A Comprehensive Guide to the Retirement Bucket Strategy
The retirement bucket strategy, also commonly referred to as the “3 bucket strategy”, is an asset drawdown strategy.
It works by breaking up your investments into three sections with various levels of risk over different timespans: one focused on short-term needs, another suited for mid-range needs, and finally an allocation designed for long term needs. The bucket strategy is a powerful visualization and organization tool that can help you navigate market fluctuations while enjoying a steady source of portfolio income during retirement. The Bucket Strategy is particularly effective helping those navigating the retirement risk zone protect from Sequence of Returns Risk.
This article will detail how to set up & manage the system as well as the pro's and con's of this drawdown strategy.
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Short Summary
The 3 Bucket Retirement Strategy is a capital preservation system that separates your investments into three distinct time horizons to provide protection against market volatility.
Implementation involves estimating retirement expenses, allocating assets, setting up buckets, regularly monitoring performance, and periodically rebalancing.
Working for this strategy: increased confidence & emotional control.
Working against this strategy: requires effort to manage & rely on accurate forecasting of costs/market conditions.
Table of Contents
The Fundamentals of the 3 Bucket Investment Strategy
Short Term Bucket
Intermediate Term Bucket
Long Term Bucket
Implementing the 3 Bucket Retirement Strategy
Estimating Retirement Expenses
Funding the Buckets
Asset Allocation
Maintaining and Rebalancing Your Retirement Buckets
Monitoring Performance
Rebalancing and Replenishing
Adapting to Market Conditions
Pros and Cons of the Bucket Strategy in Retirement
Benefits
Drawbacks
Alternative to the Bucket Strategy
Summary
FAQs
The Fundamentals of the Retirement Bucket Strategy
The three bucket strategy splits investments into short-term, intermediate-term, and long-term buckets with the aim of having money to cover living expenses in retirement without depleting a portfolio too quickly.
The bucket system offers protection against market fluctuations by allowing money from more conservative or cash-like investments to be drawn during a down market.
This preserves money held in more risky investments such as stocks to recover from volatility and compound over longer periods of time.
The ability to customize this approach based on individual retirement goals and personal preferences allows for a greater level of flexibility than alternative drawdown strategies such as the 4% rule.
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Short-Term Bucket
The short-term bucket is focused on low-risk assets (cash equivalents) with short maturities, such as cash savings accounts, certificates of deposit, money market accounts, or VERY short term treasury bills (think 1-6 months).
Income needs in the present can be safeguarded from stock market volatility while remaining accessible as an income source.
Typically, one would position between 1-5 years of expenses in low risk cash equivalents within this short-term bucket.
Intermediate-Term Bucket
The intermediate bucket, or medium-term bucket, is designed to cover expenses for years 5-10 of retirement.
Money in the intermediate bucket should be invested in conservative to moderate risk investments that can at least match inflation.
Longer-maturity bonds (2-10 year), longer certificates of deposit, preferred stocks, large cap value stocks (dividend producers), income funds, and REITs are typically placed in this bucket.
The goal with the intermediate bucket is to match or very slightly outpace inflation without taking on significant risk to your investment principal.
Long-Term Bucket
In this strategy, the long-term bucket is the higher risk portion of your retirement portfolio.
The money in the long term bucket is invested with an eye on a 10+ year time horizon, providing the opportunity for significant growth.
Growth stocks, small cap stocks, emerging market stocks, high yield bonds, Nasdaq or SP500 index funds would all belong in the long term bucket.
The growth from the long term bucket is used to refill your short term and intermediate term buckets, which we will explain in more detail in the rebalancing portion of this guide.
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Implementing the Retirement Bucket Strategy
Implementing the retirement bucket strategy requires estimating your future cost of living and then using that estimate to determine how much money to fund each bucket with.
Estimating Retirement Expenses
Accurately estimating retirement expenses can be difficult.
I recommend using an expense tracking app such as Everydollar or Mint to obtain the most accurate read on your current spending.
You can then use that amount as a baseline and fine tune things to arrive at a "retirement estimate".
(Watch this video guide to learn how to set up an expense tracking system).
You may want to add in an inflation factor to reflect the erosion of purchasing power over time.
This can be accomplished using online financial planning tools, however, for best results, I recommend the services of a Fee Only Fiduciary Financial Advisor.
