Harold Evensky, chairman, Evensky & Katz/Foldes Financial in Coral Gables, Florida, says one “bucket” strategy is based on time or age: individuals would have a “bucket” of assets to use from age 65 to 75, another to use from age 75 to 85, and another for after age 85, for example.
A second “bucket” strategy, according to Evensky, is based on goals or fixed versus variable expenses. One bucket could be set aside for basic living expenses, another for funding college savings of a child or grandchild, and another for traveling or whatever other goal or variable expense a retiree has.
Evensky tells PLANADVISER he is not a fan of either of these bucket strategies. The problem with the goals-based bucket strategy is if the goals are not prioritized chronologically, the individual may over-save and not have money for the short term, or vice versa, Evensky says. Daniel D’Ordine, CFP, DDO Advisory Services, LLC, in New York City, adds that food, shelter and clothing are obviously fixed expenses, and most would say vacations are variable expenses, but the line between fixed and variable often gets blurred by investors.
“The time-based bucket strategy is manageable; an individual would invest the short-term bucket in bonds and the longer-term buckets in stock,” Evensky explains. “But as the individual gets older the tax and transaction costs of rebalancing buckets will eat the person alive. That strategy is cost and tax inefficient.”
Cost and tax efficiency are the reasons D’Ordine advises clients who are working and in retirement-savings accumulation mode to fund three buckets of assets—tax-deferred, taxable and tax-free. He tells PLANADVISER the goal is to prevent a situation during retirement in which everything is in the tax-deferred bucket. “If all of the assets/accounts from which retirees are drawing are tax-deferred, then [the retirees] are at the mercy of ordinary income tax brackets,” he notes. According to D’Ordine, in many states—such as New York, California and Massachusetts—that can mean that to spend $100,000, a retiree would need to withdraw $140,000 or $150,000.
He suggests three buckets for retirement income:
- Tax-deferred – This would include employer-sponsored defined contribution (DC) and defined benefit (DB) plans, individual retirement accounts (IRAs) and non-qualified deferred annuities—all for which retirees would pay ordinary income tax on distributions.
- Taxable – This could include a taxable brokerage, mutual fund or investment account—from which retirees would pay capital gains taxes, which D’Ordine notes are currently more favorable than ordinary income taxes.
- Tax-free – This would include Roth IRAs, Roth 401(k) or 403(b) accounts, and cash value life insurance, if appropriate. D’Ordine says municipal bonds fall into this category because the income is typically tax-free.
With these buckets, if an individual needs $25,000, she should determine the least expensive way to tap assets to get this money, D’Ordine explains. “It could be a loan or withdrawal from a cash value insurance policy, or it could be a withdrawal from a tax-deferred account, depending on the individual’s tax bracket.”
He adds that some people will be in a low tax bracket, and depending on the total amount of assets they have, having different tax buckets may not matter. However, in general, he says, “The decisions you make while accumulating savings can make a big impact on your experience taking distributions. Small decisions now can make a big difference.”
The bucket approach Evensky has suggested since the 1980s is a split between a cash flow reserve and an investment component. Some of an investor’s portfolio needs to be invested over a long time horizon to maximize potential returns, he explains. But, for income needed in the short-term, investors need to minimize risk.
Evensky would suggest that individuals carve out of their portfolios the amount they would need in the next five years and put that money in money market accounts, short-term bond funds with a duration of one or one and one-half years, or possibly certificates of deposit (CDs), depending on the individual’s tax bracket. The rest of the person’s portfolio would be invested for the long term, which D’Ordine says should be really invested, meaning in a professionally managed, global portfolio.
Working with some academics last year, Evensky now thinks carving out one year at a time is optimal. For example, if a person decides he needs $40,000 per year as income in retirement, he could put that amount into a CD and invest the rest. This strategy addresses one of the major risks in retirement, he notes—the sequence of withdrawal risk, or risk of having to take money from investments when markets are down.
Where do defined contribution (DC) plans and Social Security fit into Evensky’s bucket strategy? He says these are factored in when determining an individual’s needs in retirement. “Typically we would encourage deferring withdrawals from DC plans as long as possible—typically it’s the last place from which we would suggest withdrawing—so those accounts would be part of an individual’s long-term investment bucket,” he says. However, rarely they make an exception when a person wants to delay Social Security and needs to access other funds in order to do that.
While often individuals are encouraged to delay taking Social Security to get a bigger monthly payment, D’Ordine takes a different approach. “Of course, if an individual needs the money, he should go ahead and take it,” he says. “But, even if a client doesn’t need it right away, I tell them they can wait, but they are giving up three or so years of income that will take them until a certain age to recover.” He suggests individuals look at why they would give up that income, and what will they need to do to replace it. “They may either have to continue working or withdraw from assets, and if they withdraw from assets, that may cost them.”
Sponsors of DC retirement plans can and should help individuals with a withdrawal strategy and have the tools to help them set up buckets for retirement income, says Roberta Rafaloff, vice president of institutional annuities at MetLife in New York City. “We strongly believe that retirement income should be the outcome of every DC plan,” she tells PLANADVISER.
She suggests plan sponsors think of income options available for DC plans as a spectrum from maximum income flexibility to maximum income guarantees. Systematic withdrawals are on the maximum flexibility end and immediate or deferred income annuities are on the other end of the spectrum.
MetLife recommends plan sponsors offer partial annuitization for DC plan participants. “Participants can build an income stream with some portion of their assets, and the rest can remain in the plan and continue to be invested and, hopefully, grow,” Rafaloff says.
She thinks offering participants choice is a great idea, so plan sponsors can offer participants an opportunity to purchase an immediate annuity that starts at age 65 as well as a longevity annuity, starting at age 85. “Some people think they can manage assets 10 or 15 years into retirement, but they worry about having assets if they live longer,” she notes.
Rafaloff says it is really important for DC plan sponsors to start thinking about how they are going to offer income solutions within their plans. She suggests they consider what participants are looking for, how to measure success of their plan to include retirement income, and what products they can include to make sure employees are prepared for retirement.
D’Ordine concludes that every person is different and will have different situations. “My only blanket approach is not to have a blanket approach,” he says, suggesting financial professionals use as much information as possible to help individuals make the right decisions.