Allocate Assets by Buckets – “Basic Principle 2”

Background on Bucket Investing

Overview

Bucket investing is a conceptual model that helps plan the amount of money to save, invest and spend both before and after retirement. At a high level think of buckets as representing different piles of cash and assets that you possess. The 1st bucket is used for short term investing or spending. It is called bucket #1 or the Income bucket. The 2nd bucket is used for midterm investing or withdrawing of assets. It is called bucket #2 or the Safety bucket. The 3rd bucket is used for long-term investing or withdrawing of assets. It is called bucket #3 or the Growth bucket.

What you do is split your money, putting some into or withdrawing some out of, each bucket. Discussed later will be how much goes into each bucket and how much is withdrawn from each bucket over your working and retired time frames. How you divide the money you earn will depend upon how much you have to invest, how much income you will need to live on, when you will need it, how many years you will need that income for, and for what rate of inflation and investment returns you predict.

During your working time frame, consistent with the Rich Person Asset Building Model described in the previous chapter, the goal is to increase your income and reduce your expenses so that you have a happy life based on the activities and relationships with your family and friends. Money earned during this phase of your life is apportioned to current expenses and for saving for the future. A good way to account for money earned during the working portion of your life is to build a personal budget and track your performance against it monthly or quarterly. At the end of the year the behavior observed is put into thoughtful revisions for next year’s budget.  Typically the quiet time that often occurs between Christmas and New Year’s is a good time to conduct his review and planning exercise.

It is assumed that looking carefully at one’s expenses, a reasonable budget can be put together consistent with the Rich Person Asset Building Model. But that now leaves us with the task of assigning the excess income created during your working life into investing in assets that will provide a comfortable and financially stable retirement.

The excess money you are earning during your working life first goes into bucket #1. As mentioned before, the money in this bucket goes into short-term investments so that it is immediately available for routine monthly living and emergency expenses. The rule of thumb typically used is that this bucket should hold an amount equal to 6 months of your expenses.

Once you’ve filled bucket #1 to the allocated amount, the next step is to start filling buckets #2 and #3. Bucket #2 is for intermediate mid-term expenses such as saving for a car, a home, or a child’s education. Bucket #3 is for long-term expenses such as your retirement.

During your retirement life the meaning and use of these buckets changes. At this point your earned income drops substantially. Your income is now comprised mainly of government benefits such as Social Security, employer retirement plans, and required minimum distributions from self-funded retirement plans. In this situation because your income from these sources is typically less than your expenses, you start withdrawing from your three buckets rather than adding to them.

During retirement the short-term bucket #1 continues to be invested in something very conservative and available short-term.  This bucket will produce the expenses that you need over a 7 year time horizon. Because you’ve been doing a good job of understanding your annual expense budgets your 7 year forecast should be fairly accurate at this point in your life. The guideline is that as a retiree you should attempt to live on a maximum of 4 to 5% of your assets rather than 6% or more. Although the higher numbers are potentially doable, the chance for success dramatically increases as you lower your requirement for income or if you get lucky and the inflation rate is low. During most seven-year time periods, the usual investments for bucket #1 assets are in FDIC insured saving and checking accounts, short-term notes via CDs, treasury bills, or treasury notes with laddered maturities. Investing in an intermediate annuity, or tax-deferred annuity with penalty free withdrawals, may also provide you with guaranteed, potentially tax favored income for a specific period. There is much more detail in a later chapter. The key point here is, potentially contrary to what you may think is right, you will draw down not only the interest in this bucket #1 but also the principle in bucket #1. The reason the bucket models will work however, is because you will not touch buckets #2 or #3 until bucket #1 is completely dry.

In bucket #2, or the Safety bucket, the money that is in there will be growing for the 7 years while bucket #1 is supplying all your supplemental income and covering your living expenses. The bucket #2 money is also invested conservatively, but it can handle slightly more risk and provide more hope of reward than the money in bucket #1. At the end of the 7 years you pour the money from bucket #2 into bucket #1. It may be that your bucket #2 will now be completely empty, but if it has done reasonably well, or inflation has been low, there may be a little excess over what bucket #1 needs to provide the next 7 years of income for you. When this replenishment takes place you will likely need to add more money into bucket #1 than what you did initially. This is because inflation has typically set in and you will need more income to buy the same amount of goods and services. At the end of the 7 years, bucket #3 is used to start replenishing bucket #2 if market conditions are favorable. This usually means trading some of your more risky investments of bucket #3 for more conservative and risk-free investments of bucket #2.

