Buckets of Money
Buckets of rain
Buckets of tears
Got all them buckets comin' out of my ears
These lyrics from Bob Dylan’s classic Blood on the Tracks album come to mind when I hear people talk about the bucket system for portfolio management. Although not a new concept, I’ve been seeing more articles lately about this technique whereby an investor keeps two to five-year’s worth of income in a liquid cash account (bucket) for spending. One or more other buckets would be used to hold stocks and bonds to earn a higher return albeit with some additional volatility. The idea is that an investor, especially one drawing income on a regular basis, will be more willing to place a portion of their portfolio in riskier investments knowing that they have a bucket of safe money to provide their spending needs for at least a few years even if the stock market drops as it did recently by about 20%.
For example, if you had a $1 million nest egg and wanted $40,000 per year to supplement your social security income. You might put $80,000 (two years) into a stable money market account and $320,000 (eight years) into a bond fund. The combined amount of the two conservative buckets would be $400,000 or 40% of the portfolio. This would leave $600,000 for stock market investment or 60% of the portfolio. You would take income from the first bucket for two years until it was nearly exhausted. At that time, you would draw from one of the other buckets to replenish the spending bucket and start the process over again. Another variation of this approach might be to keep five years of income in a stable account and the rest in a mixture of stocks and bonds.
This methodology makes perfect sense in theory. There is nothing inherently wrong with a bucket system. However, there are practical obstacles to consider. A bucket system produces a lower return on the amount that goes into the spending bucket. You wouldn’t want to keep too much in a regular bank account paying no interest. Further, when the spending bucket needs to be replenished, you would have to determine how to draw from the other buckets. The other buckets would also change in value with the performance of the funds within them so some administration effort is required anyway. Things get messier when you realize that there are many types of financial accounts. A married couple might have a joint taxable account, two Roth IRAs, two Traditional IRAs and other retirement accounts like 401(k)’s and variable annuities. A supposedly “simple” bucket system can eventually become not to so simple.
There can also still be some anxiety for investors prone to worrying about their money. For instance, let’s say in the earlier example that $20,000 per year is needed for income. The spending bucket would be just $40,000 and there would be $160,000 in bonds, for a total of $200,000 or just 20% in conservative investments. Would you be comfortable with the remaining 80% in the stock market? Your income needs would be met for at least the next 10 years, but how will you react if the much larger bucket of longer-term funds drop dramatically? I imagine that most people would find this scenario a bit unnerving, putting a great importance on getting the right overall initial investment mix.
A client recently asked my opinion of the bucket system. I asked, “Which one?” because there are many. I went on to say that it’s fine conceptually and I would support anyone’s attempt to use such an approach. Even so, there are limitations. Although not terribly difficult to manage, I think the same result or better can be achieved in an easier manner. In fact, I advise clients to maintain two major buckets, but I don’t call it a bucket system. The portfolio would be divided into two primary asset classes: stocks for growth and bonds for income. The funds would be chosen to generate the best total return for the given level of acceptable volatility overall. The growth side would be stock funds and the income portion would be comprised of bond funds. In both cases, I would use index funds to implement the plan to incur the lowest-cost possible in the most diversified manner.
The split between the two primary assets classes would be based on particular needs and the individual investor’s desired risk profile. In this scenario, an income investor would draw from the bond funds as needed for spending. Rebalancing every year or two to the target mix of stocks and bonds would automatically take care of replenishing the spending “bucket” and keeping the overall risk level of the portfolio in check. The total return generated should be as good or better than the typical bucket system that I’ve seen promoted by many advisors.
This method sets an appropriate initial risk level and keeps it in check. Stocks should never have to be sold when they are down and there would be no idle cash. I believe this promotes the best total rate of return possible for a desired level of risk. The best part is that this option truly is simple!
Admittedly, even my simple approach can get more complicated when there are multiple accounts and taxes to consider, especially when there are IRAs with Required Minimum Distributions (RMDs). That said, you may have these challenges anyway, so you might as well make the rest of your plan as easy as possible. While my methodology could be characterized as a “bucket system” as well, I don’t call it that. In fact, I don’t really have any name for it. It’s just a simple and effective, low-cost way for anyone to manage their portfolio.
Having a catchy name offers more marketing panache for advisors wanting to showcase their expertise and gives financial writers and commentators something to write and/or talk about. Essentially, any bucket system is really just about managing behavior and addressing the psychological side of investing. If having buckets of money helps an investor stick with a disciplined program, I’m all for it. So, the next time I hear a reference to a bucket system, I’ll lean back in my chair and play back Dylan’s words in my head:
Buckets of rain
Buckets of tears
Got all them buckets comin' out of my ears