Several years ago, a 91 year old retired minister called me to ask about our asset management services. After telling me a little of his history and background, which included riding in a horse-drawn wagon as a circuit preacher, he returned to his investment portfolio and said, “now what I’m looking for is something with long-term growth potential.” I asked him to please share with me his secret for such optimism at his age, half wondering if his brand of religion allowed for perpetual trusts and told him most of my clients his age won’t even buy green bananas.
When managing the retirement portfolio, I like to use the “bucket system” system of investing. Not to be confused with a Bucket List, meaning the list of things you want to do before you die. The Bucket System of Investing assigns assets to five buckets, each with its own set of requirements. The system works for any age group, but I find that elder clients like the system best. In simplistic terms, each of the buckets can be described as follows:
1. The Income Now Bucket: As its name implies, this bucket identifies the income the retired investor must have now and for the next two to ten years to maintain their current lifestyle. Assets placed in this bucket should be as risk-free as possible and are limited in scope by the liquidity and safety requirements imposed by this bucket. If fixed income from pensions or social security are sufficient to fund the income requirement, this bucket may only contain a cash reserve fund. If there is a gap, then immediate annuities or short-term municipal bonds or bond funds can be used. Due to interest rate risk, longer-term bonds or CD’s with maturities greater than five years should be avoided. The point is, this bucket is for short-term can’t-miss needs.
2. The Income Later Bucket: This bucket identifies the income one has to have down the road – perhaps ten or more years from now. The assets placed in this bucket and the available investment options vary widely depending on several factors. Nevertheless, the advisor should be able to calculate an amount that should be allocated to this bucket and provide reasonable assurances to his retired client that by the time this bucket is needed to provide income, there will be sufficient funds with which to do so. As the time approaches, some or all of the assets in this bucket are poured back into the Income Now bucket and managed according to that bucket’s requirements. For this stage of life, there should be an expectation for some form of long-term care costs, either for facility care or home health care. If the person has long-term care insurance, then the net cost above what the insurance pays needs to be factored in. Tax-deferred annuities, laddered bonds, or dividend-paying stocks or funds may be appropriate vehicles here.
3. The Lump Sum Now Bucket: This bucket identifies the client’s short-term lump sum requirements, and often does not employ an investment vehicle at all because the funds are actually spent over a one to three-year period. Examples of this for the retired portfolio include paying off a mortgage or prepayments to a long-term care facility. Cash Equivalents such as CD’s or Short-Term Treasuries, or Ultra Short Bond Funds can be used to fund this bucket.
4. The Lump Sum Later Bucket: The retired client may face lump sum requirements down the road (five or more years out) that open up the available investment options. But again, these are requirements, not maybe-if-there’s-enough goals (we’ll talk about that bucket next). These are known future obligations that the client doesn’t have the ability or desire to fall short on. Examples may include a balloon note payment, upfront costs to a retirement community, or a business buyout obligation.
5. The Surplus Bucket: Here’s where it gets a little more fun, because at this point, all of the client’s known current and future obligations have been accounted for and funded for in the appropriate bucket. The Surplus Bucket gets whatever is left and can be used for either short or long-term items such as funding a grandchild’s education, leaving a charitable legacy, or making gifts to children. Risk is often less of a concern here because you are certain that your required needs have been funded for already.
The Bucket System is not for everyone, and some studies suggest that investing this way could actually result in lower expected returns than if the entire retirement nest egg were placed in a single-strategy bucket with income and lump sums taken from that bucket as needed. Maybe so. But from a purely psychological standpoint, my experience is that clients weather volatile markets better when they know that their current lifestyle money is not affected by the turbulence while their future lifestyle money is allowed to experience a full market cycle untouched by current requirements. This is especially true for those whose assets are now the source of their monthly paycheck.
David W. Russell, CFP®, CSA® is Vice President and Trust Officer with Argent Trust in Nashville, TN. He is founder and editor of Wealth and Honor, an educational website offering community and resources to families in age transitions. His book, What You Need to Know: The Adult Child’s Guide to Becoming an Effective Financial Caregiver is available on Amazon.