How Risky Is the Market

In bucket #3 you’ve put in the amount of money that was left over from your total assets minus the amount that was required for bucket #1 and bucket #2. Remember that both bucket #1 and bucket #2 contain the amount that you need based on your expenses, cost of living, and expected rate of returns. Since you’re not counting on bucket #3 for income to live on and you can wait a long time, up to 14 years, before needing to draw on bucket #3, you can take some risk of putting that money into the stock market, real estate, and other more high risk, high return investments. Looking at the “How Risky Is the Market” figure, you can see how stock market risk lessons greatly with time. So putting some money in the stock market in a broadly diversified portfolio, including some real estate investment trusts, and then ignoring it is a very sound strategy. 14 years should be enough time for some of the market’s fluctuations to balance out.  With any kind of luck that should be long enough for you to get some pretty decent returns. One can use a variety of long-term cyclic models to know when to get in and out of the market to capture most of the upside and reduce most of the downside. This will be discussed later too.

The above discussion has described briefly how the three buckets differ in their goals, and how they are invested. In real life, however, the buckets are not independent of one another. You don’t treat them as self-contained entities to be emptied into one another. Instead, the buckets must work in tandem: income, safety, and growth. For example, say your bucket #3 investments were growing at 12%, (higher than the 10% you might have projected).  You could then take the excess and add it to your bucket #2. That would be taking from Growth money (bucket #3) to ensure there is always Safe money (bucket #2) available for Income (bucket #1). Conversely, if a bear market caused bucket #3’s growth to slow, a sophisticated investor might even want to take money from bucket #2 in order to replenish the Growth bucket.

But here’s a rule: you don’t ever want to empty bucket #2. You never want to need to go directly from the Growth bucket #3, into the Income bucket #1, because no one knows when the next bear market will occur.  One of the worst things any investor can do is run out of Income or Safe, bucket #1 or #2, money and be forced to liquidate stocks from the Income bucket #3 in a down market!  Regularly, probably on an annual basis, you ought to take a look at how each bucket is doing and if necessary reallocate among the three. Excess from bucket #3 should end up in bucket number #2. And any extra bucket #2 money can be banked where it is, or flow it into bucket #1 to extend its life. Because bear markets typically last one and a half to 2 years, an aggressive investor should always have at least a couple years income in bucket #2 if for no other reason than to tide them over through a bear cycle. However, I recommend keeping far more safe money available than just 2 years’ worth.  If possible, 7 years is a good period.

How Much Money to Have in each Bucket at Retirement?

During one’s working years the buckets are filled somewhat in order.  Exceptions are when there are opportunities to leverage employer incentive programs for funding retirement, and/or government tax incentives for home purchase, paying for child’s education or funding retirement.  In this case the buckets might be filling somewhat simultaneously (although disproportionally).  For example, in one’s first jobs there may be opportunities to participate in employer matched 401K programs.  If so, contributing the maximum amount matched is a good strategy.  In this case one’s paycheck would be split between Bucket #1 income needs for living expenses, and some Bucket #3 Growth assets for retirement.  Thus partially funding Bucket #3 with matched or tax subsidized funds before Bucket #2 was fully funded still makes financial sense.  Later in mid-life if someone had children, contributing to a government tax advantaged college fund would also make sense, filling Bucket #2, even if Bucket #1 were not yet fully funded.

Scenario of Bucket Distributions Upon Entering Retirement

The “Scenario of Bucket Distributions Upon Entering Retirement” figure is a screen shot of an Excel spreadsheet which calculates present and future values based on assumptions.  The present and future value formulas used for calculating the amounts can be seen in the excel sheet itself. It is based on 7 year cycles of withdrawal from Bucket #1 and #2.  In this example at the end of this 14 year cycle there is enough money to reinvest in Bucket #1 and part of Bucket #2, for a repeat of the cycles.

Sources and References:

  1. “Buckets of Money, How To Retire In Comfort and Safety ”, Raymond Lucia, Wiley, 2004

How Much Money to be putting in each Bucket during Employment?

The “Income over a Work-life and Retirement Timeframe” figure discussed previously shows a generalized model of income over time. 

Income over a Work-life and Retirement Timeframe

For Bucket allocations, the “Income over a Work-life and Retirement Timeframe” figure becomes something like the “Bucket Investment Ratios over Lifetime” as shown in that figure.

