By Dr. Jim Dahle, WCI Founder
The Buckets Strategy is a retirement asset allocation and spend-down strategy that you should certainly know about. It was popularized by Ray Lucia's book Buckets of Money: How to Retire in Comfort and Safety. You don't need to read a whole book to understand it, though.
Like any retirement asset allocation or spend-down strategy, the idea is to minimize the Sequence Of Returns Risk (SORR). This is the risk that despite having solid average returns on your portfolio over your retirement years, the crummy returns show up first and cause you to run out of money. Falling asset values combined with withdrawals that are too large can decimate a portfolio quickly.
What Is the Bucket Strategy for Retirement?
To understand the Buckets Strategy, you must first understand the “standard” way things are done. The standard way is to pick an asset allocation you can tolerate that is also likely to provide enough growth to meet your goals. You withdraw from the portfolio each year and then rebalance the portfolio back to the standard asset allocation you chose. This essentially causes you to withdraw from the asset classes doing well and perhaps even sell some of those high-performing assets to buy some low-performing assets when rebalancing.
The Buckets Strategy does not pick a set asset allocation. Instead, you allocate money by when it will be used.
#1 Short-Term Bucket
The short-term bucket consists of money to be used in the next 1-4 years, typically invested in cash or similar investments where nominal principal cannot be lost. Inflation is a risk, but it is minimal given the short time period. This bucket allows you to withdraw money from the portfolio to live on without having to sell any assets low in a bear market like 2022, where both stocks and bonds are down.
#2 Intermediate-Term Bucket
The intermediate-term bucket consists of money that will be used when the short-term bucket is exhausted, typically invested in bonds or a conservative mix of bonds and riskier assets. The idea behind this bucket is that it can be tapped in the event of a prolonged bear market where you have already exhausted the short-term bucket.
#3 Long-Term Bucket
This is the risk part of the portfolio. It is for money that won't be used for 7-15 (or more) years and is invested aggressively in stocks and real estate.
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An Example of the Bucket Retirement Strategy
Let me show you an example so you can see how this works. Let's say you've decided you're going to have three buckets and they're going to look like this:
#1 Two years worth of spending, all invested in a money market fund
#2 Five years worth of spending, all invested in a short-term TIPS ladder
#3 The remainder of the money, all invested in risky assets—split between stocks and real estate, none of which will be touched for the first seven years
Let's say you have a $4 million portfolio, and you plan to spend $100,000 per year. You're going to have the following assets in the following buckets:
#1 $200,000 in a money market fund
#2 Five $100,000 TIPS: a two-year, a three-year, a four-year, a five-year, and a six-year
#3 $1.65 million invested in stock index funds and $1.65 million invested in real estate
What is your asset allocation? It is:
- 41% Stocks
- 41% Real Estate
- 12.5% Bonds
- 5% Cash
That's pretty aggressive for a retiree. The “age in bonds” rule would suggest a portfolio that is more like 40/60, not 82/18. This buckets portfolio is far more aggressive than even the “age minus 20 in bonds” rule of thumb. The benefit of being aggressive is that your portfolio is more likely to keep up with inflation in the long term and you're likely to leave more to your heirs. The downside of being aggressive is that you can have a very big loss in the event of a bear market and that you might even panic and abandon the plan. Imagine this retiree had even more money. Let's say the portfolio was $6 million. Now, it's an 88/12 portfolio. The first two buckets aren't a percentage of a portfolio; they're simply the amounts you spend each year. What if the portfolio was only $2 million? Now, the asset allocation is 65/35. As you can see, it's no longer about the asset allocation; it's about the buckets.
So far, so good. But here's where it gets interesting. Are you going to replenish those buckets, or just let them ride? If you just let them ride, you first spend your cash, then you spend your TIPS (one TIPS for each year), and then all that is left is your risky assets. If you retired at age 60, all you have left are risky assets by age 67. If you live to 97, you'll have a portfolio that is 100/0 for the last 30 years of your life. Everything you ever spend at that point will be exposed to the markets. I can't imagine a lot of people will sleep well with that portfolio.
