My youngest son, Will, is a freshman at Indiana Univer-sity. We dropped him off there last August. As we were driving back from Blooming-ton, I was marveling at the fact that when my parents dropped me off, the only way for us to communicate was by mail or long-distance, landline telephones. Now, we can call, text, email and Facetime to be in contact with him almost instantly. It makes a parent feel better.
Retirement income generation has not improved like communication has. The average 6-month CD rate on Sept. 1, 1987, when I was a freshman at IU, was 6.79%. For the decade of the 1980s the average was 13.4% (Source: Bankrate.com).
Lower rates bring difficult decisions for those in or nearing retirement. You can work longer, save more, reduce your standard of living or take on more risk. Even after the historic increase in rates by the Federal Reserve over the last year and a half, rates are still low by historical standards. In addition to lower rates, today’s retirees must cope with a near-total disappearance of private-sector pensions. These factors have made generating an income stream to live from challenging. The bucket approach is one way to address these challenges.
The bucket approach is an asset allocation strategy that divides your retirement resources into three pools, or buckets, based on when you will access the money. The first bucket is for your living expenses in the current year. Just take the amount you need to generate from your retirement savings each month, multiply it by 12 and that is the amount you should have in the first bucket. Determining the amount needed is accomplished by taking your monthly spending and subtracting your other sources of income like social security and pensions. This pool should only be used to invest in very stable investments like savings accounts, money market accounts and short-term CDs. Liquidity and stability are the most important considerations for this bucket. Even though these assets are liquid, this account should not be considered a replacement for your emergency fund.
The second bucket contains your spending money for the next four or five years. One way to invest this money is in a “ladder” of CDs or treasury notes, with one maturing each year for the next four or five years. This bucket can be invested slightly more aggressively than the first one, but you don’t want to stray too far. With this bucket, as with the first, the most important thing is that it is liquid when you need it, and that the value is stable. At the end of year one, you will use this pool to refill the first bucket.
The third bucket is for long-term growth. The investments in this bucket can be more volatile like stocks and longer-term bonds. The objective of the bucket is to grow the portfolio over time and use the profits to replenish bucket two. This bucket will have the potential for more volatility than buckets one and two, and you should expect that every so often it will have a down year. However, the point of segregating the longer-term assets is to make it easier to accept those declines and allow time for the investments to recover. We want to avoid tapping into this bucket during slumping markets, and hopefully the long-term nature of this bucket will reduce the temptation to try to time the market. We want to be able to grow the income over time, so it is important that we can keep pace with inflation so we can maintain the purchasing power of the portfolio. It is also important to rebalance the portfolio to prevent the equity portion from becoming too large and exposing you to more risk and volatility than you intend.
The bucket structure will need periodic maintenance, such as moving assets from bucket two to bucket one to cover the next year’s spending and moving profits from bucket three to bucket two to replenish it and keep five to six years’ worth of spending in relatively stable investments. Some investors prefer to actually segregate the buckets into three different accounts. This may add clarity but is not necessary. As with most aspects of investing, the bucket approach will take discipline to work to its fullest potential.
To hear the podcast of the Smart Money Management radio show on this topic, or others, go to our website at alderferbergen.com.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Asset allocation does not ensure a profit of protect against loss.
Securities and financial planning offered through LPL Financial, a registered investment advisor.
Member FINRA/SIPC.