The Bucket Strategy

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Chances are you thinking about finances a lot, approaching retirement. In fact, it's probably one of the primary drivers when making the decision to retire, next to what you will do with all of your newfound free time. But do you ever wonder if there's a better way to manage your finances in retirement? A way to understand your situation better and what it may look like fifteen years into retirement? A way to alleviate some of the stress you have around your investments and increase the likelihood that your retirement income lasts for the rest of your life? Well, there is a better way. It's called the bucket strategy.

Hello everyone, and welcome to the Retired-ish Podcast. I'm your host, Cameron Valadez, certified financial planner. And today, I'm sharing with you one of the simplest yet effective strategies to implement throughout retirement, called the bucket strategy.

The bucket strategy is sometimes referred to as time segmenting and may even have some other names and variations. But the version I discuss in this episode is one that I've personally used in practice and have experience operating with people just like you. This strategy is a way to mentally organize your financial assets in a way that allows you to have a repeatable process for spending down your retirement assets in an efficient manner. The best part about it is that it's much simpler than most other strategies out there, yet very, very effective. I will warn you not to confuse simple with easy.

While the concept is simple in nature, it's not necessarily a breezy walk in the park to manage each and every year in retirement, but more on that later. Another great benefit is that if implemented properly, it can help prevent poor financial behavior, whether they be mistakes made when buying and selling investments, tax-related decisions, or budgeting, et cetera. The reason it does this for you is because once created, you will have a clear understanding of exactly why a certain asset is invested the way it is and or why a certain asset or investment is purchased or sold. It also shows you when that specific asset will be used and what for. You hear me talking about having a purpose for your money all of the time on the show.

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If you're like most and struggle with identifying or allocating specific purposes to your different buckets of money, no pun intended, then this strategy will help you do just that. You can implement a bucket strategy for yourself or for yourself and a spouse. You can implement it if you own simply one retirement account in two bank accounts or, say, five different accounts between you and a spouse. Rental, real estate, various bank accounts, stock, awards, and trusts, you name it. There isn't exactly one black-and-white way to implement the strategy, as everyone's will look a little bit different, but the core concepts are the same.

Again, this is a mental strategy that can also be physically created using software or even mapped out on paper as well. It's not a certain type of account or financial product itself. More often than not, it is used when a retiree will need to draw off of their assets to fund their retirement lifestyle alongside other income sources such as Social Security or rental income, for example. However, it can also be used before you, or you, and a spouse begin to collect Social Security or turn on a pension, for instance, which I will get into an example of a little bit later. This strategy is used primarily instead of randomly withdrawing from, say, your 401(k) account or trust account in random intervals and randomly selling different investments inside of those accounts when you need the cash for regular monthly income or for random lump sum withdrawals for major purchases.

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And because it's relatively simple, it's much easier to stick to, which is really all that matters. Now, when it comes to the portion of your assets that consist of investments in things like stocks, bucketing can help prevent you from liquidating those highly volatile investments when markets are down bad, which is when you can really hurt your portfolio's longevity and increase the risk of running out of money well before you pass. It essentially serves as a behavioral coach for your money and helps prevent the dreaded sequence of returns risk. A sequence of returns risk, or what we will refer to as SOR risk for short, is essentially the risk of beginning to draw off of one's retirement savings at exactly the wrong time. However, the wrong time isn't dictated by you. It's dictated by the markets.

And because of this, it's completely random and unknown. In other words, there's no way for you to know if the exact day, month, or year you retire will end up being a good time in the markets, a crash, or a drastic temporary market correction. This is a very serious risk, and I believe it's the biggest risk to a new retiree. So let me give you some examples with real-world scenarios to clear this up and help you realize just how serious SOR risk is. These examples and references stem from the book Lucky Retiree by David Makia, and the examples given use the real market returns from 1968 to 1970.

David looks at the results of ten identical retirees who retire over that two-year period. Each retires with $500,000 in their retirement portfolio, and they're all the same age of 62. And they all need to withdraw $21,000 in the first year of retirement to supplement their standard of living from their various investments. They will also plan to increase that dollar amount each year by whatever inflation is. He also assumes that each one will live until age 92.

