By Scott Keegan, Associate Wealth Advisor
In a previous blog, I discussed how bucketing can be used to help clients’ investment portfolios participate in the growth of equity markets while protecting their distributions through more conservative investments in Bucket 1. I’d like to now home in on Bucket 2 and its purpose in the portfolio.
While Bucket 1 is filled with two years’ worth of income that a client will draw from the portfolio, Bucket 2 contains three to five years’ worth of income. The buckets work similarly to a conveyer belt; as each year passes, we systematically move money from right to left to make sure we are always two years ahead of expenses in Bucket 1, five years ahead in Bucket 2 and six or more years ahead in Bucket 3.
What Does Each Bucket Do?
- Bucket 1’s job is simple: Don’t lose money.
- Bucket 2’s job is slightly more complex: Bridge the gap between Buckets 1 and 3. Bucket 2 does this in two ways:
- Risk level of investments
- Accessibility of money when needed
- Bucket 3’s job is to hold assets for the long term.
Bucket 1 is generally invested in short-term bonds, which historically don’t have huge returns but are an effective tool to gain a small return while minimizing downside risk. On the other hand, Bucket 3 is invested for long-term growth to help drive performance for the portfolio.
If we only had these two buckets, we could risk leaning too heavily toward either side. This would play out by being too conservative or too aggressive, which could have two outcomes:
- Being too conservative and not getting enough money return to last through retirement.
- Going for too much growth and risking having to pull money out at market low and then missing out on growth when markets come back, which hurts performance.
Bucket 2 helps level this seesaw by investing in conservative income and growth investments. This will look like a strategy that is typically 40% stock and 60% bond inside of this bucket. This allows for the potential of higher returns than Bucket 1, but not as much risk as Bucket 3 to bring the portfolio to a more moderate state overall.
Bucket 2 Bridges the Gap
The second way Bucket 2 bridges the gap is in the accessibility of money. According to RIMES, the S&P 500 on average takes 425 days (or 1.5 years) to recover from a 20% or more drop. This is the reason we always keep two years’ worth of income in Bucket 1, but if – on average – it takes 1.5 years to recover, what do we do when we see a recovery that takes longer than average? This is where the accessibility of Bucket 2 is crucial.
Let’s imagine we see a recovery take four years and we only have Buckets 1 and 3. After we live off Bucket 1 for the first two years, we would need to sell investments in Bucket 3 at a loss in order to generate income distributions. This wouldn’t be the optimal way to handle this situation, which is why we keep three to five years’ worth of income in Bucket 2.
If we see a prolonged recovery and we have used up Bucket 1, we can dip into Bucket 2 for income. Since Bucket 2 was invested for conservative growth, whereas Bucket 3 was invested for long-term growth, it should not have dropped the full 20% like the S&P 500, making it a better place to pull distributions from in a prolonged recovery.
Each of the buckets has its own role in the portfolio, and Bucket 2 is the glue that holds Buckets 1 and 3 together. It may not seem quite as exciting as Bucket 3 or as necessary as the income Bucket 1 protects, but it is vital to making the bucketing system work for clients.
Do you want to have a conversation about the state of your buckets? Request a complimentary consultation.
This piece is not intended to provide specific professional advice. To determine what is appropriate for you, consult a qualified professional. All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.