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Vanguard : The bucket strategy for retirement investing

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12/03/2015 | 02:30pm CET

Maria Bruno: Hi, I'm Maria Bruno, senior retirement strategist at Vanguard. And I have the pleasure today of being here with Christine Benz, director of personal finance at Morningstar.

Now I'm usually the one sitting here answering retirement questions, but today we're turning the tables a bit and I'll be asking Christine to share her retirement expertise on some of the planning topics that I also cover. So, Christine, thanks so much for joining me today.

Christine Benz: Maria, it's great to be here.

Maria Bruno: So in your role at Morningstar, you do a lot of work around retirement planning strategies, but also best practices for people as they approach retirement or are in retirement. And I think the obvious first step would be to talk about asset allocation and, particularly, as you're approaching retirement, really how to build an asset allocation to balance current and future goals but also digging a little bit deeper and thinking about the portfolio construction considerations as well.

Christine Benz: This is an important part of retirement planning, and in my experience, and I'm sure yours too, Maria, this is a piece of the puzzle that people really struggle with. So one system that I often talk about and Harold Evensky, who's a financial planner in Florida, really devised what's called the bucket strategy to retirement portfolio planning. And it's a really intuitive concept. I feel like the lightbulb goes off when I talk to people about it.

The basic idea is that you're thinking about what your living expenses are and how much of your portfolio will replace those living expenses, and then kind of segmenting that portfolio by your expected time horizon for your money. So your near-term living expenses, maybe the next one to two years' worth of living expenses, that's money you don't want to take any risks with because if it falls a lot, if your investments fall a lot, that could affect your standard of living. So you're just investing in cash with that component of the portfolio.

And then maybe if you have a slightly longer time horizon with a portion of your portfolio, you can step out a little bit on the risk spectrum. So in the bucket construct that I write about, we're thinking about maybe years two through ten or three through ten of retirement. That's primarily going to be anchored in bonds and probably bond funds for most investors. So moving from short to intermediate bond funds. Maybe a little bit of some sort of an allocation fund as well in this component of the portfolio. So you're taking a little bit more risk but not too much risk because your time horizon isn't all that long.

And then for monies that you expect to use later in retirement, you can definitely take more risk with that component of that portfolio. So there you're investing primarily in stocks in a globally diversified stock portfolio. If you have some of those other kind of aggressive kicker asset classes, if you had precious metals equity as a small portion of your portfolio, you'd keep it there too. This is the high-risk, high-volatility, higher-return portion of your portfolio.

Maria Bruno: Okay. Well, let's dig a little bit deeper, if we can, because I know I get this question a lot primarily around the liquidity bucket or the cash reserves how much to have. So regardless, and I think you would agree, regardless of what stage you're in, you need some type of emergency reserves. The question is how much and where to invest that.

So usually for people who are working, I would generally say about at least three to six months' worth of living expenses. But then when you get into retirement and you really don't have that human capital cash flow, right, you're not making money, dependent upon your portfolio or other income streams, maybe it's a little bit more prudent to go a little bit longer into one year or perhaps even two years.

Christine Benz: That's exactly how I would think about it that you want to enlarge that emergency fund piece. And the beauty of having that cash piece, and this is really the lynchpin of the whole bucket strategy, is that the longer-term pieces of your portfolio, they're going to be volatile to varying extents. Knowing that your near-term living expenses are set aside, that lets you put up with the volatility. You can psychologically endure those tough market environments. I hope we don't go back to 2008, but those volatile market environments are easier to deal with knowing that you're near-term living expenses are set aside.

Maria Bruno: Okay. And I think it's important to reinforce as well, though, that there's an opportunity cost to having too much in emergency reserves. You think you might be playing it safe by staying out of the market, but inadvertently what you're doing is overexposing yourself to inflation risk down the road. So I think it's just finding that balance.

Christine Benz: Absolutely. And sometimes I talk to people and they say, 'Well, my bucket one, my cash piece is five years' worth of living expenses.' Unless you have an awful lot of wealth where you can afford to have that much stashed in cash-most people can't-I would say that you really do need to mind the opportunity cost. I think one to two years' worth of cash in liquidity I think is plenty.

Maria Bruno: Okay, good. Okay. And then think about the longer-term portfolio and then have the asset allocation appropriately reflected. Okay.

I often get the question in terms of, all right, 'Once you set this asset allocation in this model, then how do you actually go about meeting the spending needs?' And one of the things that I generally recommend is to take any type of portfolio cash flows, be it required minimum distributions from IRAs or dividends or capital gains from taxable accounts, and have them reinvested or invested in the cash account. Would you give that guidance as well or do you approach it differently?

Christine Benz: No, I like that approach. I think there are a few ways that people could do it.

Maria Bruno: Yes.

Christine Benz: But certainly investors, if they are getting income distributions or maybe capital gains distributions, if they wanted to just send that money over into the cash bucket, I think that makes a lot of sense. That allows you to refill that bucket one as you're spending out of it.

Maria Bruno: Okay, yes.

Christine Benz: So that it's kind of building. You're not coming to the end of a year and saying, 'Ah, I've spent everything that was in bucket one.' It's getting filled throughout the year, so I think that makes a lot of sense.

The issue, though, is that sometimes people come to the end of a year. They've been spending out of their bucket one and those income distributions aren't sufficient to refill bucket one. And this is a common predicament because income is in scarce supply these days. So in that case, I say then let's look at that total portfolio and potentially do some rebalancing. We'll scale back. Whatever part of the portfolio has performed really well, we'll potentially sell that, improve the risk-reward profile of the long-term portfolio, while also meeting our income needs for next year.

Maria Bruno: Yes, exactly. I often think about this in terms of we talk a lot about retirement income, but yet generally we advise retirees not to invest for income. So I think we probably should call it retirement spending to try and alleviate this whole focus on income, particularly in today's environment where interest rates are so low, really focusing on the total return of the portfolio because you're really spending, hopefully, over the long term growth and income.

Christine Benz: Exactly. I think a little mindset change is in order. A lot of people are inculcated in this idea my portfolio has to deliver my income needs. Well, unless you're really willing to edge out on the risk spectrum, that portfolio might not deliver your income needs with income distributions alone.

Maria Bruno: Yes, absolutely, because often you're exactly what you said, you're altering the risk-return profile. And you may not see the manifestation then, but if there is a market correction, like we saw in 2008, I think that's when we then see the markets realign and really where the risk attributes may not be aligned. So I think that's an important thing to note.

Important information

All investing is subject to risk, including the possible loss of the money you invest.

© 2015 The Vanguard Group, Inc. All rights reserved.

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