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Funding the Buckets
Funding the three buckets requires estimating the duration of each bucket (the years it will fund), and therefore how much money should be allocated to each bucket.
This is a uniquely individual decision.
A common three bucket approach is:
Immediate Bucket: Years 0-5
Intermediate Bucket: Years 6-10
Long term Bucket: Years 11+
NOTE: The short-term bucket needs to be in cash, or cash equivalents. For this reason, Bucket 1 is not given an asset allocation, but rather treated as ALL CASH. Buckets 2 and 3 will be "invested" and thus will require an asset allocation that guides your investment strategy.
With the above note in mind, when calculating how much to fund each bucket with, we will fund bucket 1 with the length in years of cash.
Buckets 2 and 3 will be funded according to ones asset allocation (portfolio allocation) using the funds remaining AFTER bucket 1's cash requirement has been met.
Assuming one were to need $50,000 per year to support their standard of living, without factoring in inflation, one would fund the buckets in the following amounts:
Immediate Bucket: Years 0-5, $250,000
Intermediate Bucket: Years 6-10, based on portfolio allocation
Long term Bucket: Years 11+, based on portfolio allocation
Asset Allocation
Asset allocation (also referred to as portfolio allocation) is a method of providing guidelines as to the amount of risk we will take on with our investment portfolio.
Portfolio Allocation rules are designed to manage risk, diversify your investments, and provide guidance when we move to actually selecting the investments held in each bucket.
The portfolio allocation for the retirement bucket strategy assumes that we set up a portfolio allocation for the funds remaining AFTER we fund the immediate bucket (short term bucket) with cash or cash equivalents.
For example, assume one has $1,000,000 of investable assets.
We determine that their risk tolerance will allow for a 60% equity, 40% bond (60% risk, 40% conservative) portfolio allocation.
With $250,000 required to fund bucket 1 (our cash bucket), $750,000 remain to be distributed between buckets 2 and 3 according to our portfolio allocation.
To complete the above bucket funding diagram, we would fund the buckets in the following amount:
Immediate Bucket: Years 0-5, $250,000
Intermediate Bucket: Years 6-10, 40% of remaining funds, or $300,000
Long term Bucket: Years 11+, 60% of remaining funds, or $450,000
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Maintaining and Rebalancing the Retirement Bucket Strategy
Once funded, the buckets must then be invested according to your portfolio allocation.
Investment selection is a skill.
If it is not a skill you already possess, I recommend seeking out the services of a Fee Only Fiduciary Financial Advisor who can assist you in building your portfolio allocation as well as selecting the investments that would comprise it.
With the 3 buckets funded and invested, they must be monitored and rebalanced with a regular frequency.
Monitoring Performance
The success of your retirement bucket strategy requires keeping a close eye on it and making periodic adjustments.
Your buckets value will drift due to growth or deterioration of the investments held within those buckets.
Review how the buckets are performing by comparing them to your financial plans' required rate of return.
If they are underperforming, rules should be in place detailing how to resolve that.
If they are overperforming, rules should be in place detailing how to take advantage of that.
One way of doing this is to regularly rebalance your buckets.
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Rebalancing and Replenishing
Rebalancing your buckets is a process of keeping the buckets values in line with the timeframes and portfolio allocation percentages outlined above.
For example, say the stock market dramatically outperformed the bond market during the year.
At the end of that year of outperformance, your bucket 2 is now at 36% of your portfolio value, and bucket 3 is now at 64%. Bucket 2 would be 4% below the value our strategy outlines, while bucket 3 would be 4% above.
One would rebalance by liquidating some of the investments in bucket 3 and then funding bucket 2 with those funds. The funds would be invested based on the bucket 2 investment rules (bonds).
In this way we prune/trim our winners and reinvest those funds according to our portfolio allocation.
The same process would take place were the inverse to occur and we have a down market. Suppose during our down market our bucket 2 ended up at 42% of our portfolio value, meaning bucket 3 would be at 38%. We would thus rebalance 2% of the funds from bucket 2 into bucket 3.
Adapting to Market Conditions
It’s important to adjust the portfolio allocation in each bucket of your retirement strategy according to changes within the market.
By being flexible and responding accordingly as conditions evolve, you can help protect yourself from unforeseen risks while potentially capitalizing on opportunities.
Adjusting withdrawal rates depending upon how the market is performing may also help.
