A Bucket Approach to Portfolio Allocation for Retirees

One of my important functions is to advise retirees on allocating assets--a perspective that shifts at retirement from nest egg accumulation to decumulation.  The retiree goes from hoping that markets fall so that he or she can buy assets cheaply to praying for rising markets to push their nest egg higher, from which they will generate a paycheck for the next 25 years or so.

The need to generate the paycheck and the increased sensitivity to declining markets raises the potential for emotional factors to derail the whole process for the retiree.  This was seen in 2008.  With a drop in stocks of 37%, it was easy to understand the fears of those living off their nest egg.

One approach to this problem is the so-called "bucket approach" to asset allocation.  This approach provides a structure for riding out market downturns.  Although it seems unique, it actually is not so different from a standard approach--as I'll explain later.  The bucket approach is very nicely described by Christine Benz, Morningstar's Director of Research in A Bucketed ETF Portfolio for Moderate Retirees.

This article lays out a specific allocation in terms of 3 buckets with recommended ETFs for each bucket.  This creates a nice visual effect for the retiree to understand the purpose of each part of the portfolio.  The first bucket is intended to meet expenditures over the first few years and is comprised of low-risk cash equivalent types of ETFs.  The second bucket is primarily fixed income and is positioned to meet the middle years, and the 3rd bucket is riskier stocks, high-yield bonds and commodity ETFs intended to produce growth.

The advantages of the bucket approach is that, as mentioned above, it should enable the retiree to weather market downturns and visually see how the portfolio replenishes its needs.  Furthermore, it is efficient and doesn't require retirees to spend their retirement managing their portfolios.  Ms. Benz argues that her recommended portfolio should enable a retiree to withdraw 5% of assets, inflation adjusted, over a 20-year time frame.

I believe that her article is useful reading for anyone in retirement or nearing retirement.

As mentioned above, though, the bucket approach is not much different from the standard asset allocation approach.  For example, for some of the retirees I manage assets for and advise, I use the 40% stocks/60% fixed and cash allocation model.  Ten percent of this allocation is cash; so, right off the bat, the usual approach will have the 2 years' cash needs met as in the bucket approach.  Also, the 10% allocation will be replenished on an ongoing basis via portfolio re-balancing.  The 40% stocks is, as above, intended for growth; but, if stocks do very well, they could be used to replenish the other parts of the portfolio and, in fact, could be used to meet cash needs.

One stipulation I put in for retirees drawing down their nest egg is that the yield on the overall portfolio be at least 60% of  cash needs.  Thus, if the retiree is drawing down 4%, the portfolio needs to yield at least 2.4%.  This may mean some jockeying into dividend ETFs, etc.  Thinking about this a bit, you'll realize that more than 2 years' protection is built in !

Furthermore, if the market is down, all cash flows go to cash.  We live in a world where markets have always recovered (at least in the U.S.) and, thus, people believe they always will.  Those in retirement need to be careful, I believe, in making this assumption.

Are You an Accumulator or a Decumulator?

Accumulators are adding to their nest egg. Many are dollar-cost-averaging (DCA) by investing a fixed number of dollars on a regular basis. As long as they don't plan to start drawing funds within the next 5 years, they should love a market that is dropping because they can lower the average cost of their shares. Young people pay attention! Even in a market that goes nowhere over an extended period, accumulators can come out ahead by continuing to buy as prices drop. DCA is a relatively simple process. Decide on how your investments are to be allocated, and then sit back and watch it take place pretty much automatically.

Decumulators are in an entirely different boat. One that can sink them in a declining market if they aren't careful. They are drawing a paycheck from their nest egg. They are said to be on distribution. They are in the opposite situation of DCA and, therefore, need to be careful. It's not just a matter of reversing the accumulation process and selling a given number of shares of stocks or funds across the board. Doing such would require selling more shares in a declining market to raise the required distribution. Instead, decumulators need to think about a plan whereby they set up a short term fund from which to fund their distribution. Typically this fund is started with at least payments for 9 months and longer. For example, if a retiree requires $3,000/month from his or her nest egg, they would want to put at least $27,000 in the fund. Next, you need to replenish - aggressively in a down market. This requires dividends and interest to go into the fund. If you decide to reduce stock exposure by 5%, it should go into the fund.

This process has enabled decumulators to avoid having to liquidate stocks at fire sale prices and, therefore, keeps positioning structured for the next market upturn.

In the absence of a thought-out plan, it is easy to have emotions come to the forefront and dominate the investment process.

Bottom Line
Accumulators: enjoy the market and buy on the cheap.
Decumulators: proceed in line with your plan.