These days, no longer can one rely on just their hard-earned savings to achieve a safe and comfortable retirement. They must also plan and follow specific financial planning goals and strategies after they retire to ensure that they do not outlive their retirement savings. One of the most well-known rules among retirees and financial advisors is the 4% rule of thumb, which states that a retiree should withdraw only 4% of his or her savings in the first year of retirement and adjust the rate according to the inflation rate in the subsequent years. The downside of following this ‘static strategy’ is that market, economy, and inflation rates are never the same rather frequently change status. You might get exposed to higher risks while trying to afford retirement. Thus a better alternative for retirees – keeping in mind all the above factors – would be to follow the Retirement Bucket Strategy. Under the bucket theory of investing, the retirement period is divided into different time segments to determine withdrawal rates. Hence, the decision is based on the risk tolerance of the retiree and the time they have left after they retire.
What is a retirement bucket strategy?
The retirement bucket technique aims to create a sustainable and dependable stream of income during the retirement life of a person. The retirement bucket approach is based on the simple logic that you should hold liquid assets such as cash and low-interest investments to meet your short-term/daily living expenses. For the long term, you can keep assets like equity and bonds in a diversified portfolio along with a cash buffer to minimize the risk posed by economic downturns and inflation.
The different ‘buckets’ of assets that one can adopt in their plan are explained in the following section.
Bucket 1: High liquidity to meet everyday necessities
This bucket consists of all the liquid assets so that they can provide money for day-to-day, short-term expenses. The vital aspect of the buckets retirement withdrawal strategy is making a section of assets that provide cash irrespective of market corrections or downturns. Investments that provide low yields and cash make up the contents of this bucket. We can observe from the components of this bucket that the goal is not to achieve returns but to ensure that the principal amount of retirement savings does not get wiped out. This way, the retiree’s basic expense needs are met.
To calculate the amount to allocate under bucket 1, you should start by estimating your spending needs annually. Remove any other sources of income that are not a part of the portfolio and are certain, like pension payments or social security benefits. After performing the above calculations, the final amount you obtain is the starting amount for Bucket 1; it is the amount that the bucket will need to provide the retiree every year.
Risk-averse investors would prefer to hold their cash holdings which are equal to double the above-estimated amount. On the other hand, investors who get worried about the opportunity cost they might incur by holding a large amount of cash in hand might opt to form a liquidity pool. The liquidity pool can consist of two components: having cash in hand for one year, and the other would include holding a relatively higher-yielding asset (a short-term bond, for instance) for a year and so forth. A retiree would consider having an emergency fund to fund unforeseen expenses such as medical bills, and more.
Bucket 2: Low-risk investments for stable gains
This bucket aims to ensure income production and overall financial stability. The worth of this bucket is estimated at five years or more of living expenses. Therefore, the majority of this bucket consists of investments that supply the best-quality fixed-income exposure. Even so, it may contain some good dividend-paying equity assets.
If needed, you can refill bucket one from the income streams obtained from this share of the portfolio if the assets in the former bucket are depleted. Although we can fund the amount in bucket 1 from the proceeds received from bucket 2, we cannot wholly eradicate bucket 1. The majority of retirees desire a regular and steady income stream to help meet their expenditure needs. Retirees can resort to bucket two if the yields from bucket 1 are meager to maintain the same standard of living.
Bucket 3: Investments for inflation-beating returns
The assets included in this bucket are meant for gains in the long term. This retirement bucket is composed of high-quality global stocks to obtain high returns in the long term. The investments included are equities. This portion of the portfolio has the potential to give high performance in the long run. Thus it needs trimming at regular intervals to avoid the total portfolio becoming too volatile or equity heavy. Besides possessing a high return potential, this portfolio also has a higher loss potential compared to other buckets. Buckets 1 and 2 are built to avoid suffering from heavy losses by the retiree from Bucket 3 during market slumps.
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Advantages of a bucket retirement strategy
By holding short-term investments that are highly liquid(in the first bucket), market fluctuations might only affect the buckets that include long-term investments. Clients may not get very concerned if the long-term investments are affected by market declines since income flows are expected only later. Such psychological benefits prevent clients from making panic-stricken rash decisions that might harm their investments or portfolios.
This kind of behavioral bias can be attributed to concepts like mental accounting, cognitive biases, and local fallacies, which are again commonly observed in investors. For example, one can observe that people usually spend more on credit cards than cash since the expenditure does not feel real. In the same way, clients might get encouraged to take on higher risks to have great returns, and in turn a comfortable retirement.
To ensure that the retiree does not compromise on their standard of living during uncertain times, the retirement bucket theory allows the client to fall back on income accrued from the other buckets to fill the cash crunch in the first bucket. This process is also termed ‘bucket maintenance.’
The retirement bucket approach also lets the retiree benefit from diversification of portfolio based on maximizing returns while minimizing total risk.
Disadvantages of a bucket retirement strategy
Although the retirement bucket strategy can provide psychological benefits to the clients, it is a strategy that can be difficult to implement. Estimating allocations across buckets is a challenge since there are no tools to calculate precise amounts for each bucket. A few methods are used to come up with allocation, but there is no way to tell if the amount arrived at is appropriate.
Additionally, setting up different accounts across different buckets may lead to problems associated with Portfolio Reporting Software as these programs report on investments on an aggregated or individual account basis. Holding assets in different accounts would also incur costs such as transaction costs. Managing combinations of retirement and taxable accounts could create challenges for financial advisors. Rebalancing could also turn out to be a hurdle if funds are not allocated properly.
Retirement can get stressful unless there is a proper retirement plan and strategy set in motion during one’s earning years. Retirees can resort to the Retirement Bucket Strategy if they wish to have more standardized returns with manageable risk. The strategy also offers clients the opportunity to be flexible on asset type and other varying investments. The scale of benefit to the client depends on several factors, such as historical risk tolerance and the advisor’s ability to maintain such types of portfolios.
Overall, the retirement bucket style is a good way to allocate assets to different timelines to ensure a smooth income inflow. However, one needs to modify and rebalance the different buckets according to the market environment and their unique financial needs.
Connect with a qualified financial fiduciary to effectively plan for your retirement. Use Paladin Registry’s free advisor match tool and get connected with 1-3 qualified advisors who may be able to help you with your specific queries and create a customized financial plan for you. You may also set up a free initial consultation with them before deciding to hire one.
For additional questions on how to plan and manage your finances effectively for your retirement needs, visit Dash Investments or email me directly at email@example.com.
About Dash Investments
Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm, managing private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.
Dash Investments offers a full range of investment advisory and financial services, which are tailored to each client’s unique needs providing institutional-caliber money management services that are based upon a solid, proven research approach. Additionally, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.
CEO & Chief Investment Officer Jonathan Dash has been covered in major business publications such as Barron’s, The Wall Street Journal, and The New York Times as a leader in the investment industry with a track record of creating value for his firm’s clients.
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The blog articles on this website are provided for general educational and informational purposes only, and no content included is intended to be used as financial or legal advice. A professional financial advisor should be consulted prior to making any investment decisions. Each person's financial situation is unique, and your advisor would be able to provide you with the financial information and advice related to your financial situation.