Are you familiar with the “bucket” retirement strategy? According to the Wall Street Journal, the term “buckets” was first used by financial planners in the mid-1980s to help investors visualize the process of generating income in retirement.
Let’s take a closer look at how the bucket strategy works, the types of investments necessary for these buckets, and if investors should utilize this strategy more than 30 years after it was introduced for their own retirement needs.
How Does the Bucket Strategy Work?
Andrew Nadeau, CFP and senior wealth advisor at Bigelow Investment Advisors, said the bucket retirement strategy is the idea of “bucketing” client’s goals based on the time horizon for their respective needs, and allocating risk appropriately based on these time horizons. Depending on the strategy and needs of the client, buckets may be “refilled” or replenished over time.
What Goes in Each Bucket?
The bucket approach may be based on a two-bucket or three-bucket model. Katie Kavehrad, financial planner at Paradigm Wealth Partners, recommends investors split their retirement portfolio into three separate buckets. Each bucket should hold the following investments.
Bucket 1: Immediate Bucket
The immediate bucket is used to cover expenses during the first 1-2 years of retirement.
“These funds need to be highly liquid cash held in a high-yield savings or a money market savings account,” said Kavehrad.
In addition to expenses, Kavehrad recommends including an emergency fund in the immediate bucket. This may help cover unexpected expenses like car repairs or healthcare needs.
Bucket 2: Intermediate Bucket
The second bucket is typically used after the first two years of retirement and up to 10 years of retirement. Kavehrad said the goal of an intermediate bucket is to grow enough to cover expenses during this time frame, while avoiding high risk or volatile investments.
“Keeping to conservative or moderate risk portfolios with the goal of income production and stability makes the most sense for this bucket,” said Kavehrad.
Bucket 3: Long-Term Bucket
The last of your buckets, the long-term bucket, has the goal to outpace inflation and grow as much as possible. These funds will be long-term funding for retirement.
“The focus of the portfolio should be stocks and other high growth, high volatility investments,” said Kavehrad.
As investors split their retirement portfolio across three buckets, each bucket should also have a different time horizon, asset allocation, objectives and risk level. Kavehrad said using this strategy allows you to draw down some assets for living expenses while allowing others to continue to grow for future needs.
Bucket Strategy: Benefits and Downsides
There are several benefits associated with using the bucket retirement strategy, including flexibility and control of an investor’s situation regardless of market conditions. However, there are a few downsides to using buckets to be mindful of when employing this strategy.
Nadeau said one of the biggest risks an investor faces is known as “sequence of return risk.” Essentially, this is the risk that an investor would need to start accessing of their portfolio as the market is experiencing turbulence.
Nadeau uses the example of a person who retired at the end of 2007 or 2008. As they retire and start drawing down on their portfolio to meet their cash flow needs, they are putting additional stress on those funds while simultaneously experiencing shock from the markets.
The bucket strategy nearly eliminates this sequence risk.
“Since you are focusing on pulling from the ‘cash’ or shortest-term bucket that is likely not subject to the same fluctuations as the other buckets, this allows the remaining buckets time to recover and improve before they have to replenish that first immediate bucket,” said Nadeau.
Another downside is that when markets are down, Kavehrad said the bucket strategy either continues to spend from the third, long-term bucket or leaves ir alone until the markets recover.
“Typically, in a down market, one would be selling bonds and buying stocks, but that doesn’t work within the bucket strategy because rebalancing isn’t addressed,” said Kavehrad.
Ernest J. Lacroix IV, founder and financial planner at Achieve Financial Solutions, said while managing the glide path across multiple accounts may be a downside to the bucket strategy, investors are able to rebalance each account with each passing year. This leads to another benefit of using the bucket strategy: knowing that one’s immediate cash flow needs are taken care of allows some folks to tolerate the ups and downs of their long-term investments better.
Should I Use the Bucket Strategy for Retirement?
Each person has specific needs as they head into retirement and will be considering a multitude of factors including goals, objectives, risk tolerance and financial needs. The bucket strategy is just one of the many approaches they may use to plan ahead for the future. It can help manage expectations around time horizon, risk tolerance and capacity, and managing drawdown.
In our uncertain future, Nadeau said the bucket strategy is appropriate for retirement and other financial situations outside of retirement such as investing excess savings. Even a pre-retiree can make the most out of the bucket strategy.
“Having a plan that can allow you to spread out your portfolio risk in different buckets while still providing the assurances that are needed earlier on in that transition is crucial. It may also help insulate investments during challenging times and help keep your plan on track for success,” said Nadeau.
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