A Fee Only Fiduciary Financial Advisor can help you navigate market conditions and the downstream portfolio changes that would be required.
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Pros and Cons of the Retirement Bucket Strategy
The retirement bucket strategy requires ongoing monitoring and periodic adjustments which require time and effort.
Before committing yourself to this approach, you must consider personal factors such as risk levels, goals, health, and desired investment outcomes.
Benefits
The 3 bucket retirement strategy can provide an excellent buffer against sequence of returns risk.
By having appropriate cash or cash equivalents, one can navigate market downturns without eating into investments that may have locked in unrealized losses.
Not only that, but the retirement bucket strategy is predictable, stable, and clearly documented.
It is easy to track progress and monitor, making it "kind" on the heart.
Finally, this organized way of thinking simplifies complicated issues concerning investments and retirement income allowing you to focus on enjoying life.
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Drawbacks
Managing and adjusting this strategy according to market fluctuations can require time and effort which some people may find challenging.
Because the retirement bucket strategy is by nature a "conservative" strategy (requires setting aside substantial amounts of cash that could otherwise be invested), it can sometimes be difficult to watch the broader stock market soar while your portfolio doesn't perform in quite the same manner.
It can also be difficult to predict annual expenses accurately or estimate lifespan accurately.
The 3 bucket retirement strategy may also be limited in its utility depending on one’s wealth.
These things should be taken into account before deciding if this particular approach will suit your overall goals best or not.
Discussing the benefits and drawbacks of the retirement bucket strategy with a Fee Only Fiduciary Financial Advisor will help you determine if it is the right strategy for your unique circumstances.
Alternatives to the Retirement Bucket Strategy
It is wise to explore other strategies as well - such as the 4% rule and systematic withdrawal approaches.
The 4% rule simply states that you would only distribute 4% of the portfolio value each year - regardless of market performance or your spending needs.
The retirement income you would draw would fluctuate year to year but would always be pegged at 4% of your portfolio value.
This would preserve your portfolio so that it could last at least 30 years without running out of money.
With the Systematic Withdrawal approach you would just take your total portfolio value at retirement, divide it by the number of years you estimate you will live post retirement, and distribute that amount of retirement each year without adjustment.
It’s also worth mentioning that the 3 bucket retirement strategy is very dynamic in that it can be combined effectively with other portfolio construction and distribution methodologies.
The 3 bucket retirement strategy is very modular - you can have an income producing bucket combined with a cash equivalent bucket that balances out a more risky “growth only” bucket. Then one can have a dynamic spending strategy to help reinforce the particular composition of ones retirement bucket strategy.
Figuring out how a retirement bucket strategy can fit into your comprehensive financial planning is something you should discuss with a fee only fiduciary financial advisor.
As with all things, there are complexities in executing the 3 bucket investment strategy beyond what we could cover in this written guide - so be careful trying to execute this on your own.
If you’ve identified that this might be a portfolio protection mechanism that you may be interested in, you can reach out to us here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.
Summary
The retirement bucket strategy is a great way to organize your investment assets.
It involves dividing investments into buckets that cover short-term, intermediate and long-term scenarios.
Consult with a Fee Only Fiduciary Financial Advisor to determine whether the retirement bucket strategy is the right retirement distribution strategy for you.
Click here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.
Frequently Asked Questions
What is the 3 bucket strategy?
The 3 Bucket Strategy is a well-known financial planning method that categorizes assets into three separate ‘buckets’: short-term income needs, intermediate requirements and long-term necessities. Assets within each bucket should be invested in different ways depending on when the money will need to be accessed. These buckets include funds for immediate cash flow, intermediate funding requirements as well as investments geared toward future objectives like retirement or estate planning. The advantage of this approach lies in allocating available resources across multiple time horizons, which ensures steady access to capital without taking on too much or too little risk.
What is the safe bucket strategy?
The goal of the safe bucket approach is to create a retirement plan that works with your risk tolerance and provides income. To do this, it calls for you to incrementally move gains from higher-risk assets into those offering more safety as time goes by. This process is called rebalancing and is done over time.
What is the 25 times rule for retirement?
At the time of retirement, it is recommended that you have a savings balance equal to 25 times your estimated annual spending in order to fulfill the ‘25 Times Rule’. Thus, if one plans on living off $50,000 annually post-retirement, then they need at least $1.25 million saved up for later life.
Other Financial Planning Resources:
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