Bucket strategies provide a pot of 'safe money'

Using bucket strategies to manage clients' retirement income has become more popular in recent years and the reason is pretty simple: Dividing a client's portfolio into separate pools, or buckets, each with varying investment objectives, works. “The basic concept is to separate the investment money from the dollars that need to stay liquid,” said Harold Evensky, president and principal of Evensky & Katz LLC, a $700 million advisory firm. With the global financial crisis driving home the value of a predictable income stream, techniques to provide clients with a pot of “safe money” that generates secure income, as well as a pot or pots of money set aside for growth, should be a part of every financial adviser's toolkit. There is debate among academics and throughout the financial planning community over the optimal number of buckets to be used in the strategy. But regardless of whether the portfolio is simply split in two, or divided into a half-dozen or more separate pools, the one constant is the presence of a bucket dedicated to between two and five years of safe and liquid income.

KEEPING IT SIMPLE

Mr. Evensky, who has been using bucket strategies for more than 20 years, detailed his approach in a chapter of the book “Retirement Income Redesigned, Master Plans for Distribution” (Bloomberg Press, 2006). He prefers to keep it simple, with just two buckets: one as a cash reserve account and one for total return to keep refilling the cash bucket. Using the example of a retired client with a $1 million portfolio, Mr. Evensky said that he would allocate $900,000 to a balanced portfolio of stocks and bonds. The smaller $100,000 bucket would be invested in money market funds and short-term bonds “that have little or no chance of generating an investment loss.” With Mr. Evensky's method, he determines when assets are sold out of the total-return bucket and moved to the more liquid cash bucket in a process designed to avoid selling at a loss but also keeping the cash bucket replenished. Another simple and straightforward bucket technique involves dividing a portfolio into pools based on specific time frames. For example, in a three-bucket model, the pool of assets dedicated for use in the next five years is invested 100% in short-term liquid fixed income. The second bucket of assets, which is dedicated for between five and 10 years, might be 80% in bonds and 20% in stocks. And the long-term allocation set aside for use in more than 10 years is invested in 60% bonds and 40% stocks. As with all bucket strategies, the idea is to keep the longer-term pool exposed to enough risk to be able to fund the near-term cash bucket, which provides the retiree with a steady paycheck. At its core, the bucket strategy is similar to the kind of liability-driven investing that has been gaining popularity among pension funds. Instead of concentrating on a maximum risk-adjusted total return, the portfolio is targeting specific obligations. This shift in focus is particularly relevant when it comes to income during retirement, a time when investors are more reluctant to take on the kind of risk often required to generate longer-term income. “There's a psychological appeal of separating a portfolio into buckets, and that's why people like it,” said Mike Henkel, managing director at Envestnet Inc., a technology platform that helps advisers construct bucket models for their clients. Although one could argue that the use of buckets is merely behavioral-finance sleight of hand, he and others think that “mental accounting” has real benefits both for advisers and their clients. “We know that as a retiree, they can't afford to sell investments in a down market,” Mr. Henkel said. “But if you had three years' worth of income put aside in January 2008, you would have been OK.” Like any retirement income strategy, this isn't the answer for everyone, especially those investors without a large enough portfolio to spread across multiple buckets. And for advisers, managing multiple buckets for multiple clients presents new challenges, said Christine Benz, an analyst at Morningstar Inc. “Some advisers might find that bucket maintenance is a full-time job,” she said. The argument against going beyond two or three buckets isn't just the additional work of managing such portfolios, but also the additional transaction costs that will be incurred by clients as assets are moved between buckets in the re-balancing process. “There are challenges related to when assets should be moved and what should trigger those moves,” Ms. Benz added. “Clearly, it's important to arrive at a well-thought-out plan for bucket maintenance.” Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com.