Bucket Investment Ratios over Lifetime

In this figure, income increases over one’s working lifetime, starting in earnest at age 22 with the first job, then with large promotions to higher management levels at age 29, 38 and 47.  During this time between 5-15% of total earned income is invested in Buckets #1 and #3. At age 58 transfers start from Bucket #3 to Bucket #2 over  14 years, to fully fund Bucket #2 by retirement age 72.  Note that this is modeled as a uniform annual funding, but in fact the right strategy is to move larger amounts when the long term economic cycle over those 14 years is good, and little if any amounts when then long term economic cycle over those 14 years is bad.  At retirement the earned income falls to zero, and three cycles of Bucket management occur at ages 72, 79 and 85. 

Bucket #1 Investments – A Safe Secure Financial Base for Emergencies & Early Retirement Income

Overview

Bucket #1 should provide consistent, sometimes guaranteed, and potentially tax favored income. You want to take very little risk with your bucket #1 monies. This is the bucket that provides your living expenses while you’re working and later in retirement it’s the bucket that’s going to sustain you while the other two buckets grow. Thus think “shooting for a zero risk”.

You don’t want to worry about losing your job during your working life or your monthly retirement check when you have retired. You want to limit your choices to only very safe investments. That means little, if any, price fluctuation and virtually no chance of losing any principal.

The choices vary from time to time. The attractiveness of many investments waxes and wanes depending on what’s happening with interest rates and how aggressive lending institutions, insurance companies and government policies are at any one point in time. Sometimes, for example, bonds are the best choice. Other times CDs, and fixed annuities may lead the pack. A good financial advisor can help you make sound choices here.

Insured Checking, Savings, CD’s, Laddered Treasury Notes and Bonds

Another way to structure bucket #1 guaranteed income portfolio investments is to ladder them. In a seven-year bucket strategy the ideas to ladder six fixed investments, each maturing one year apart, starting at the beginning of year 2 and ending at the beginning of year 7. After that it’s time to empty bucket #2 and replenish bucket #1. Certificates of deposit at the local bank are probably the easiest investments to ladder. However depending on interest rates, US treasury securities with comparable interest rates and maturities have a slight advantage if you live in an area with a state income tax. That’s because government securities held by you personally are exempt from state income tax that CDs are not. Credit unions sometimes pay higher rates than banks, but whether you use banks, money market mutual funds, short-term treasuries, credit unions, or in immediate annuities, the yield should be comparable and your principal should be very safe.

Short-term bond mutual funds are sometimes attractive if it looks like the long-term interest rates are flat or declining. If this is the environment, such funds are attractive because they hold short-term government securities maturing 1-5 years, and the mutual company makes all the investment decisions for you. You don’t have to shop for CDs and treasuries yourself.  The fund picks the right bond investments at the right time. A caution is that in periods of rising interest rates, the share price can decline faster than the benefit of a little higher interest rate!

Immediate Annuities

Upon retirement what you want for your bucket #1 is a convenient and hassle-free retirement income. An Immediate Annuity Contract is just that: it delivers a check to your door each month or automatically deposited to your checking account on the same date, month in a month out. An Immediate Annuity Contract is a great way to go if you don’t want to deal with reinvesting interest every 6 months from a bond portfolio, shopping among banks for best interest rates when your CDs mature, dealing with brokers, or dealing with the government.

An Immediate Annuity Contract is issued by an insurance company guaranteeing payments for specific retiree each month on a specific date. It can last for either a fixed number of months, the rest of an annuitant’s life, or for the life of joint annuitants. The most cost-effective is typically to use an annuity that pays out principal and interest over a fixed number of months rather than over one’s life expectancy. Thus taking an annuity duration equal to the bucket’s seven year lifetime is a good strategy.

Annuities also give you tax advantages. You only pay tax on the pro rata amount of interest you receive in the year you receive it; the rest is deferred until it is withdrawn in subsequent years. Depending upon the tax laws of the time, it may also help avoid or reduce taxation of your Social Security benefits.

Social Security

Social Security is put into bucket #1 because you’re contributing to it by law throughout your working life. During your working years how much you contribute is not a consideration or option.

It is a useful exercise in your own annual review to visit the Social Security admin website, www.SSA. Go and look at a copy of your statement for accuracy of your contributions and also to get a current estimate of what you may be able to obtain in retirement depending upon the age in which you choose to start taking benefits. Tracking potential payout amount over one’s working life will give you a feeling for how the government, under various administrations, is likely to handle Social Security payouts when your time comes to collect them in retirement.

