If there is one certainty right now, it’s that uncertainty rules the roost. The economy continues to grind forward, showing signs of both bullishness and a decline. Various metrics continue to straddle the line between good and bad. Consumers are spending, but that spending has slowed. All of which has created a volatile environment for investing.
This is a major problem for those in or near retirement. Volatility can wreak havoc on a portfolio’s income potential.
The answer could lie in an interesting strategy for deriving income. Called a bucket strategy, this portfolio option divvies up a portfolio to ensure protection and growth potential – and right now could be the best time to enact such a strategy for retirement.
Locking In Losses
For younger investors and those with plenty of working years left, volatility isn’t necessarily a big deal. When you have decades of employment income still to come, the current market losses don’t matter as much. But for those in or about to enter retirement, volatility can seriously impact their portfolio and ability to keep a nest egg of financial support into old age.
This has to do with something called the sequence of withdrawal risk. Basically, when you start retirement and bigin making large withdrawals during retirement, it can significantly impact your portfolio’s ability to keep supporting those withdrawals. This is because you are basically forced to lock in losses in order to take out the money, which is now gone and not able to grow inside your portfolio.
The economic and financial impact can be severe. A report from Pacific Life shows that identical portfolios with initial $200,000 investments and a rolling 20-year period (1989–2008) in the S&P 500 produce dramatically varied results. The worst portfolio happens to belong to investors who retired at the beginning of the dot-com bust, with a 37% loss in their first year. By year 19, they had already run out of money. 1
With uncertainty rising and recession risks remaining, retirees or those near retirement could be setting themselves up for disaster and an increased sequence of withdrawal risk issues.
Build Your Buckets
Given that this is a major problem for retirees, there are numerous ways to combat or potentially prevent sequence risk. Annuities and lifetime income options have recently garnered a lot of attention as a potential savior. However, there is another option that does not involve giving an insurance company your savings.
It’s called the bucket strategy – and it’s really quite simple to use.
First developed in 1985 by wealth manager Harold Evensky, the bucket strategy is a way for investors to plan “now vs. later” spending and to create a paycheck from their portfolios. A portfolio is divided into several buckets for various stages of retirement. The easiest and simplest bucket uses three pools of money. However, some bucket approaches can use as many as five.
- Bucket One is perhaps the most critical for retirees, and represents spending in the near term. Here, retirees figure out how much money they need to live on for two, three or even five years, depending on preference and risk tolerance. This pool of money is held in cash, CDs, money markets, short-term bonds, etc., and is designed to be spent. With their savings for the next few years tucked away in cash, retirees can ignore what goes on in the market. It doesn’t matter if the S&P 500 crashes, your income for the next few years is safe.
- Bucket Two represents spending five to seven years down the line. Here, investors have a more defensive allocation. This includes Treasury bonds, investment-grade corporate bonds, municipal securities and other fixed income assets. Investors may even want to add a slice of strong dividend-paying stocks to this bucket. The idea is to not take on too much risk, but growth and return on principal are important. Again, the more conservative nature of this bucket allows for investors to not unnecessarily worry about what is going on in the market.
- Bucket Three is where investors can go for broke and represents income further down the line. Here, investors can allocate their savings to stocks and high-growth asset classes, such as junk bonds, REITs and other more volatile securities. Because investors already have their near-term needs met and some money tucked away for tomorrow, they don’t have to worry about the volatility here. If this bucket loses money today, it doesn’t matter, because it won’t be tapped for spending until much later.
Fill Up & Maintain Your Buckets
Once investors have their buckets set, it’s time to start maintaining them. Here, gains are selectively pruned and moved up the line. So, if the market has a good year, investors can sell some stocks in Bucket Three to place into Bucket Two. Interest income and dividends as well as maturing bonds from Bucket Two get moved to Bucket One.
The win is that if the later buckets experience losses, it doesn’t necessarily matter, because Bucket One already has today’s spending locked away. Investors have the ability to wait it out and then book gains and rebalance the buckets.
And if investors are below their planned spending for a year in Bucket One, they can reallocate that money as they see fit – saving it in cash for next year or moving it into Bucket Two for longer-term savings.
Building a Bucket Portfolio
Investors looking to follow a bucket strategy for their portfolios can be an easy choice to implement. The key is to separate your holdings and funds and block off asset classes. Some financial advisors have recommended that investors open three different accounts under one brokerage firm in order to help separate their assets into three buckets.
However, that might be difficult for most investors who have assets under various 401(k)s, IRAs and other taxable accounts. For those investors, a checking account/money account could serve as Bucket One, while retirement accounts serve as Bucket Two and Bucket Three in order to reduce taxes.
Additionally, the bucket approach works well for investors with a decent-sized nest egg to begin with – one that can be separated and have years’ worth of income locked in various vintages. Smaller investors may not find the approach as useful.
As for selecting funds, the world really is an investor’s oyster. The idea is to keep following the framework of cash, defensive securities, and aggressive securities for the respective buckets. In theory, you could build a bucket approach with just a few broad-based ETFs, by holding broad bond funds in Bucket Two and total market based funds in Bucket Three. The way the strategy works is having that cash buffer and rebalancing gains from Buckets Two and Three to Bucket One.
The Bottom Line
For retirees and those near retirement, today’s volatility and rising risks are major issues. The sequence of withdrawal risk has started to increase. With that, these investors need a plan to overcome outliving their money. The classic bucket strategy could be the answer. By separating their assets and having living expenses covered for a few years, investors can ignore the market noise and continue growing their portfolios.
1 Pacific Life ( 2023). The Impact Of The Sequence Of Returns
