in bonds. They won’t be joining the throngs who are selling stocks in the downturns. One of the key insights we gain from looking at mutual fund inflows and outflows is that investors levy big costs on themselves from year to year by buying funds high and selling them low. Employing a bucket approach is designed to help retirees avoid those bad timing decisions that can erode long-term returns.

MC: For younger investors, it seems to me that a bucket approach could justify holding a much higher

percentage of your portfolio in stocks than is commonly recommended. For example, if you’re 45 years

old, not planning to retire for another 20 years, have the discipline to ride out the market’s ups and downs,

and already have one or two years’ living expenses in cash, why not put the rest in stocks, even if it means

your equity allocation is 90% or more?

CB: While I think the bucket approach is most useful for people who are already retired, or getting ready

to retire, it can also be a helpful lens for younger accumulators. With no imminent need for cash (apart

from the standard emergency fund), a 45-year-old can visualize why a very equity-heavy portfolio makes

the most sense. Equities can fall and stay down for a long time, but that young accumulator still won’t

have to tap the equity portfolio for living expenses, so it can eventually recover when the markets do. That said, I do think bonds should play at least some role in accumulators’ portfolios, especially starting

around age 45–50 or so. For one thing, declining stock prices are frequently accompanied by falling interest

rates, so bonds can gain in value during weak stock market environments. In contrast, cash investors don’t have the same potential for capital appreciation— they’re just stuck with lower and lower yields in such periods. One other fact of the last recession is that even though older workers experienced job losses at a lower rate than their younger counterparts, on average it took unemployed older adults a longer time to find new jobs. To me, that’s a common-sense reason to begin adding bonds to your portfolio as you age—to help tide you through such a scenario. You wouldn’t want to be unemployed and tapping your equity portfolio while it was in a trough.

MC: In the current low interest-rate environment, I suspect many investors feel tempted to reach for higher yields without realizing the risks they may be taking on, such as credit risk, liquidity constraints, or increased duration. How have low interest rates affected your view of the optimal asset allocation?

CB: It was exactly this issue that made me want to focus on retirement portfolio planning. I was constantly hearing from retirees who told me they had purchased X or Y risky security, all in the name of earning a livable income stream from their portfolios. Many of those same retirees also told me they were allergic to ever touching their principal. So my retirement portfolio concept has always been this: Let’s try to figure out an asset allocation that will allow your portfolio to grow without a crazy amount of volatility. And then, on a year-to-year basis, we’ll be opportunistic about where we go for cash. In an environment in which prevailing yields are higher, maybe we’ll be able to get all of your living expenses from yield. In other years, when the yield gods are stingy but the markets are good—and this has really been the case since 2009—we’ll get most of your living expenses from rebalancing the appreciated portions of your equity and long-term bond portfolio. And then maybe there will be years when income is low and it’s not a good time to pull from stocks or bonds; in those years we’ll be especially glad we have a cash cushion. Everyone loves income-producing securities, but there are other ways to meet your cash flow needs in retirement. That’s my message.

MC: Does the low interest-rate environment also cause you to change your recommendations with respect to lifestyle choices, for example deciding when to retire or choosing a safe withdrawal rate? What about investors who are already retired—should they be prepared to alter their spending habits in response to market conditions?

CB: Your question hits on something really important: The market environment when you retire will play a huge role in how your portfolio behaves and how much you can safely take out each year without running out of money. People who retired in the late 1960s, for example, encountered a lousy equity market in the early 1970s, followed by sky-high inflation and declining bond prices. The 4% guideline that you often see cited as a safe initial in-retirement withdrawal rate comes from this period—it’s pretty much a worst-case scenario. In most other rolling time frames of 25 to 30 years, taking out just 4% would have been too conservative. For example, in my model bucket portfolio “stress tests,” I simulated our portfolios’ returns assuming a retiree took a 4% withdrawal in 2000 (year 1 of retirement), then inflation-adjusted that dollar amount each year thereafter. In the 16-year period ending in 2015, our portfolios not only supplied desired cash flows, but ended up comfortably above where they started out. Again, there’s no magic in the asset allocation—it has just been a fairly good market environment, with decent equity and bond returns despite the crash of the dot-com bubble and the 2008– 09 financial crisis. The problem, of course, is that if you haven’t yet retired, you don’t know what the market will look like during your retirement years. It’s better to be safe than sorry. Most retirement researchers agree that a 4% initial withdrawal rate is a reasonable starting point, but it’s also wise to stay flexible. That means you should plan to ratchet down your spending in years when your portfolio has declined in value, and you can potentially take more out when it has gained a lot. If you have some flexibility in deciding your retirement date—many people do not—it’s obviously better to retire into an environment marked by relatively low equity valuations and high bond yields, because low valuations portend better future returns for the total portfolio. Unfortunately, that’s not where we are today.

*If you enjoyed this specific article please let us know. We are planning on releasing part 2 of the bucket approach when they cover it next month. If you find it of value in helping clarify how we manage portfolios shoot us an email. If we don’t hear any feedback we will simply move on to another topic, but if you enjoyed we will continue with more depth next month.

Important Disclosures

Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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