Really only choice you have, upon retirement, is what your age is when you want to first start taking your Social Security benefits. Over the decades there been arguments between financial planners as to whether it’s best to start taking benefits as soon as you’re eligible versus deferring them until the oldest age at which are required to start. The 2 main factors are (1) your health which affects your life expectancy, and (2) if you are enjoying your work and the earned income you are obtaining in the years between when you could first take rate Social Security and the last year when you have to start taking payments. If your health is good, and your life expectancy high, and you’re enjoying your work that’s providing sufficient earned income, you’ll want to defer starting Social Security benefits. If the opposite situation is true you want to start taking benefits as soon as you can.

Because social security is a government program, and its benefits are likely to vary all over the map during your working life, the best thing you can do is not worry, or count upon it, until you actually retire.

Bucket #2 Investments – A Low Risk Financial Building Block for Economic Downturns & Late Retirement Income

Overview

When working, bucket #2 is acting as a safety valve for any economic downturns suffered by the bucket #3 investments. The traditional 50% bond and 50% stock portfolio financial planning scenarios in more recent decades have been superseded by recommending investments in 35% bonds and 65% stocks. 

The bond portion of this investment strategy during the working years is being held in bucket #2, and as one nears retirement, typically 14 years before the anticipated retirement date, bucket #2 is evaluated to see if it’s total cash value is projected to be sufficient to provide 7 years of inflation-adjusted income at that time. If not, during that timeframe and at a high point in bucket #3’s performance, monies are withdrawn and added to bucket #2 so that upon retirement it contains the needed funding.

Best Bets For Bucket #1 and Bucket #2 Investments

Upon retirement, the investment time horizon for the bucket #2 is 5 to 7 years. From an investment standpoint you neither want nor need to take excessive risks with bucket #2. There is plenty of risk and excitement when you invest your bucket #3 monies.  Focusing on higher-yielding fixed income securities for bucket #2, versus bucket #1, usually makes the most sense. Investments that are aimed at producing income and growing in value are typically fixed income securities.  These are designed to make regular payments to you, and provide a reasonable degree of certainty that the money will be available when it is needed. They are safer than growth oriented investments of bucket #3 in the sense that these payouts are more reliable than those invested for growth.  The “Best Bets For Bucket #1 and Bucket #2 Investments” figure shows a variety of opportunities to provide the safety required.

The only items that I think are suspect in the above list are: to be investing in preferred stocks, in medium and long term bonds, or junk bonds. This is because the stock market and the strength of longer term and riskier bonds is too much risk in my view for bucket #2. Given the bucket #2 is supposed to have its principal secured and be growing in a safe manner for 7 years, I believe the investments I just stated are much better considered as bucket number 3 candidates.  There are still sufficient options in the above list for diversifying bucket #2 investments.

Tax Subsidized Education Funds

These funds are listed under bucket #2 because although they are not really part of retirement planning per se, the investment vehicles they use are typically found in bucket #2. This is because the timeframe for investment between the birth of a child and its need for educational expenses is roughly on the order of the same 14 year time horizon is bucket number 2 retirement focused investments.

There are several types of Education Savings Plans for K-12 and College Students. These types of accounts allow you to save money for school expenses and then withdraw funds tax-free:  (1) Qualified Tuition Programs (QTPs), or 529 Plan and (2) Coverdell Educational Savings Accounts (ESA).

Qualified Tuition Programs (QTPs) (529 Plans)

A Qualified Tuition Program, or 529 Plan (named for the section of the tax code that describes it), is a state-sponsored savings account set up to pre-pay for K-12 and college expenses. The owner of the 529 account can make contributions that may be withdrawn by the beneficiary to pay for qualified education expenses at an eligible educational institution that can participate in a student aid program administered by the Department of Education. These institutions include: Public, private, or religious K-12 schools (tuition only), Colleges, Universities, Vocational schools, Other postsecondary institutions.

529 Plans have no age or income restrictions for contributions or withdrawals. The only limit on contribution amounts is that the total contributions may not be greater than the amount needed to pay the beneficiary’s qualified education expenses.

