Retirement Income Strategies — And Here’s Our Plan for When We FIRE

For years, I have read articles about retirement that I frankly didn’t understand—the three-bucket system, buying a lot of SPIAs, time segmentation, etc. Let me rephrase: I understood the math and the finances. But I didn’t understand the point. Why bother? Mathematically, I thought all of these work out worse than a simple everything-is-invested strategy (i.e. total return). What in the world was the point of all these other income strategies?

Let’s look at the risks and benefits of each and why you might consider (or reject) them.

Income in Retirement and the Sequence of Returns Risk

First, before you start worrying about drawing from your investments, your retirement income should include guaranteed sources of income. This includes pensions, Social Security, SPIAs, and dividends. As we get set to retire in our mid-40s, we earn almost $1,000 a month in dividends in our taxable account and $1,000 after expenses from a single-family home rental. Our income starts at $2,000, and after that, we begin to think about drawing from our investments.

Your investments have been increasing during your working career. Once you retire and begin the decumulation phase of your life, plenty of things change. Instead of adding to your accounts, you are suddenly drawing from them. Since you don’t have an income from your job, you need to figure out how to create an income from your investments. On a practical level, how do you do this? The solution that seemed obvious to me was that every month I would sell some of my investments to meet my expenses for the previous month. This is the “total return” approach and the one most often discussed in retirement planning.

The problem, of course, is the sequence of returns risk. That is, if the market does particularly poorly when you first retire, your investments will be worth less. You still need to live and generate income for your spending, so you sell your investments. Now you have less invested, so when the market recovers, you will not benefit as much from the rise. This is the basis of the 4% rule—you can spend 4% of your invested portfolio and have a reasonable chance it will last 30 years. If returns are poor early on, you will be OK as long as you don’t spend more than 4%.

Now, imagine it’s your second year of retirement. You’re enjoying your life, and you have no plans to do any work. Your investments are doing fine. Then, the market takes a tumble. What do you do? Do you keep living your life and sell your investments while they’re down? Do you tighten things up and live like a hermit? How can you continue to feel OK about your spending when your investments are down? Numerous “solutions” to this conundrum have been devised, including the three-bucket strategy, time segmentation, and income protection. Let’s dive into these three.

More information here:

I’m Retiring in My Mid-40s; Here’s How I’ll Start Drawing Down My Accounts

A Framework for Thinking About Retirement Income

The Three-Bucket Strategy

In the three-bucket strategy, you have three buckets of money: cash, short-term investments (like bonds), and long-term investments (like stocks and real estate). You spend money from your cash bucket and replenish it periodically. If the market is doing well, you replenish it from your stocks (that is, you sell stocks and put the money into cash). If the market isn’t doing well, you replenish it from your bonds. You might have 2-3 years of your spending in cash. That way, if the market tanks, you can still spend your cash and keep your stocks invested. You can still feel good about spending money because you’re not having to sell your stocks while they’re down.

The bucket strategy can decrease your likelihood of running out of money but only if you execute it well and the market drops in very particular ways. In the worst case, imagine that the market is flat for a decade—depleting your cash and bonds—before a big drop. In the best case, the market decreases in years 2-5 and then rebounds dramatically. Since you were spending from cash and bonds, you kept your stocks invested and they benefited from the rebound. Big ERN from Early Retirement Now has a detailed analysis of this strategy and concludes the cash bucket may or may not be better than just diversifying with bonds. You can also interpret the three-bucket strategy as just forcing you to rebalance—for example, back to 60/25/15 stocks/bonds/cash regularly—which can be beneficial since you’re always buying the “discounted” asset.

The risk with the three-bucket strategy is that large amounts of cash will decrease your long-term returns. The benefits are that it simplifies your life, helps with the emotionality of selling assets in a down market, and forces you to rebalance.

Time Segmentation

In time segmentation, you own assets that mature at specific times (such as each year in the first 10 years of retirement). Ideally, these assets are fairly safe, such as CDs or Treasury Inflation Protected Securities (TIPS). As you reach that year of retirement, the asset matures and you move the money into your checking account. Then, you use the stock (or growth) investments to buy another year of safe assets. You are building a bond ladder for the next X number of years, usually 5-10. Some people will ALSO use the phrase “bucket” strategy for this or include the bucket strategy under time segmentation. The distinction is that, in time segmentation, you have specific bonds maturing intentionally each year, whereas with the three-bucket strategy I outlined before, you spend money from the three buckets depending on market performance.

