Why a bucket approach can help when investing for retirement

  • By David Blanchett,
  • The Wall Street Journal
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Many people use the bucket approach for savings--a bucket for vacation money, a bucket for college savings, a bucket for retirement, etc. This approach to investments into separate buckets—physical or mental—works not because it’s a better way to invest, but because it’s a better way for many people to think about their investments and to make savings more appetizing.

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To see if you’re the kind of investor who should use a bucket approach, consider this thought experiment: Say you’re 65 years old and about to retire with $1 million in your individual retirement accounts. How comfortable would you be with 60% of your assets in stocks? (Write down your answer.) Now say you’re 65 with the same $1 million saved, but you’ve got $100,000 in one IRA, $300,000 in another IRA, and $600,000 in an old employer 401(k) plan. How comfortable would you be if the first IRA, which you use for spending for the next three years, was 100% invested in cash, the second IRA (which feeds into the cash fund) was invested 50/50 in stocks and bonds, and the 401(k) plan was invested 75/25 in stocks/bonds?

If you think the second structure sounds safer or more palatable--even though the equity portion of the portfolio is the same in both examples--the bucket approach may be right for you.

In my experience, retirees are more comfortable taking on equity risk in their portfolios when the portfolio is presented using buckets. When the portfolio is viewed in its entirety (as the full $1 million), some retirees may think they can’t afford to lose any money so they invest too conservatively, ignoring the fact that typically part of your savings should continue to grow in retirement.

With buckets, there is still a conservative portfolio, the cash-based near-term bucket, but the other buckets become increasingly risky. Buckets, therefore, can be especially useful for very conservative retirees because most people need to take on some equity risk in their portfolios if they want to fund a retirement that will last 25-plus years. My Morningstar colleague Christine Benz has written on how to implement the bucket approach.

There have been a number of advisers who have said that using buckets increases the return of the portfolio through things like tactical rebalancing decisions. I disagree. The act of slicing a larger portfolio into smaller portfolios (buckets) will improve returns only if you use some relatively dubious assumptions.

So, the next time you think you can’t afford to take any risk in your portfolio, don’t view it as a single portfolio. Cut it up into buckets based on when you’re going to need the money and see if that changes your perspective. Sometimes a self-offered illusion can lead to better investing behavior.

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