Coverdell Educational Savings Accounts (ESAs)

A Coverdell ESA is a savings account sponsored by a bank or other financial institution. The account is set up to pre-pay for K-12, college tuition, and other education expenses. The savings account’s beneficiary must be at least age 18 (or a special needs beneficiary) to withdraw Coverdell funds. The beneficiary must withdraw the funds before age 30 or the funds will be distributed and taxed. If the age requirements are met, the funds may be withdrawn tax-free if they are used to pay qualified education expenses. If the beneficiary turns age 30 before withdrawing the funds, they may avoid taxation by transferring the account to another qualifying relative or by rolling the ESA into a 529 Plan

Coverdell ESAs have certain restrictions that 529 Plans do not have: Funds must be withdrawn or transferred after the beneficiary is age 18, but before age 30; Qualified expenses do not include computers or internet access; You may not contribute if your income is more than $110,000 for Single, Head of Household, and Qualifying Widower filers and $220,000 if Married Filing Jointly; There is a maximum annual contribution of $2,000 per beneficiary (not per account and not per contributor).

From a financial planning standpoint, in the first few years of a child’s life, investments in the Tax Subsidized Education Fund can be put into bucket #3 type investments. However, such funds are listed in bucket #2 because contributions are likely to be within the 14 year planning horizon of bucket #2 investments. Also safety of principal is much more important than extra earnings. It is likely the majority of the monies in a student’s fund will come from direct contributions and much less so from the investment income. Having the security that the money will be there when needed is more important than a little extra money in the account.

Treasury Bond Funds

Bond funds investing in treasury instruments have the safety of the underlying security and could almost be considered a bucket number 1 investment. However they will vary in value as interest rates rise and fall. What is your straights are falling they offer both safety and a slight upside from the interest rate change. However, there been times when interest rates have risen very rapidly and if one invests in treasury bond funds you need to be tracking interest rate changes carefully and switch out of the fund as interest rates move into a rising trend. Because of witnessed so many interest rate changes I think it’s better to invest in either government or high-quality corporate bonds directly versus via a fund. In doing so, I always plan to hold the bond to maturity. My, and others, ability to time interest rate changes is poor.

Money Market Funds

Money market funds have the convenience of being available through most banks and act as a savings account with a little bit higher yield than those that are FDIC insured. The advantages as extra interest rate and often times the bank, but not the federal government, will guarantee the principle. When the economy is growing in the financial institutions appear stable this can be a good way to get a interest premium over the basic federal rate in a convenient manner. The only caution is as if the market looks like there may be turmoil in the financial institutions it’s best to move monies from a money market to an FDIC insured account. Fortunately this is being done at a bank this can be done without penalty and is available on a daily basis.

Variable Annuities

These investments act a lot like tax-deferred mutual funds, but with the guarantee that you won’t lose your principal if you die. The insurance company pays to your heirs the full amount invested if you die, even if the market has suffered a decline. They are variable in the sense that the return varies with the performance of the subaccounts you choose. If you invest in stock subaccounts, your return reflects the stock market’s performance. Similarly, bond subaccounts will mirror the bond market. The money grows tax-deferred and you don’t pay taxes on your earnings until you withdraw the money. Most popular variable annuities for bucket #2 are those that give you a guaranteed return rate of say 5 or 6%, or the return of the stock market portfolio held in the annuity for a specified number of years. You do pay an extra fee for this type of guarantee, and you may be forced to amortize your guaranteed return over several years at a significantly lower interest rate if you elect a fixed return. Thus the effective return maybe more like 3 or 4% instead of the 6% guaranteed. But during periods when stocks are producing dismal returns and you’re particularly fainthearted, your bucket #2 remains safe and earns at least a reasonable rate while you sleep comfortably. On the other hand when stocks produce better returns you get the greater the two. Thus if your stocks go up you get the returns the stock market and if stocks decline in value, you’re protected with a guaranteed floor rate. The downsides of Variable Annuities are that your money is locked up and also subject to a surrender charge, management fees, mortality and expense charges. Sometimes fees can be high. Also, your money is subject to a pre-age 59 ½ penalty, so don’t want a Variable Annuity if you think you will be touching the money before that magic age. Further when you pull the money out of a Variable Annuity, the earnings are taxed as ordinary income as of most of the gains will have come from capital appreciation. Once again, for bucket #2 this is okay.

Tax Deferred Fixed Annuities

Depending upon the interest rate and your tax bracket, Guaranteed Investment Contracts, Stable Value Funds or Tax-Deferred Fixed Annuities often make ideal bucket #2 investments. By way of background, the fixed annuities are similar to a tax-deferred CD but are offered by an insurance company. They pay a fixed return that is usually higher than treasuries, and they are typically adjusted annually or over a number of years. The annuities are sponsored by an insurance company instead of a bank, and taxes are deferred each year in on the profits you earn. Naturally the tax-deferred money grows more quickly than money that’s taxed annually. The Tax-Deferred Fixed Annuity Contract offers an excellent blend of both safety and high yields when interest rates are low with the potential to move higher. Having an investment that performs well in a rising interest rate environment is a great way to protect against interest-rate risk. Unlike bonds yields, a Guaranteed Investment Contract or Tax-Deferred Fixed Annuity usually gets better if interest rates rise. And, if interest rates decline, the yields will also decline but that’s okay. The reason that’s okay is because as interest rates move lower, stock prices usually rise, thus your bucket #3 holdings should more than make up for the lower yields on a Fixed or Tax-Deferred Fixed Annuity.

