Advisors are putting their clients' money in buckets. In the increasingly popular strategy, you divide a portfolio into three sections or buckets. The first bucket holds cash and other safe instruments, while the other sections take on more risk. The aim is to reassure nervous clients that at least some of their assets will be able to cover expenses — no matter how markets perform over the short-term.

Some critics dismiss the buckets, saying that the approach could reduce returns while not necessarily providing more safety. But a growing number of clients and advisors are embracing the buckets.

Dennis Gallant, president of GDC Research, an industry consultancy, says that advisors have been using buckets for two decades. But the popularity of the buckets has increased in the last two years as more advisors have sought techniques that could reassure frightened clients. According to a survey by GDC Research, 3 out of 10 advisors are now using some form of buckets. “The bucket approach resonates with clients,” says Gallant. “Bucket strategies tend to be conservative, and advisors who used buckets saw their business grow during the market downturn.”

Three Buckets — or More

Using three buckets works particularly well for nervous retirees who are reluctant to hold stocks of any kind, says Norbert Mindel, chief investment officer of Forum Financial Management, a financial advisor in Lombard, Ill. To comfort clients, Mindel recommends that the first bucket should hold cash, while the second and third buckets hold a mix of stocks and bonds.

Say the retiree has $1 million and needs $50,000 a year to live. The first bucket would hold $150,000 in cash and certificates of deposit — enough to cover three years of living expenses. When the first bucket runs low, the cash can be replenished from the second bucket, which would hold $350,000, including 80 percent of assets in investment-grade bonds and the rest in stock funds. The third bucket would have $500,000, with 60 percent in stocks and 40 percent in bonds.

Say stocks drop more than 35 percent as they did during the downturn of 2008. The retiree would still have enough assets in the first two buckets to cover living expenses for 10 years. “The goal is to reassure clients so that they don't panic in downturns and sell their stocks,” says Mindel.

Advisors have developed many kinds of bucket strategies. While some rely on three buckets, others use many more. In 2009, Nationwide began promoting its RetireSense program, which employs five or more buckets. In the program, the advisor first determines how much the retiree needs to cover essential annual expenses, such as food and rent. Say the client needs $20,000 annually and only has $14,000 a year in Social Security. The advisor might suggest covering the remaining $6,000 with an immediate annuity.

With the essential expenses covered, the client can now turn to establishing buckets for other costs. Each bucket covers a five-year period. So a retiree who is planning for a 30-year retirement would need six buckets. In the first bucket, the client would put enough cash to cover 5 years of expenses. The second bucket, which covers years 5 through 10, would have a mix of safe stock and bond funds.

The bucket for years 10 through 15 would hold more stocks — but temper the risk with an annuity. A good choice could be a deferred variable annuity, says Brad Davis, Nationwide's associate vice president for retirement income solutions. A typical variable annuity would invest assets in stock funds. If the markets soared, the client could keep the profits. But if the markets stagnate, the client would receive a guaranteed minimum amount of income.

Say the client puts $200,000 into the annuity, and stocks are flat. At the end of 10 years, the benefit base — the theoretical portfolio used for calculating guaranteed income — would grow to $400,000. The client would have guaranteed annual income of $21,000, or 5.25 percent of the benefit base.

Davis concedes that the bucket strategy could underperform a traditional portfolio that would have 60 percent of assets in equities and 40 percent in bonds. But he argues that retirees don't necessarily want to maximize their returns. “As people get older they want less risk,” Davis says. “For retired clients, financial advisors should be focused on managing risk — not on maximizing returns. The clients need to live on their assets, and they should be protected from potential disasters.”

The (Inevitable) Critics

Some analysts quibble with the bucket approach. While putting cash into buckets may make clients feel more secure, the strategy may not actually make portfolios safer, says Tim Noonan, a managing director of Russell Investments. Noonan says that in the traditional 60-40 portfolio, all the assets are working to deliver returns. But if you set aside a big cash stake in a bucket, then part of your portfolio is not hard at work, and the expected returns of the portfolio will be lower. “With the cash bucket, you may feel safer for the first five years, but you have increased the probability that you will run out of money before you die,” he says.

Noonan is particularly wary of bucket strategies that rely on annuities. He concedes that annuities can be fine vehicles for insuring that retirees have minimum amounts of lifetime income. But Noonan disagrees with many strategies that require buying an annuity now to provide income 10 or 20 years down the road. Because annuities are expensive, investors should postpone buying them as long as possible, he argues.

Noonan says that you should only buy an annuity when it becomes clear that a portfolio of stocks and bonds is not on track to produce an acceptable level of income. “Every year that you stay in stocks, you increase the possibility that markets will rise and enlarge your portfolio,” he says. “When you cash in your stocks to buy an insurance guarantee, you will get no growth. The growth goes to the insurance company.”

Noonan's argument should carry weight with investors who expect that stocks will climb. But frightened clients will not be persuaded. For them, the bucket strategy may look like the best bet.