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The important thing to know about these examples is that the only thing that makes each of the ten retirees different is the time in which they retire. More specifically, the particular month they retire. The first person retires in January of 1968, and each retiree thereafter retires one quarter later. So the second retiree retires in April of 1968, and so on and so forth. The first retiree is able to supplement his income from his investments, starting with $21,000 in the first year and increasing it each year thereafter for inflation, and even has a balance north of $198,000 when he dies for his spouse and his other heirs.

This is also assuming he had no other reasons to withdraw any lump sums over that 30-year time frame. And I'll tell you what, that's almost entirely unlikely, as you will need or want to access lump sums of money at some point, so you'll need to solve for that too, but I digress.

The second retiree retires in April of 1968, and he was also able to sustain his income for that entire 30-year period, but he's left with more than $1 million in his investments when he passes. So imagine having roughly an extra $858,000 by simply retiring three months later.
As you can tell, the second retiree had extremely lucky timing, although he had no idea at the time. David also points out that another retiree who retired in April of 1970 makes it and dies with roughly 2.6 million left over. And the one with the worst luck, who retired in January of 1969, runs out of money entirely before he passes. This is sequence of returns risk, or timing risk, if you prefer to call it that. David begs the question why anyone would want to leave their retirement up to sheer dumb luck or chance and that you wouldn't drive, say, a vehicle around without car insurance or not carry health insurance as you age.

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Therefore, it's quite unthinkable that you wouldn't figure out a way to efficiently preserve your ability to preserve income for the rest of your life. The main reason why most people fail to do this is simply because they didn't know. And I'll tell you what, being spooked by the stock markets and deciding not to invest in them at all is not a feasible solution unless you have a money tree, of course. Now, I shared this because one of the many benefits of the bucket strategy aims to help alleviate SOR risk when implemented and maintained correctly. Luckily, you listen to this podcast, and so now you know.
So let's get into the nitty gritty and see an example of how all of this can work. Taking all of your assets into consideration, we can begin to mentally assign them to different segments or buckets. Again, call them whatever you want. Each bucket has a different purpose. Giving each one a specific purpose is what makes this strategy work.

There's no rule as to how many buckets you can have. You can have three, five, seven up to you. However, I use three because, for me, the simpler, the better. The purpose of the first bucket I like to assign is for money that a retiree or soon-to-be retiree will need this year and maybe next year or in the first few years of retirement. This is money that needs to be spent in the more immediate term. Give this one a name of some sort that you can relate to or remember.
We often refer to it as the Today Bucket or the Now Bucket. An example of what money would go into this Today Bucket could be your emergency fund, your first one or two years of supplemental income need, such as that $21,000 a year from our previous example, and any planned expenses, such as those things that you've already told yourself you're going to purchase, or you know you're going to need to purchase within a year or two. The purpose of this segment of money is to be spent in the near term. Therefore, this money should not be invested in things like the stock market.

There should be no real estate in here either because, of course, that is a rather illiquid asset that you can't necessarily get money out of, like an ATM, without borrowing from it. So this bucket would consist of cash and any other liquid cash alternatives like money market accounts or even government money market mutual funds. The key is that you need to be able to access it quickly. Don't worry too much about the rate of return that you get on this cash. Sure, in an environment like the current one, you can get four to five percent on cash alternatives, with interest rates being as high as they are.

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But the difference between, say, three and five percent isn't that big of an issue if the money is to be spent, say, a couple of months from now. The next bucket is money that you won't need in the next one to two years. This is money that you will need fairly soon in retirement, but not immediately. The main purpose of this money in this bucket is to earn more than your cash in the first bucket but also be there in one to two years when you need to refill your first bucket. Everyone structures their buckets differently depending on the types of accounts they have and their lifestyle needs. An example of what you would put in this second bucket might be the next three to five years of your supplemental retirement income need.

Again, if we use our example from earlier, where each retiree started with $21,000 of income that they needed to draw from their investments, we would do the math on, say, an average 3% inflation rate and keep three to five years worth of that income in this bucket. As far as how to invest it, the primary goal is to aim to keep up with inflation. You don't want this money earning nothing. But you also don't want to take so much risk that three to five years from now, there's a chance that there isn't enough in that bucket to replace the first bucket that you're spending from. Depending on the interest rate environment at the time you allocate this money, this may consist of CDs, government bonds, annuities with guarantees, et cetera. This money needs to be working for you in some capacity.