Another advantage of putting Tax-Deferred Fixed Annuities in bucket #2 is that the taxes due on the interest are deferred until after bucket #1 is depleted (when these assets are moved to bucket #1). At that time the deferred annuity can be annuitized, that is, set up to provide a fixed sum at regular intervals. That is it’ll produce an income to replace what had previously been in bucket #1, and the taxes will be spread out over a period years versus having to be paid all at once. If in contrast, bucket #2 contained in IRA, pension, 401(k) or similar plan, the fund is tax-deferred and so it will all be considered as ordinary income when paid out, regardless of whether you used a Fixed Annuity.

If interest rates inch upward, the credit rate on a Fixed Annuity Contract would most likely renew at the higher market rate. And unlike 10 year treasuries or other bonds, there’s no downside principle risk if interest rates change. But note too that there is no upside to appreciate if interest rates decline. Thus when interest rates are already low, with the potential to move up, fixed annuities superior to bonds or bond funds. When rates are high with potential move down, bonds may be a better choice.

Fixed Annuities are great complement stocks. This is especially true when interest rates are on the rise. However, many financial pundits and self-proclaimed money experts continually beat down annuities as an investment. The reason is most insurance company products are not well understood. Fixed Annuities, unlike Variable Annuities, are no frills investments. These do not have extra fees or charges and no out of the ordinary expenses. They would not provide any upside potential like Variable Annuities, no death benefits to speak of, and no potential to shift from safety to growth by one easy phone call. All the profit the insurance company makes on the sale of Fixed Annuities is priced into the interest rate they credit. If you don’t like the rate don’t buy the product. Fixed Annuities are like tax-deferred CDs paying a fixed, usually highly yielding interest rate. As long as investors understand they are buying a contract that shouldn’t be touched for 5 to 7 years, due to the surrender penalty and until after age 59 ½ due to federal and state tax penalties, they he can enjoy higher returns and comfort of having those returns pegged to market interest rates.

Bonds and Notes

Mutual bond funds are really good for some investors. For example in the 1970s and 1980s, when interest rates were high with the possibility of moving lower, bonds were an especially good choice. More recently as the stock market imploded and the Federal Reserve began lowering interest rates, most bond funds posted magnificent results. Bonds can either be held to maturity, in which case they pretty much pay a fixed return for specified time and upon maturity return the principal. Loans to risky borrowers and those with longer maturities offer the highest yields. Safer and shorter term loans usually yield significantly less than longer term and riskier bonds.

Investing in bond mutual funds has advantages if market interest rates stay the same or move lower. They provide small investors access to the best bonds at the best prices. The diversification offers bondholders insulation from the potential risk of default or if a business event could cause a rapid depreciation in a single bonds value.

Bond funds come in Open Ended, Close Ended, and Unit Investment Trusts. The Open-Ended Funds offer an unlimited number of shares forever. You can redeem your shares with the mutual fund company when you want the money. The Closed-End Fund sells only a certain number of shares. Thus its shareholders must negotiate with other investors to sell their share, which means the price received can be and usually is less than the quoted market price. Unit Investment Trusts are groupings of bonds that are selected with similar maturity dates and interest rates, then held until maturity.  When a given bond in the unit investment trust matures, your pro rata share the proceeds is returned to you. The disadvantage of open end bond funds is that they are very sensitive to the overall interest rate. Value will change slightly as some bonds in the fund mature and the fund manager takes the cash and buys a new bond at the current market rate.  These changes in yields are gradual and hardly noticeable but over time they can affect your overall income dramatically. Therefore Guaranteed Investment Contracts are used when rates are low and mid to longer-term bonds are used when rates are high. This maximizes the performance of bucket #2 while minimizing the risk. As a word of caution, do not get lured into buying bonds with the highest yields. Chasing the yield or a hot fund is usually a recipe for disaster. Higher yields may also mean higher risks, so be careful.

