How to Customize the Bucket Portfolios

To date, I've created 15 bucket portfolios--moderate, aggressive and conservative; tax-efficient and tax-deferred; fund-family specific and free-range. Surely there is a bucket portfolio there for every size and shape of retiree, right?

Well, maybe not. As much as I've tried to create portfolios to suit investors in a range of situations, people approach retirement with vastly different financial circumstances and portfolios. The asset allocation and portfolio for a 65-year-old with a full pension should look quite different from the portfolio of someone that age who's actively withdrawing living expenses from his portfolio.

Moreover, most investors have their portfolios spread across multiple account wrappers--traditional and Roth IRAs, company retirement plans, and taxable brokerage accounts, for example. That means that using the bucket system isn't as simple as picking off a single model portfolio that can be housed in a single account.

Finally, it's a rare soon-to-retire investor who's willing or able to completely upend her already existing portfolio in favor of my portfolio mixes; she may want to hang on to certain favorite investments, or there may be tax consequences associated with repositioning.

For investors attracted to the bucket concept and/or a specific bucket portfolio in our lineup, here are the key steps to take when customizing it to suit their own parameters and preferences.

Step 1: Determine portfolio cash-flow needs.

My bucket portfolios' allocations are expressed in percentage terms. But an investor's cash flow needs are essential to determining the percentage of the portfolio that goes into each bucket. Differences in required cash flows can have a big influence on the portfolio's allocations.

For example, an investor who planned to withdraw $60,000 a year from his or her $1.5 million portfolio would park anywhere from one to two years worth of those cash flows ($60,000-$120,000) in cash, another eight or so years worth of living expenses ($480,000, give or take) in high-quality bonds, and the remainder of the portfolio in higher-growth assets, mainly stocks. That investor's portfolio would be 8% cash (assuming she parks two years worth of living expenses in cash), 32% bonds, and 60% equity.

By contrast, another retiree, this time with a pension and a desire to leave money behind for her kids and grandkids, planned to withdraw just $20,000 a year from a $1.5 million portfolio. Her cash stake to accommodate her modest liquidity needs would be just 1.3%-2.6% of her portfolio, her bond portfolio would be just 11% of her portfolio, and the rest would go into her stock bucket. (Of course, she might wish to have even more in cash if she wanted to allow for periodic larger-than-usual discretionary expenses, such as travel, or wanted to hold an emergency fund alongside her cash for living expenses.)

Those examples illustrate that the starting point when crafting your own bucket portfolio is to take a step back and think about your required cash flows from your portfolio, above and beyond certain sources of income such as Social Security or a pension are providing. Next, test that amount to see if it passes the sniff test of sustainability, discussed here. Armed with that amount, you can then determine how much to allocate to each of the three buckets.

Step 2: Assess accounts and look for consolidation opportunities.

As pleasingly simple as maintain a single bucket portfolio might seem, most investors hold their assets in several different accounts--401(k)s and IRAs (both traditional and Roth) as well as taxable accounts. Each of these wrappers carries its own tax treatment, so consolidating the portfolio can only go so far.

That said, investors should look across accounts for consolidation opportunities before implementing a bucket strategy. Multiple accounts of the same tax character can be merged together--for example, several smaller taxable accounts can be collapsed into a single larger one, and several IRAs can be rolled over into a single IRA. Retired or soon-to-retire investors might also consider rolling their company retirement plan assets into their IRAs, though that's not advisable in every situation. Consolidating accounts will not only reduce the number of moving parts in the aggregate portfolio, but could also mean that the retiree qualifies for lower-cost share classes, free advice, or other goodies associated with having a large kitty at a single investment provider or two.

Step 3: Let sequence of withdrawals determine positioning.

Following consolidation, the pre-retiree should take a step back and consider withdrawal sequencing. Which account(s) will be tapped first in retirement, and which will be further down in the queue? This article outlines some basic considerations when sequencing withdrawals, though most tax advisors would emphasize that tax diversification is valuable throughout retirement; it's rarely a good idea to deplete each account type sequentially before moving on to the next.

Armed with a sense of when you'll draw down each account, you can then determine how the bucket system overlays your various accounts. For example, let's say an investor holds a third of her portfolio in each of three major tax wrappers: taxable, traditional, and Roth. Because the taxable accounts carry the highest ongoing tax drag and are usually first in the withdrawal queue, those accounts would hold plenty of cash (bucket 1), as well as perhaps some bonds. The tax-deferred accounts, usually next in the withdrawal queue, would hold primarily high-quality bonds. Because Roth accounts usually go last in the withdrawal sequence, they'd hold mainly stocks. However, there may be good reasons to override that distribution sequence, as discussed here--for example, if you'd like to reduce your IRA balance before required minimum distributions kicking in, you might prioritize pre-RMD withdrawals over taking money from taxable assets. This article takes a closer look at the topic of marrying multiple accounts with a bucket strategy.

Step 4: Retain favorite holdings where appropriate.

As I've said on numerous occasions, the model portfolios shouldn't be construed as a call to completely upend all of your holdings. If investors have specific holdings they like and believe in--even individual stocks, which aren't components of my portfolios--they can use them in lieu of my recommended holdings.

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I'd also urge investors to take extreme care when customizing their existing taxable portfolio to any sort of bucket regimen. While the tax ramifications of giving a portfolio a tax-efficient makeover may be less painful than you imagined, as discussed here, selling long-held positions may in fact trigger a sizable capital gains bill.

Step 5: Home in on your maintenance strategy.

The last step in customizing a bucket strategy is to decide what sort of maintenance regimen you'll employ with your portfolio. How will you refill bucket 1 (cash) when it becomes depleted? How often will you rebalance? Those decisions, and others, can have major implications for the risk/reward profile of your portfolio through retirement. This article does a deeper dive on the key decisions investors need to make when implementing and maintaining a bucket strategy.