The third bucket, in my example, is for money that you have no need for in the short to intermediate term. This money is money you shouldn't need for maybe eight-plus years or maybe even ten-plus years or longer. It will basically be the remaining amount of money that hasn't already been assigned to a specific purpose in the previous buckets.

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The goal of this bucket is to refill the second bucket. Hopefully, you see the pattern here of each bucket refilling the previous as needed. The primary goal of this money is to outpace inflation. I repeat the primary goal of this money is to outpace inflation. Other goals for this money could be to grow significantly should you need to fund very high potential long-term care expenses in the future if you don't have long-term care insurance or to have money to leave behind to a spouse or children if that's what you desire.

That being said, the money in this bucket needs to be given the opportunity to grow significantly over time. Of course, there is no guarantee of that, but you will need to give it a chance. One of the best ways to try and do that is to invest in the stock market, aka the world's biggest and most profitable companies. Real estate can also be an option as well. But when you take out the rental income portion of the return from real estate, the appreciation by itself of real estate over the long term typically doesn't do as well as the general stock markets.

There will be a portion of this money that isn't used until far later in retirement, such as in years 20 through 30. So a portion of this bucket will have a considerably long time to go to work for you. This bucket will inherently have much more fluctuation in the account balances, aka the volatility over time. And it should.

To help you understand this a little bit further, looking at mainstream equities, aka stocks, they have historically provided rising dividends along with an increase in value or appreciation compounded at an average rate of around, give or take, 10% over the long term. Inflation, on the other hand, historically has been around 3% a year on average. Therefore, you can see that, on average, mainstream stocks have outpaced inflation by three times the average long-term rate. The cash dividends alone have historically increased at an average rate of nearly twice the long-term inflation rate.

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Another fun statistic I like to share is that if you were to invest in mainstream stocks the day before the Great Depression started, it took roughly four years net of inflation for your investments to get back to even. So, if you had a strategy like this in place, you would have weathered that since you had the other two buckets. If you didn't, and you saw your life savings drop significantly or maybe in half, you would likely get out and permanently destroy your ability to have money for the rest of your life. Now, it's important to understand that what the general stock market does is totally different from what you, the investor, might experience, and that is because of your own behavior. In other words, this only has a chance of happening if you allow it to.

This is the beauty of this strategy. By setting things up this way, it allows you to understand the purpose of this money and allow it to do its job without unnecessarily interrupting it. Because when you take the money from your own resources to live on, it should never come from this bucket. Which means you shouldn't have to sell these long-term investments like stocks at potentially bad times in the market. In order for this strategy to have a chance to work as intended, it is paramount that you implement it a few years before you retire.

If you're going to try and combat a sequence of returns risk or retiring at the wrong time, this has to already be in place to work. Now, if you're already retired, you should still aim to implement something like this as soon as possible. Just know it is best to implement it ahead of time. Okay, so what if you have a bunch of different assets or accounts? How do I split them up into different buckets?

Well, I'll use an example of a financial picture that is fairly common nowadays. Let's say you and your spouse have a couple of bank accounts, maybe one joint and a couple of individual accounts or CDs. Then you each have a pretax retirement savings account of some sort like an IRA, 401(k), or 457, et cetera. One of you has a Roth IRA, and one of you inherited some money from a parent who recently passed, unfortunately, and the money is sitting in your personal trust bank or investment account after the estate's been settled. Let's also assume you have paid off residential rental property nearby in town.

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Again, there is no black-and-white answer as to what bucket a specific account goes in. It can be any combination. For example, the first bucket in my scenario can be all three of the bank accounts since they are in cash and have part or all of one of the spouse's retirement accounts. The third bucket may have the Roth IRA and maybe the entire trust account or part of it. The second bucket can also have one or more of these accounts.

Again, it will depend on what you have and your specific circumstances. Taxes also come into play when making these decisions. Typically, if someone owns, say, a Roth IRA in addition to other assets, I will typically have them allocate that to their third bucket. The reason for this is that the Roth IRA is one of the only investment vehicles that can compound tax-free. Therefore, I want them to defer that growth as long as possible and give it the ability to grow the most.

In addition, the rental real estate would also likely fall into that third bucket since it's less liquid, and at least for inheritance purposes, it's usually one of the better assets to leave to other heirs due to the potential step up in cost basis at death. This essentially can allow beneficiaries to later sell if needed and recognize few if any, tax consequences. Now, if, according to the person's financial plan, they could maybe defer Social Security until full retirement age or age 70, I may have them live off of their savings until they reach those ages. We may use pretax money or money in, say, the trust account that's only partially taxable. During this time, their taxable income may be low enough to where we can get money out of the pretax retirement accounts at lower tax rates than they would otherwise pay.