OK, maybe instead you decide to replenish the buckets as you go. Let's say you rebalance the portfolio every year and refill your two buckets. Let's say it is a terrible year for stocks, and they lose 40% of their value. Now, you're selling stocks low to refill the buckets. What was the point of the Buckets Strategy again? Wasn't it to avoid selling low? Seems pointless now.
You need a guideline that tells you when to refill the buckets and when not to refill the buckets. Perhaps you decide you will not refill the buckets after any year that the stock market is down, but if the stock market is up, you will refill them all.
- Year 1: market up, refill all buckets
- Year 2: market down, no refilling. You now have one year of cash and five years of TIPS
- Year 3: market up, refill all buckets
- Year 4: market down, no refilling. You now have one year of cash and five years of TIPS
- Year 5: market down, no refilling. You now have five years of TIPS
- Year 6: market down, no refilling. You now have four years of TIPS
- Year 7: market down, no refilling. You now have three years of TIPS
- Year 8: market is up, refill all the buckets
- Year 9: market is up, refill all the buckets
- Year 10: market is up, refill all the buckets
Seems pretty good, right? You could “weather” a stock downturn of up to seven years before you had to sell stocks low. However, even selling stocks after one up year if it follows four or five down years might still be selling low. But the strategy seems pretty good. Bucket #1 loses zero nominal principal in a two-year bear market. Bucket #2 loses zero real principal in a seven-year bear market. If you started two years before retiring, you could even fund Bucket #1 with TIPS. When was the last time we had a seven-year bear market? It hasn't happened since we started keeping good records in 1927.
You can see a four-year period during the Great Depression, two years during the Stagflation of the '70s, and three years after the dot.com bubble burst. But that still gives you three more years to play with. The two years of cash would get you through most bear markets, and you would rarely get very far into the intermediate bucket. You could take it a little further even and only refill the buckets after two years of positive stock returns. That would give you a six-year period in the early 1930s, a five-year period in the late 1930s, a five-year period after World War II, and a five-year period after the dot.com bubble. Your seven-year cushion would still see you through just fine.
I really like this strategy. It addresses the sequence of returns risk and inflation risk quite well. It encourages retirees to take on an adequate level of risk, knowing that no money that they need any time soon is really at risk. If you are a particularly risk-averse investor, make the first bucket 3-4 years instead of two and the second bucket 7-10 years instead of five. Surely, at some point, you'll acknowledge you're going to be fine, while still investing the majority of your assets for the long run.
More information here:
Other Kinds of Buckets
There is another way to incorporate buckets into your financial plan. You can bucket assets according to your financial goals and the purpose for the money. We realized a while ago that we're going to live the rest of our lives solely off of our taxable account and HSA. Why not start investing the other assets for where they're actually going to end up?
- Roth IRAs
- Roth 401(k)s
- Taxable account
- Defined Benefit Plan
- Donor Advised Fund
- Charitable Foundation
- Taxable Account
Why are we still investing our Roth IRAs as though we're going to spend them? We're not. They probably won't be spent for 50+ years. So, why not invest them very aggressively? I'm 47. Nothing is coming out of those tax-deferred accounts for another 25 years, and even then, it will start at less than 4%. Why not invest those very aggressively? My risk tolerance goes way up once I know something isn't my money. I'm super risk tolerant with my kids' 529 money, so why wouldn't I be with money that I know is almost certainly going to charity? So what if they get a little less? Why not put it at risk and try to give them a lot more?
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A Word of Caution
A Buckets Strategy does not excuse you from making sure you're only withdrawing a reasonable amount from the portfolio in the first place. Let's say you're planning to spend $100,000 a year but only have a $1 million portfolio. That's a 10% withdrawal rate, a fool's errand per the Trinity Study—even with an aggressive portfolio.
You'd have $200,000 in cash, $500,000 in bonds, and only $300,000 in risky assets that you're supposed to live on for the last 23 years of your 30-year retirement. That $300,000 had better perform REALLY well that first few years. The data suggests you're going to run out of money two-thirds of the time in only 15 years, and it's just about guaranteed by 20 years. But if you're starting out at something around 4%, this should work just fine. You'd have 8% of your portfolio in cash, 20% in short-term TIPS, and 72% in risky assets.
What do you think? Would you use a Buckets Strategy of some type during retirement? What would your buckets look like and how would you refill them? Comment below!