At the most extreme end, you just put all of your money into safe assets paying 4% a year for 30 years and call it good. You have a bond ladder, where each year your bonds mature and pay you 4% of your assets to fund your spending. Then, you die at the end of year 30. I’ll only be 77 when we hit year 30 of retirement, so this won’t work for us. This assumes you live no longer than 30 years because all of your assets will be gone. A solution to this problem could be to build a bond ladder with 90% of your assets and invest the remaining 10% in stocks. At the end of 30 years, the stocks should be up and could sustain your lifestyle.

What if your stocks don’t perform well enough to buy another year’s worth of safe assets? You’ll eventually reach a point where your safe assets are all spent down and you’re left with your stocks. Some may argue that you just need your safe assets for 10 years—to get out of the peak sequence of return risk years. While the first 10 years matter the most, each subsequent decade also has an impact on your likelihood of success, particularly if you have a 40- or 50-year retirement, as Big ERN has pointed out. You could also use time segmentation to cover the time before you can collect a pension or Social Security—for us, that would basically be 13 years—when your portfolio will need to bear less of a burden to supply your income.

Given current high TIPS rates, using time segmentation seems like an attractive option. If the market is doing well when your bonds mature, you could spend from your stocks and reinvest the money from the TIPS into another year’s TIPS. However, Wade Pfau has done an analysis that suggests time segmentation is not necessarily better than a dynamic total return approach, since it’s effectively a forced glide path that increases your stock percentages, just like a dynamic total return.

The risk with time segmentation is minimal as long as bond returns are decent. It’s just complicated. The benefits are that it will get you through the most dangerous decade for the sequence of return risk and make you feel like you are allowed to spend your money.

More information here:

A Doctor’s Review of the Retirement Income Style Awareness (RISA) Profile

The Best Way to Create a Retirement Income Plan (and a $1 Million Example)

Income Protection

Income protection is pretty simple—you have a system to pay you regularly, just like you did when you were working a job. This can be done with one of the only good annuities: the SPIA. You give an insurance company a chunk of your money, and it deposits an amount into your checking account every month. There's no sequence of return risks—the insurance company takes on those.

There are several problems with SPIAs. First, there may be tax consequences associated with getting that big chunk of money to give the insurance company (e.g. selling your taxable account assets). By selling stocks each year, you could stay in the 0% capital gains tax bracket ($96,700 MFJ in 2025), but selling $1 million would put you into the 20% bracket. Second, there’s no inflation protection—SPIAs don’t increase their rates over time. Third, the insurance company needs to make a profit, so you are necessarily going to get less money than if you invested it yourself. Finally, there’s no potential for upside gain, where your portfolio grows dramatically. The money is gone and there’s no possibility of it growing. Also, there is no money left for a bequeathment when you die.

The benefit is that you never run out of money to spend. You can minimize the effect of inflation by buying serial SPIAs—for example, when you turn 70, 75, 80, and 85.

Our Strategy as We Get Set to Retire Early

So, what is our strategy? We’re in our mid-40s, and we're too young to buy a SPIA (and can’t readily do so anyway due to where our assets are currently). There’s some evidence to suggest that a partial time-segmentation strategy may be effective, more for 1929-like events than the stagflation of the '60s. On a behavioral finance level, I worry most about a 1929-like market event where our assets absolutely crater. I would have a hard time spending ANY money in that circumstance. If something like the stagflation of the '60s showed up, we could very happily cut our spending and still have a pretty incredible life.

We’re planning to have two years of spending in cash and three years of spending in TIPS. If the market is good, we’ll sell some of our stocks and move the money into our checking account. If the market is bad, we’ll spend from our cash and then our TIPS. If the market continues to be bad after a couple of years and we’re looking at continued poor performance, we’ll adjust down our lifestyle so that our draw on our stocks will be 4% of the current portfolio value. This is different from a safe withdrawal rate because it is based on a percent of the current portfolio value rather than the value at the start of retirement. We’ll eventually have to sell stocks if the market is down for five-plus years, but by then, we’ll be 100% stocks so hopefully we can catch the upswing of the market and ride it back to positive territory. Having a rising equity glide path, where you move from 70% stocks to 100% stocks, seems to be helpful.

If it’s too overwhelming to figure out, you can always do a consultation with a good financial planner to double-check your numbers and help you have confidence you are on the right track. Ultimately, like most things in personal finance, your retirement income strategy is personal. It will be influenced by your retirement horizon, your withdrawal percent, your risk tolerance and capacity, any non-investment income sources (Social Security, pension), etc.

You DO have to figure this out, though, if you intend to retire one day. No one is going to care more about your money than you do!

What is your retirement income strategy and when will you have to fully implement it? How flexible are you willing to be depending on what happens in the market? What other strategies can people use?