Managing an investment portfolio in retirement is like playing a game of tug-of-war against yourself. On the one hand, you need to pull cash out of a portfolio for monthly expenses. On the other hand, you need your investments to grow to support future spending and offset the ravages of inflation. These twin goals often compete against one another.
Enter the bucket strategy. In theory, the bucket strategy helps retirees manage these competing goals. It does so by creating “buckets” to hold cash, bonds and stocks based on when you’ll need to spend each bucket (more on the bucket strategy in a moment).
Let’s first look at retirement investing and spending without a bucket strategy. In my experience, most retirees have a number of investment accounts, including tax-deferred, tax-free (i.e., Roth) and taxable. In addition, they have a bank account, usually including both a checking account and a savings account. To meet their spending requirements, retirees liquidate investments and transfer interest and dividends on a monthly, quarterly or yearly basis.
Some might describe the above as a “bucket strategy.” The first bucket contains spending money in bank accounts, while the second bucket contains all of the investments needed later in retirement. What we are focused on here, at least initially, is the standard 3 bucket strategy.
How the 3 Bucket Strategy Works
The 3 bucket strategy works as follows:
- Cash Bucket (Bucket #1): Contains two years of living expenses in a checking or savings account.
- Fixed Income Bucket (Bucket #2): Contains five years of living expenses in bonds and other fixed income investments.
- Growth Bucket (Bucket #3): Contains the remainder of a retiree’s portfolio in stocks and other high growth, high volatility investments.
(Note: The number of years worth of expenses in buckets one and two above can be adjusted to meet a retiree’s specific risk tolerance.)
This strategy has an initial appeal for several reasons. First, it appears to insulate a retiree from short-term market fluctuations. Even if stocks drop precipitously, the retiree is protected with two years of cash and another five years of relatively safe bonds. Second, it isolates risky investments like stocks into a bucket that won’t be touched for many years. Third, it’s easy to understand, an important criteria for retirees who, unlike me, don’t spend their time reading white papers on the 4% Rule.
Why the Bucket Strategy is Flawed
First impressions can be deceiving. Notwithstanding its initial appeal, there are both theoretical and practical problems with the Bucket Strategy.
Let’s assume we use the 3 bucket strategy described above. As we begin retirement, we have two years worth of expenses in Bucket #1. A year later it’s down to just one year of expenses, Bucket #2 has more or less than five years of expenses, depending on performance and inflation, and Bucket #3 has gone up or down based on market performance.
What do we do?
One approach would be to refill the cash bucket. Some of this might come from bucket #2, if our fixed income investments had gone up in value. Unless fixed-income had a banner year, however, most would come from bucket #3. In addition, if bucket #2 had gone down in value, we would need to top it off from bucket #3 as well.
Do you see the problem?
All we’ve really done is take assets from Bucket #3 (stocks) and moved them to Bucket #1 (cash) and maybe Bucket #2 (fixed-income). The result is that we are effectively spending money each year out of the very Bucket (#3) that is suppose to be used seven or more years down the road.
It gets worse. Let’s imagine that stocks are down for the year. Believing that the bucket strategy can insulate us from short-term market fluctuations, we don’t transfer assets out of Bucket #3. Instead, we allow Buckets #1 and #2 to slowly drain, while we hope for a stock market recovery. While this really is at the heart of the bucket strategy, I’ve yet to find sensible answers to the following questions:
- How much does the market have to fall before one should leave Bucket #3 alone?
- How much does the market have to recover before one resumes taking withdrawals from Bucket #3?
- How low should one drain the first two buckets before refilling them from Bucket #3, even if the market hasn’t recovered?
- In a down market, shouldn’t one be adding to Bucket #3? (more on this question in a moment)
Interest & Dividends Don’t Solve the Problem
One answer to these questions that I’ve heard proposed is to use interest and dividends to refill buckets. Again it has an initial appeal. Bucket #3 would produce dividends, which can be transferred to the other buckets. Bucket #2 will generate interest, which can be moved to the cash bucket. To the extent that investments are held in taxable accounts, this approach seems all the more sensible. Since interest and dividends will be taxed, why not spend them?
Interest and dividends present, at best, a partial answer. Transferring dividends from Bucket #3 in a down market would likely be a mistake. Retirees would be better served reinvesting those dividends back into stock mutual funds. That’s exactly what would happen if one rebalanced a portfolio where stocks had fallen significantly over the course of a year. Taking dividends from Bucket #3 may feel different than selling shares to generate spending money, but the result is the same (disregarding taxes). Assets are taken from Bucket #3 when market prices have fallen, which is exactly when dividends should be reinvested.
The Bucket Strategy also ignores traditional asset allocation. As noted above, the value of the first two is tied to years of retirement spending. Yet retirement spending rules, such as the 4% Rule, require a heavy allocation in equities. While there is no one “right” allocation, analysis using historical data suggests equities should comprise 50 to 75% of a retiree’s portfolio. The bucket strategy doesn’t account for this.
Finally, the bucket strategy doesn’t address rebalancing. One could rebalance within a bucket, but there is no overall approach to rebalancing because the first two buckets are based on years of retirement expenses. As a result, when markets are down, the bucket strategy either continues to spend from Bucket #3 or leaves it alone until some uncertain point in the future when markets recover. With rebalancing in a bad stock market, a retiree would be selling bonds and buying stocks. That doesn’t happen with the bucket strategy.
A Better Approach
I confess that not long ago the bucket strategy was how I planned to manage my investments in retirement. It wasn’t until I started thinking about implementing the strategy that the issues surfaced. That’s not to say that it has no value. Thinking about a cash account in terms of years of retirement spending can give retirees some peace of mind during a falling stock market. It’s a point I made in this video:
Beyond cash, all a retiree needs is one “bucket” for investments. The portfolio would hold between 50 and 75% in equities for those following the 4% rule or similar retirement spending strategies. The remaining 25 to 50% would be held in intermediate term Treasuries and TIPS.
The beauty of this approach is not only its effectiveness, but also its simplicity. Imagine a retiree refills her cash bucket once a year. At the same time, she rebalances the portfolio back to say a 60/40 allocation. The result is that she will sell high and buy low every time. If stocks are up and now account for 65% of her portfolio, she’ll sell enough stock funds to rebalance to her target allocation. If stocks are down, she’ll sell bond funds to rebalance.
Where does her spending money come from, you may be asking. From an asset allocation perspective, it doesn’t matter because she is withdrawing spending money and then rebalancing what’s left. The end result will be the same once she rebalances her portfolio back to her target asset allocation.
Where the cash comes from and how she rebalances may matter from a tax perspective. In this regard, it’s probably wise to move interest and dividends from taxable accounts to the spending account if they are subject to tax. Once a retiree reaches 72, they may also move Required Minimum Distributions to the cash account, since they will be subject to tax. And then our retiree will rebalance what remains, using tax-advantaged accounts to do the rebalancing as much as possible to avoid any additional tax liability.
As a good friend of mine says, easy peasy lemon squeezy.