Conventional wisdom success suggests that if you want high yields and low volatility, bond funds make the most sense. This is often just not true. When interest rates rise to bad things can happen. The bad effects are: stocks usually lose value in bond prices decline. Stocks are reserved for long-term growth and bucket #3. The best assets for bucket #2 are those that offer a yield competitive with intermediate bonds and move without the price fluctuation.

Treasury Inflation Protected Securities

Intermediate and long-term government securities are one of the best ways to avoid default risks. These securities include treasury notes which mature in 2 to 10 years and treasury bonds which mature in 30 years. There also Series E Savings Bonds and Series 1 Inflation Index Bonds which you must generally hold for at least 12 months, and Treasury Inflation Protected Securities (TIPS). These are all subject to federal tax only (exempt from state tax) and, of course, are guaranteed by the federal government

Episodic Investment in Bucket #3 Assets

Bucket #2 can also be used to potentially enhance your overall rate of return by taking advantage of certain buying opportunities. For example, following almost every stock market correction in the last 50 years, there was significant recovery over the ensuing 6 months of 2 years. Because we have ample time and bucket #1, a more aggressive investor may choose to divert some of their bucket #2 money into bucket #3 shortly after a steep stock market decline. Thus, as the market rebounds, the return on that portion from bucket #2 could dramatically outpace the fixed for semi-fixed return of normal bucket #2 investments. After the rebound, one could pay back the money borrowed from bucket #2 and leave the excess profits to grow in bucket #3.

Bucket #3 Investments – A More Risky, but Higher Growth, Long Term Financial Engine for Feeding Buckets #1 & #2, and Passing Wealth to Heirs

Overview

Bucket #3 is reserved for stocks and other long-term investments. The goal of this growth portfolio is for long-term appreciation. It complements the ultraconservative bucket #1 which will provide you current income. It also complements a moderately conservative bucket #2. It’s designed to churn out yet more inflation indexed income with which to replenish bucket #1. When setting up bucket #3 in this manner you have an advantage over other investors because you’re firmly focused on the long term (14 years in the model that we’ve been using). This is key because successful stock market investing is not when you invest, or even which stocks you buy, but for how long you invest and how diversified you are. Given a long enough time frame and proper diversification, bucket #3 is where you get the biggest bang for your investment buck.

When it comes to funding bucket #3 there are two ways to go about it. One is to use dollar cost averaging, where money is invested in increments over a long period, rather than as a lump sum. This approach makes perfect sense during your working lifetime when you’re setting aside monthly a specific amount out of your paycheck to put into this bucket. Later when it comes to postretirement, putting money into funding bucket #3, it’s best to put it in as one lump sum. This is because using dollar cost averaging for this task is too much like trying to time the market.

Matched IRA Contributions

As was mentioned earlier, when you have matched employer contributions to a retirement account, or can use self-employed retirement accounts, SEP-IRAs, putting the maximum amount of money into them that’s allowable is a great investment strategy. The offer the flexibility of being able to be invested in a variety of vehicles most commonly found suitable for bucket #3.

Homeownership, Primary Dwelling, Mortgage

Most financial planners do not consider one’s primary dwelling as an investment. This is because you always need a place to live. However one has to be practical about this. If you’re fortunate to be working in a community where growth in real estate appreciation is present, the value of a home over what it will cost you to move to another accommodation can be considered as a bucket #3 investment. The excess primary home value goes into bucket #3 because the time horizon upon which most people sell homes is much longer than bucket #2. Also housing prices do go through long-term economic cycles where they can rise and fall in value, sometimes dramatically. The reason most financial planners don’t like you considering this excess real estate value for your retirement planning is that oftentimes you’re forced to sell a home when a particular life event, like a job change, occurs. As such you may be selling at the bottom of the market, just as likely as you might be selling at the top. This inflexibility is why home value should not be counted on heavily for retirement.

The other caution with investing in primary residences is that they create a lot of expenses, both in mortgage payments, taxes and upkeep.  Many of these are not tax-deductible. These increased expenses detract from one’s ability to invest those dollars in other income producing bucket 3 investments. Thus was one has to be thoughtful about the size of a primary residence that one acquires. Ideally one would have fully paid off a mortgage, or moved to a smaller residence that was fully paid off, by the time one retires.

