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December 23, 2020

Buckets of money: An investment strategy for retirement planning

The bucketing strategy divides a retirement portfolio into different risk segments called buckets. Retirees can use their cash bucket to cover their day-to-day budget needs. The remainder can be invested in riskier assets to promote growth to cover a retiree's future needs.

During your career years, figuring out how to fund your lifestyle isn’t too difficult. As long as you spend less than you earn, you’re doing well. After decades of diligent saving and investing, new retirees face a new challenge. How to fund their lifestyle when their monthly income doesn’t cover their expenses.

The bucket strategy is one investment framework designed to help answer that conundrum. The strategy breaks out investment strategies based on different time horizons. It provides for immediate financial needs while optimizing part of the portfolio for long-term growth. Here’s what you need to know about it.

What is the bucket strategy?

The bucket strategy is a retirement framework that allows people to group investments based on timing. It helps retirees balance risk and reward over a longer time horizon (like a 30-year retirement window). Given the low-yield bond environment and the slow disappearance of private pensions, the bucket strategy can make a lot of sense for retirees. It can help retirees decide how much they can risk for growth, and how much money needs to be accessible. Even better, retirees can use the strategy to create a “retirement” paycheck. This monthly paycheck can be used to fund gaps in your retirement budget.

A simple version of the bucket strategy divides a retiree’s financial assets into two buckets. The “Cash” bucket would have money available in cash (savings accounts, CDs, or Money Market Funds) for short-term needs. The “Investments” bucket includes investments such as stocks, bonds, and real estate.

In this very simplified strategy, a retiree can sell some of the investments (or take income from the investments) to fill the “cash” bucket. The retiree can then create a “retirement paycheck” by transferring cash to a checking account each month.

The bucket strategy offers several advantages for retirees. First, the large cash cushion allows a retiree to continue living their intended lifestyle even during a market downturn. Second, dividing assets into buckets allows a retiree to accept more volatility in the investments bucket. This can lead to higher growth prospects in the long run.

Recommended buckets

Of course, simply knowing about two labels doesn’t offer much guidance to retirees. Retirees (and aspiring retirees) can read up on the various ways to implement the strategy. But for simplicity, the Retirement Budget Calculator displays a four bucket strategy. These are the four buckets.

  • Income (also called cash): This is money that you need in the short term, usually one to four years. Imagine a retiree with an annual spending of $50,000 per year. This person receives $35,000 from Social Security and other guaranteed income sources. That leaves a gap of $15,000 per year. The income bucket would need to hold $15,000 to $60,000 held in cash. The money should be accessible and not subject to risk. For example, it might be held in a Money Market Fund or a high yield bank account.  While it can feel good to have a large cash cushion, don’t overemphasize this bucket. Having too much cash can drag down portfolio performance.

    Money in the cash bucket should be separated from your primary checking account. Cash in a primary account tends to be too easy to spend. Instead, retirees can set up automatic monthly transfers from the cash account to their checking account. This allows them to mimic the monthly paychecks they earned during their career.
  • Conservative: The conservative bucket holds for four to six years from retirement. While it should be invested, it’s primary goal is to match inflation. Usually, high-quality government bonds or CDs would be appropriate for this bucket. A short-term or intermediate-term bond fund could work too. Given the low-yield environment, this bucket may just match inflation. It may even under-perform inflation slightly. However, in most cases, it will perform better than the cash bucket, and the assets should be fairly stable.
  • Intermediate: In the intermediate bucket, retirees may want to take a bit more risk. This could be the right bucket for a mix of high-quality bonds and perhaps some equities depending on your willingness to accept volatility.
  • Growth: The goal of this bucket is to produce long-term growth for your investment portfolio. Even if you’re retired, a large proportion of your assets should be poised for growth. This is money you won’t need for a decade or more. Most of this money should be invested in growth assets like stocks. The portion of your portfolio should ideally have both domestic and international exposure. Stock mutual funds or low-cost index funds could both fit well in this bucket. Preferred stock or higher-risk bonds may also fit in this bucket depending on your investment preferences.

How to fill your buckets during retirement

During retirement, you’ll need to do some bucket maintenance. It would not make sense to spend all your conservative assets during the early years of retirement. Instead, retirees will want to refill the cash bucket using assets from the other buckets.  Refilling buckets does not require rigid rule following or careful attention to the financial markets. Instead, a quick portfolio review a few times per year should be enough for a retiree to decide how to refill the buckets.

The exact refilling strategy can depend on market performance from the previous year or two. Since retirees start with enough cash to cover a few years of expenses, they should never be forced to sell assets that are “in the dumps”.

To refill the cash bucket, retirees first want to look to income (dividends or yield) from all the buckets. If the income isn’t sufficient to cover the full cash refill, investors may need to sell some portion of their assets to cover the gap.

When stocks do well, selling some of the stocks from the growth bucket is preferable. During a good year, the stock portfolio will continue to have a very high value, even after the retiree sells some shares. Of course, if stocks perform poorly, selling shares doesn’t make sense. In that case, retirees may want to sell some of the bond assets from the conservative or moderate buckets.

When neither bonds nor stocks do well, retirees can hold off on rebalancing for a year or two. After all, the first bucket starts with enough cash to cover two or three years of spending. After a few years, it is likely that some part of the portfolio has recovered enough that retirees don’t have to sell assets when the assets are at low prices. After all, the mantra “buy low, sell high” still applies during retirement.

Remember, every retirement investment strategy starts with your budget

The bucket strategy is one useful framework for managing your investment portfolio during retirement. But this strategy, along with most other investing frameworks require you to know your budget. The Retirement Budget Calculator can help you understand your cash-flow needs in a detailed way. It forces you to look in detail at your major budget categories, so you can successfully plan your total needs.

When you know and control your cash flow during retirement, any investing framework you choose is more likely to be a success.

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