Asset Allocation Using The Bucket Approach

This article was originally published on Seeking Alpha: How Does Dividend Growth Investing Fit Into The Bucket Approach To Retirement?

Summary

Plenty of informative articles on DGI

Plenty of informative articles on retirement planning and asset allocation

This blog post puts the two concepts together

Introduction

I retired in mid-2104 and am in the early stages of the so-called distribution phase of my investing career. Among other investments I have created a dividend growth portfolio of 20 (mostly) blue-chip, large-cap stocks*. How does that fit into the overall scheme of things? Hint: my DG stocks are intended for the long term which I define as greater than ten years.

(*) See current list of my DG stocks below.

Several years prior to taking the plunge, after an enlightening 32-year career at the aerospace and building systems giant United Technologies Corporation (UTX), I began the detailed planning needed to at least have a decent shot at a successful retirement.

My planning went out to age 95 (note that’s a whopping 40 years past my retirement age since longevity runs in the family).

After lots of research I opted to use a time-based asset allocation strategy incorporating a bucket approach.

Three Buckets

My bucket system uses separate portions of the overall portfolio for three distinct phases of retirement: short-term (“A”), intermediate-term (“B”), and long-term (“C”).

Funds are drawn from Bucket A to pay expenses over the next two years including routine monthly bills, occasional expenses such as car and home repairs (i.e. emergency fund), and known big ticket items coming up on the horizon such as a new car, a child’s wedding, or an around-the-world vacation.

Funds needed for spending during the eight years after that (3-10) are parked in Bucket B and funds equalling expenses after the tenth year will be contained in Bucket C. All expenses take into account my personal inflation rate: defined as 2.5% annually for the first 2 years of retirement and 3% per year thereafter.

Bucket A emphasizes safety and liquidity. No bonds or stocks here as there won’t be enough time to recover from a crash. Cash equal to cumulative expenses minus other income sources (such as my pension and part time earnings) is kept in a money market account and transferred to checking as needed to pay bills.

Bucket B is the primary replacement source as Bucket A is drawn down. Funds contained in this bucket are a combination of cash and fixed income (in my case two bond funds in a taxable account and a stable value fund in my 401k) and also considers other income sources (pension, SS benefits).

Bucket C is the replacement source for funds withdrawn from Bucket B. This bucket contains the current value of the rest of the fixed income not in Bucket B, dividend growth stocks in a taxable account and IRAs, and index funds (domestic and international) in the 401k.

The process called for a detailed review of the budget plan and portfolio performance at the end of the two-year period. The buckets will be redefined if necessary.

Figure 1 depicts the approach.

Buckets
Bucket A Funds Requirement = (Expenses 0-2 Years + Emergencies + Big-Ticket Items) – (Other*)

Bucket B Funds Requirement = (Expenses 3-10 Years) – (Other*)

Bucket C Funds Requirement = (Expenses 11+ Years) – (Other*)

Other* = Pension + P/T Earnings + SS Benefits

Detailed Example

The following is an example of my bucket approach, including details on how DG stocks will be used to generate funds to refill Bucket B.

For the initial two year retirement period (2015-2016) I defined the income sources, budget, and funds for each bucket:

Short Term (2015-2016)

Pension = $30,000 per year

P/T earnings = $5,000 per year

Expenses = $105,000 (includes inflation of 2.5%)

Emergencies = $20,000

Big-ticket item = $25,000 (new car to be purchased in 2016)

Bucket A requirement = $150,000 – $70,000 = $80,000 (actual = $90,000).

Intermediate Term (2017-2024)

Expenses = $425,000 (includes inflation of 3%)

Pension = $30,000 per year

SS benefits = $100,000

P/T earnings = 0

Bucket B requirement = $425,000 – $340,000 = $85,000 (actual = $125,000)

Long Term (2025-2054)

Expenses = $2.5M

Pension = $30,000 per year

SS benefits = $1.2M

P/T earnings = 0

Bucket C requirement = $2.5M – $2.1M = $400,000 (actual = $900,000: $300,000 in index funds and $600,000 in blue-chip, large-cap DG stocks*)

Two-Year Review (early 2017)

At the end of the first two-year period (2015-2016) both the spending side (the budget) and the income side (the buckets) needed to be redefined.