Stocks

In bucket #3 you have the opportunity to invest in individual stocks or stock funds. The question that often comes up how many funds should you own. There’s no hard and fast rule about this, but common sense plays a part. The accepted view is that 7-8 are probably as many as you can regularly track, as well as provide enough diversification. Normally recommended are a large-cap growth, a large Value, a small Growth, a small Value, an international emerging market, and a real estate fund. Remember that your aim is to cover a number of different aspects of the market with funds that will do well during different parts of an economic cycle. You want funds that don’t all march to the same drummer. When it comes to how much to put in these different areas Figure 4.1 “A Typical Bucket #3 Allocation Oriented Towards Growth” provides some guidance. There is no magic bullet here though.

A Typical Bucket #3 Allocation Oriented Towards Growth

Another question relates to active versus passive management. There are a lot of different points of view here. There are times when the market is steadily rising, In this case indexing beats active management. However in down markets and times of market turmoil having good active management will beat the indexes. Since the goal of this bucket is to hold assets for a long time and to be diversified recommendation is to use a mix of both. Typically 50-50 up to 70-30 in favor of index funds. That said one has to look at the track record of the fund managers carefully. Upon making an investment, tracking the performance of the active managers over time is done annually because experience shows managers can do really well for long stretches of time (up to a decade or so) but then there is a change in the management team, or the market changes, and they lose their magic touch. Once a manager has three bad quarters in a row it’s time to look carefully at their performance and figure out whether it’s a special cause or they fundamentally are using a wrong system. Once seven quarters have passed it’s a systematic issue and a change should be made, If not already done.

Real Estate

Real estate allocation of 10 to 20% of bucket #3 assets is appropriate. This is because like stocks, real estate over the long term can grow in value in producing come. Real estate can be made up of personally managed income property, owner-occupied real estate, limited partnerships, and real estate investment trusts. The preference tends to be for nontraded real estate investment trusts. The characteristic of such reach should be that they are in the growth stage, still raising money from investors to purchase commercial buildings, hotels, assisted living facilities, and the like. Because they’re not being traded, their prices don’t functional weight daily. They’re usually private, on their way to becoming a listed, or public, company. So they are a little less liquid but they can complement the bucket #3 stock allocation: less volatile than stocks but with return similar to that of the stock market. Particularly desirable are low leverage REITs, that is, those without a lot of debt because they have most of their properties free and clear. That way even if the real estate market struggles and occupancy rates decline, it’s unlikely there would be a total loss. A low leverage REIT in difficult times might have to cut its dividend, but is not likely you will lose your principal sum.

Precious Metals

Precious metals are only good investments when there is serious inflation occurring. With rare exceptions, precious metals of the flat or worse since late 1970s. This can change at any time however it with the 2020 perspective of potentially entering a period of high inflation this may be an area were 3 investigating.

As a hedge when your bucket #3 become large enough is investing in gold producing companies, especially if you can obtain a position in a company with good management and selling at 60% or less of their NAV (net asset value).

Legacy Bucket – Variable Universal Life Insurance

Live insurance is not primarily intended to be a bucket #3 investment. However many times a variable annuity life policy is a good investment for those who do not need to spend all the money in bucket #3, and who want to pass on the highest after tax inheritance to their heirs. In certain cases, properly funded variable universal life policy can be a great tax break and supplement your bucket #1 income by producing tax favored income at retirement when you we needed the most.

This Legacy bucket is sort of a some bucket of bucket #3. It’s place to get your money to grow tax-free, choose to invest among a large selection of mutual fund like accounts (known as subaccounts), and then when it comes time to take the money out, make tax-free withdrawals of your cost basis and borrow your gain tax-free? Plus, when you die, the death benefit pays off all the loans, and the balance is paid your heirs tax-free. This is in for people with lower modest cash flow and a need for temporary coverage. They should buy a term life insurance that is investment but as protection against financial loss, such as what might happen when a breadwinner dies. But a variable universal life policy is definitely worth looking into for those with higher incomes, or significant cash flows, and a mindset for long-term investing.

If you bought a variable universal life policy and funded it with the same amount as you would have put into mutual funds over the same period of time, you’d likely get a similar income stream, but it would be tax-free. In addition you’d be insured every year for the rest your life, and your family would get the tax-free death benefit on your death.

Sources and References:

  1. “Buckets of Money, How To Retire In Comfort and Safety ”, Raymond Lucia, Wiley, 2004
  2. https://blog.evergreengavekal.com/four-baskets-for-four-quadrants/
  3. “Principles: Life and Work”, Ray Dalio, Simon & Schuster; First Edition (September 21, 2017)
  4. “On My Radar- Park City Notes”, Steve Blumenthal, CMG, Mar 7, 2020
  5. https://en.wikipedia.org/wiki/Strauss-Howe_generational_theory