Many investors have either heard or read about the retirement income strategy that uses three buckets. Each bucket represents a pot of money with a time frame for its use. The first bucket is typically designated for years 1-5, the second for years 5-15, and the third bucket for 15+ years.
In theory, it sounds great and looks good on paper. However, in practice it can quickly become a jumbled mess, difficult to monitor and analyze because investors typically have more than one retirement account with varying balances that don't easily match up with recommended amounts for each bucket. To further complicate things, they often have tax-deferred, taxable, and tax-free accounts they’re trying to manage within the process.
That’s not to say the Retirement Buckets strategy doesn’t work, it’s just that most investors don’t have any practical ways to bring the concept to life based on their unique situation. Therefore, I've put together three simple things to consider as you develop your own strategy.
Use Account Characteristics To Your Advantage
Start by segmenting accounts without any required withdrawals, such as Roth IRAs, into the bucket that has the longest time horizon. The reasoning behind this is that, unlike traditional IRAs, Roths have no required minimum withdrawal at age 70½. With no immediate timeline for distribution, they have a clear path to grow for a longer period of time without disruption. Since they have 15 years or longer for the market averages to work in their favor, they are better positioned to hold riskier assets.
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Understand the Role Of Cash
The second consideration is based on the role cash can play in both a market downturn and in portfolio returns. Generally, it’s suggested that investors have three to five years of cash readily available from their portfolio to weather market storms. For example, in 2008-2009 investors without ample cash were stuck selling investments for less than they hoped for. However, for those with cash-at-hand, the great recession had a lesser impact because they were able to tap liquid funds instead of reducing their investment holdings during the downturn. In cases like this, the more cash you have the better off you are. Remember, it took the Dow roughly five years to get back to its previous record high.
Of course, the problem with having three-five years worth of readily available cash is that you can’t earn much of anything on it when interest rates are so low. That causes two problems. First, investors get all riled up and start worrying about whether they’re following the right plan (if maybe their money should be working harder, or if they can get away with one or two years of accessible cash instead of three or four.) It can be a futile process that usually boils down to this: Don’t try and cheat the system. Don’t let your portfolio become susceptible to an “I told you so” incident. Markets do go up and down and, at some point, a bear market or a recessionary environment will emerge and you don’t want to be caught playing the shoulda-woulda-coulda game.
Along the same lines, that much cash-at-hand can, in fact, blur investment performance, making it hard to determine if the rest of your portfolio is performing to expectations. In an ideal situation, an investor will have money outside of their tax-deferred and tax-free investments to meet their everyday cash needs; but that’s not always the case. Thus, someone with a $250,000 IRA, using a 4% withdrawal rate, could end up holding anywhere between $30,000 -$50,000 of cash to satisfy their income needs for the next few years. That amount of uninvested cash, combined with trading fees and expenses for mutual funds or ETFs can shave anywhere from 1-5% - 2.5% from a portfolios overall return.
Initially that may not sound like much, but without being aware of the role the cash and other factors are playing, a conservative retiree seeking a 5% total return may feel like they are only half way to their goal, and even decide to take more risk, based on how they are organizing their buckets and making the calculations.
Identify A Mother-Ship
Another consideration when employing the buckets concept is to identify a core asset around which you build your strategy. Instead of segmenting holdings to fit into each bucket’s time frame, earmark one particular account as the foundation (or mother-ship) that you focus on. This is particularly helpful for couples who have a hodgepodge of retirement accounts and aren’t sure or disagree on which ones should go into which bucket.
When you have a central reference point you create a foundation from which current and future investments are made based on how well the mother-ship is holding up. If it’s sailing smoothly, you may be able to ratchet up your long-term bucket’s risk and growth-oriented holdings. If she’s starting to take on water, you may want to slow down and fill your lifeboats with more cash. Either way, a core asset gives you a focal point to help manage your strategy.
Overall, the bucket strategy is a proven concept that helps investors visualize the changes they may need to make as they approach retirement and begin turning retirement savings into disposable income. While putting it into practice isn’t as simple as periodically throwing a few dollars into each bucket, investors can, however, better align their portfolio with this approach by:
- Understanding each account’s unique features and using them to their advantage
- Realizing that cash plays a role in calculating returns and weathering economic storms
- Identifying a mother-ship, which becomes the foundation upon which they can fill their other buckets with.
