New Life for an Old Idea: Investment Buckets

by Russ Banham

That wily poet Robert Burns had it right when he wrote, The best laid plans of mice and men oft go awry. Burns could have been talking about the 200709 financial crisis, which took a hammer to many peoples investment accounts, not to mention the seemingly hidebound buy-and-hold investment strategy.

A wide range of portfolio assets was pummeled small-cap stocks and large ones, domestic stocks and foreign, high-yield and investment-grade bonds, even corporate and municipal bonds. For those at or near retirement, the prospects for generating enough income to live comfortably into the sunset were severely compromised.

Yet, not all investment vehicles veered off course, with various commodities, annuities, hedge funds, assorted stocks and bonds and good old cash instruments performing moderately well. What if ones portfolio were structured in such a way to have at least a portion of invested assets in classes that would escape the brunt of the next market crisis, providing enough income to pay the bills until it passed? Such an investment strategy is now making the rounds. It doesnt have a catchy name as yet, but lets call it the three-bucket approach.

Apportioned Assets

The idea is pretty simple in theory three separate portfolios or buckets, each with a range of investments meeting specific needs over a particular time horizon. Since people have different needs, from no children to a half dozen heading off to college, the three buckets arent exactly alike for everyone. Still, theyre not that different, either: One bucket conservatively designed to produce income over a short stretch; another a bit more daringly crafted to provide income at retirement; and a third with a more aggressive mix of investments intended as a legacy to be passed on to heirs.

While not a new idea per se, financial advisors and academics say the three-bucket approach is catching on. Certainly, the financial crisis has put into perspective the need to have a specific mix of assets that can spin off cash at a time when selling other assets would be prohibitive, explains Paul Strebel, a certified financial planner in Ithaca, N.Y. who also teaches finance and accounting classes at Cornell University. Creating a bucket of assets that takes into account this need has a lot more appeal today.

Few would argue with this suggestion. According to recent studies, household assets and peoples overall wealth in the United States have fallen sharply because of the dismal performance of many investment portfolios. Many Americans have had to prematurely withdraw funds from their retirement savings for basic living expenses or have stopped contributing to their 401(k) and IRA retirement plans. Others have expressed dire concerns about having enough money for retirement.

Timed Investing

The three-bucket approach borrows from an investment strategy that has taken hold in pension fund management. Called liability-driven investing (LDI), the strategy shifts investing philosophy from the traditional maximization of asset returns to addressing future liabilities.

In the context of pension investments, these liabilities are the payments due future retirees. In the context of individual investors, liabilities would include basic expenses like food, shelter and other routine bills, in addition to future necessities like retirement income. LDI forces you to think in terms of specific cash flow needs, when you expect to have these needs and the investment strategies to satisfy them, explains Greg Merlino, CFP and president of Ameriway Financial Services in Voorhees, N.J. In many cases, these needs fall into three distinct areas hence the three-bucket concept.

Many financial planners espouse the bucket philosophy. Some, however, argue that a single portfolio rather than three separate ones can accomplish the same goals. One bucket is all you need, assuming you have in it a mix of more conservative and more aggressive investments, and then tilt these over time to reflect the investors specific situation, says Jerry Miccolis, senior financial advisor and principal at Brinton Eaton, a Madison, N.J.-based wealth management firm.

A drawback to the single portfolio approach, according to some financial advisors, is that it can get unwieldy. Over time, different asset classes and individual investments accumulate to the point where the investor cannot see the forest for the trees. Parsing the investments into three buckets, each with a specific purpose, is not only a simple way for a financial planner to describe in detail the overall investment strategy and its purposes, it also provides a way for the individual investor to stay focused, keep track and rest easy.

Tiered Risk

The easy resting is courtesy of Bucket One, the conservatively crafted portfolio designed as an umbrella for the proverbial rainy day. In this bucket are short-term investments akin to cash, a mix perhaps of short-duration bond funds, certificates of deposit, money market funds, Treasury bills and other plain vanilla assets that can be easily liquefied for a specific purpose getting an investor over the hump in a financial crisis. You wouldnt see much in the way of yield in this bucket, says Wes Moss, the host of Money Matters on News/Talk 750 WSB in Atlanta, and chief investment strategist at Capital Investment Advisors.

Bucket Two is structured for income in the near future, five to ten years, while providing a hedge against inflation. Assets in this bucket have a slightly longer time horizon than Bucket One. Id advise a mix of U.S. and international mutual funds, with a bit of emerging markets, and a diverse blend of large and small cap funds, says Mark Lloyd, a certified estate planner and president of Lloyd Advisory Services in Suwanee, Ga. Id also consider putting annuities in this bucket based on the individuals risk tolerance. Other advisors toss in short-term bonds and intermediate Exchange-Traded Funds (ETFs), which look like mutual funds but trade like stocks.

Bucket Two is composed of investments with moderate growth potential to manage inflation risk, and serves as a backup in the event Bucket One is exhausted. Hence, it is riskier than Bucket One but not too risky. Thats the province of Bucket Three, which would contain primarily a diverse mix of growth and value-oriented stocks with a 10-year or longer investing horizon. This is the legacy money youre planning to leave to your heirs or are going to need later in life, consequently, you can allow for more fluctuation in the values, Lloyd says.

The three-bucket concept isnt for everyone, but it does provide relief knowing that bills can be paid without cashing in the 401(k). At the end of the day this is all about managing emotions, says Carrie Coghill Kuntz, president of D.B. Root and Co. a Pittsburgh-based financial planning firm. Having that one bucket to draw from in a financial drought gives peace of mind.

Russ Banham is a veteran business journalist. His articles have appeared in Forbes. The Economist. CFO. and U.S. News World Report. His latest book is The Fight for Fairfax.