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If they started taking money from those later after they have already begun taking Social Security or a pension, et cetera, they are possibly in a higher tax bracket. This way, we can potentially buy out the government's share of the retirement accounts at a discount. These are just some examples. There are many other planning opportunities out there. I believe that a method like this is far superior to simply investing all money according to some risk tolerance, such as 60% stocks and 40% bonds and cash, because you want to take a moderate risk or base your investment allocations based on your age.

These methods are what most people do. They say, for example, I take a moderate risk, or I want to take a very little risk. So they invest each and every account they have according to that risk. So in my example, that would equate to them investing all four investment accounts the exact same way, although they should each be invested differently according to the goal or the purpose for that money. Not only that, but they would be missing out on other tax savings opportunities via what we call asset location, which we will tackle in a future episode.

As I mentioned at the beginning of the episode, while a strategy like this is simple, it's not necessarily easy to implement and manage each and every year. Buckets need to be refilled at the right times, investment allocations need to be rebalanced, and assets need to be bought and sold at appropriate times. Another thing that will happen is that the economy and the interest rate environment will change over your retirement years. And so you will need to find reasonable and alternative ways to account for that when trying to keep up with inflation in, say, your second bucket. However, the benefits of implementing something like this far outweigh the management.

The key is that you either need to find a way to implement it yourself and stick to it over the rest of your life, or you can delegate the task to someone else, like most other extremely important and impactful things in your life, such as having routine teeth cleanings. We don't make the clothes that we wear. We don't insure our houses ourselves. We toss that to the insurance company.

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If you have a business, you likely have employees, and you delegate tasks to free up more of your own time and your own capacity, and that allows the business to grow. And maybe we possibly have someone else prepare our taxes for us. Just remember that whatever you do, make sure it's an actual strategy or plan. Don't leave your retirement and especially your livelihood up to chance. If you want to see an example of a bucket plan mapped out for a hypothetical family, check out the example I've provided in the episode show notes today. I will also include our blog article on the dangers of sequence of returns risk and why you should care.

That does it for today's episode. If you have more questions regarding financial planning or a particular strategy that wasn't tackled on today's show, feel free to ask me a question on Retiredishpodcast.com. You can go to the Ask a Question page at the top. I will also include a link in the show notes and ask a question. I will do my best to answer it in a future episode.

And if you have a minute and find this information actionable and insightful, and you want to stay up to date on the latest and useful retirement planning content, please subscribe to or follow the show on your podcast app. If you'd like to learn more about the rules and strategies discussed in today's show, you can find links to the resources we have provided in the show notes on your podcast app, or you can visit us at retiredishpodcast.com/26. There, you can also sign up for our monthly Retired-ish newsletter, where each month, we discuss money and emotions, investing, tax reduction strategies, estate tips, Medicare and Social Security, long-term care planning, and even a brief discussion about the current markets, in layman's terms. We always include something actionable in our newsletters so that you can implement things right away, such as How-to guides and other simplified strategies.
Again, this can all be found at retiredishpodcast.com/26. Thanks again for tuning in and following along. See you next time on Retired-ish.

Disclaimer

Securities and advisory services are offered through LPL Financial, a registered investment advisor, member FINRA, SIPC. The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.

In addition, if you are required to take a required minimum distribution, RMD, in the year you convert, you must do so before converting to a Roth IRA. Investing involves risk, including the potential loss of principle. No investment strategy can guarantee a profit or protect against loss. Past performance is not a guarantee of future results.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, and bonds are subject to availability and change in price. Government bonds and treasury bills are guaranteed by the US government as to the timely payment of principal and interest, and if held to maturity, offer a fixed rate of return and fixed principal value.

Treasury inflation-protected securities, or TIPS, are subject to market risk and significant interest rate risk as their longer duration makes a more sensitive to price declines associated with higher interest rates. Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free, but other state and local taxes may apply. If sold prior to maturity, capital gain tax could apply.

Neither LPL Financial nor its registered representatives offer tax or legal advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation.
Asset allocation does not ensure a profit or protect against a loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.