For the next two-year period (2017-2018) the new budget called for spending $110,000 (monthly bills but no new big-ticket items). For the eight years after that (2019-2026) the budget called for spending of about $520,000.

Assume that for 2015-2016 actual spending matched the budget. Bucket A was drawn down to $50,000 (starting value of $90,000 plus other income of $70,000 minus expenditures of $130,000 plus $20,000 emergency fund not spent). With the $20,000 emergency fund requirement still in place plus $110,000 planned to be spent during 2017-2018 the new Bucket A requirement is $60,000 ($130,000 – $70,000). A shortfall of $10,000 exists for the period 2017-2018, which was needed to be filled by Bucket B.

The Bucket B cash and fixed income funds (bond and stable value) in place at the beginning of 2015 ($125,000) generated about $8,000 in interest over the two year period. The remaining $2,000 had to raised by transferring cash from Bucket B to Bucket A (i.e. a paper transaction since the funds are physically in the same account). This reduced the actual value from $125,000 to $123,000. No price appreciation was noted in the Bucket B accounts since all of it was cash or fixed income.

In early 2017 the new 3-8 year spending needs were determined to be $550,000. Income sources of $240,000 (pension) and $162,000 (SS benefits) were tallied. Therefore the new Bucket B requirement is $148,000. A shortfall of $25,000 existed which was needed to be filled by Bucket C.

The shortfall was handled by using part of the $48,000 of income generated by the DG stocks and index funds in Bucket C*. The remaining ($23,000) portion of the dividend income was reinvested back into the portfolio. Combined with price appreciation the long-term portion of the overall portfolio grew over the period. No shares were needed to sold to refill Bucket B.

(*) My approach does not require a high yield to be successful. The composite Bucket C dividend yield is just 2.7%.

Dividend Growth Portfolio

My dividend growth, DG, portfolio consists of the stocks found in Table 1. The rules-based process used to select a new stock is defined in Creating The Optimal Dividend Growth Portfolio.

 

Table 1

List of DG stocks

Stock (Ticker) Sector Industry
Apple, Inc. (AAPL) Tech Computers
Raytheon (RTN) Industrial Defense & Aerospace
Johnson & Johnson (JNJ) Healthcare Pharmaceuticals
Emerson Electric (EMR) Industrial  Electrical Equipment
AT&T (T) Telecom Wireless Services
Procter & Gamble (PG) Consumer Staples Personal Products
The Coca-Cola Company (KO) Consumer Staples Beverages
Alfac, Inc. (AFL) Financial Insurance
Wal-Mart Stores, Inc. (WMT) Consumer Staples Food & Staples Retail
Chevron (CVX) Energy Major Integrated Producer
T.Rowe Price (TROW) Financial Capital Markets
CVS Health (CVS) Consumer Staples Food & Staples Retail
NorthWestern Corp. (NWE) Utilities Multi Utilities
WEC Energy Group (WEC) Utilities Multi Utilities
National Health Investors(NHI) Real Estate REIT
Magellan Midstream Partners(MMP) Energy Oil and Gas Pipelines
Eversource Energy (ES) Utilities Electric
Chubb, Ltd. (CB) Financial Insurance
McDonald’s (MCD) Consumer Discretionary Restaurants 
United Technologies Corp.(UTX) Industrial Conglomerate 

Summary

My retirement planning process, including use of the bucket approach for asset allocation and spending over a 40-year time period, also incorporates a dividend growth strategy. My 20 mostly blue-chip, large-cap stocks are firmly planted in the Later (long-term) bucket.