The simplicity of a bucket system for retirement asset allocation and withdrawals may be just what clients need, according to Christine Benz – but the system does come with a few drawbacks that could be exacerbated by depressed market returns over the next decade.

The three-bucket system for retirement asset allocation championed by Benz, who is Morningstar’s director of personal finance, has come to be embraced by do-it-yourself investors who value simplicity over efficiency, but had its origins among professional financial advisors.

Benz noted in “With the Bucket Approach, the Devil is in the Details,” a Wednesday morning presentation to advisors at NAPFA’s fall 2019 conference in Chicago, that one of the earliest retirement bucket systems was proposed by financial advisor Harold Evensky as an easy way to organize a retiree’s portfolio by spending horizon.

“He said that having a cash bucket bolted onto a long-term portfolio was amazingly useful in terms of keeping his clients in their seats through periods when the market was rocky and stocks were tumbling,” said Benz. Evensky was pioneering a two-bucket system in which retiree’s short-term spending needs, enough to cover approximately two years worth of expenses, was kept in a bucket of cash and cash equivalent investments like CDs and money market mutual funds. The rest of a client’s portfolio was allocated conventionally.

Benz is a stronger proponent of a three-bucket system, in which one bucket mirrors Evensky’s short-term, cash-focused innovation, a second contains enough assets to cover three to eight years of expenses and contains mostly investment-grade fixed income instruments, and a third portfolio is intended for long-term investments in globally diversified equities and high yield bonds. The third bucket would also hold investments like REITs and multi-sector bond funds whose year-to-year value and returns could be volatile.

In a three-bucket system, retirees would tap their short-term cash bucket for portfolio income first, followed by the mid-term fixed income bucket, and finally the long-term equities bucket.

Benz said that a similar system has been proposed by retirement researchers Michael Kitces and Wade Pfau, who additionally argued for a “reverse glide path” for retirement portfolio allocations that would gradually add more risk into a retiree’s investments after they leave the workforce and as they aged.

Benz believes that a portfolio’s ideal glide path after retirement depends on the end investor’s goal. If they want growth in the portfolio, perhaps to increase the value of their estate or to boost their charitable giving, then the reverse glide path that adds risk throughout retirement may be appropriate. On the other hand, if the investor wants to spend down their portfolio and deplete their wealth through retirement, a more conservative glidepath is appropriate.

In Benz’s system, the short-term bucket of cash equivalents would be continuously replenished by selling investments from the mid-term and long-term buckets – giving advisors an opportunity to be opportunistic about how a client’s cash assets are replenished.

“One of the advantages of the bucket approach is that retirees know that their near-term income needs are set aside in cash investments,” said Benz. “The bucket approach can be a really great illustration tool – I hear from individual investors that they really get what we’re talking about, they understand the why behind asset allocation because they’re thinking ahead about the withdrawals that they may take from the portfolio.”

Allowing advisors or individual investors to be opportunistic about how they replenish their cash bucket could also help detach them from an “unhealthy mindset where the focus is all on income production,” said Benz.

But the bucket system does come with several disadvantages – one is that it does not establish a sustainable system or percentage for withdrawals. A bucket system will not salvage a plan in a retiree’s withdrawal rate is too high.

For individual investors, the bucket system might be dangerous because it does require maintenance and some kind of system for replenishing the cash bucket.

The bucket system also does little to address asset location, said Benz.

“Many retirees are bringing in multiple accounts to retirement: taxable, tax-deferred and Roth accounts, and there may be multiple accounts belonging to two spouses,” said Benz. She argues that financial professionals, as well as individual investors, should seek to simplify their holdings, even if they cannot consolidate their accounts.

The three-bucket system she proposes, as well as the two-bucket approach favored by Evensky, also may result in a large allocation to cash within a retiree’s portfolio. In an upward-trending market, especially one where bonds are experiencing price appreciation, having a large cash bucket will be a drag on investment returns.

Like almost any other retirement distribution strategy, the success rate of a bucketed portfolio will depend on the investor’s withdrawal rate and market performance, particularly early in retirement. Given depressed yields and low returns on most fixed income instruments and relatively high valuations in stocks, Benz warns that the bucket strategy needs to be carefully monitored, adjusted – and that the portfolio components should be periodically rebalanced.

In fact, periodic rebalancing can be used to partially or fully replenish an investor’s cash bucket, said Benz.

"We have to consider our maintenance approach for this kind of portfolio," she said. "How often are we taking a look and thinking about refilling bucket one? How often will rebalancing occur logistically? How will it occur logisticaly? We're not just looking at asset class exposures, but individual securities withint he buckets where valuations may be lofty and using rebalancing those securities as tools for managing the system."