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The Bucket Approach: Saving/Spending During Retirement

| September 08, 2015
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09/08/2015: Written by Greg Middendorf CFP® CCPS®

The reality is that more and more people are living longer and healthier lives which puts more of an emphasis on the importance of a well-thought out and well–crafted retirement income plan. One of the most common retirement concerns we try to alleviate for our clients is their concern of spending down retirement savings too quickly, and as a result, having to adjust their standard of living. There are many different methods to tackle this problem and in this article I am going to address one of the most common withdrawal approaches: The “Bucket Approach”. 

The bucket approach, as the name implies, involves dividing your portfolio nest egg into different buckets each designed to meet different planned goals over various time horizons.  

But before I go any further and discuss the structure and mechanics of the bucketing, are you familiar with the envelope approach to managing your household finances?

The envelope approach involves segmenting your monthly income into different envelopes to meet different objectives. For example, you have the car fund, the house fund, the savings fund and the most important “Fun Money" envelope.  You can’t forget about that one.  

I believe that the reason this envelope system has been so effective for some people is that it allows you to breakdown your finances into smaller, more manageable pieces.

The reason for touching briefly on the envelope method is because it shares some of the same traits and characteristics of the bucketing approach. So if you have a good understanding of the envelope approach, you should have no issues with bucketing. So let’s circle back and better understand how the bucketing approach is structured. I am going to walk you through a simple example using three buckets.

Bucket 1

The purpose of the first bucket is to meet your near-term expenditures over the next 5 years and is invested in a very conservative fashion using assets like cash, CDs, treasury bills, etc. No matter what the markets are doing you want to make sure this money is very safe, reliable and liquid to meet your short-term needs.   

Bucket 2

The second bucket is designed to meet your needs over the next 10 years and this is typically positioned with a more moderate level of risk.  Mostly bonds with a splash of conservative and income producing dividend paying stocks (an HCM favorite).

When you take a step back and look at buckets 1 & 2, it is comforting to know that the first 15 years of retirement are covered with relatively safe and income producing assets so no matter what happens with the markets you can have the ability to fund your need. 

Bucket 3

The third and final bucket is structured to accomplish your longer-term goals.  It is designed to provide long-term growth to combat inflation and to replenish buckets 1 and 2.  With a long-term time horizon, this bucket usually consists mostly of stocks allowing for a higher return potential.  For example, small cap stocks, emerging markets and high yield bonds.  

How does this work in real life?

Now that we have the framework for each of the buckets, let me quickly demonstrate how this approach may work in real life.  The visual here is the above 3 buckets. Keep this picture in your mind.

Picture bucket 1 (the safe bucket) with a water-spigot – out of that spigot flows your income needs. Every year this bucket is depleted to meet your needs and it must be replenished.  That is the purpose of buckets 2 and 3. A portion of bucket 3 spills over to bucket 2 which spills over to bucket 1 to meet your spending needs. Visualize the waterfall.  

Now that you have a relatively good understanding of the Bucket Approach, one of the biggest potential drawbacks involves the execution and the ability to adapt to a changing market.  

The concept of using a bucket system is intriguing in theory, but the traditional approach may not make a lot of sense in today’s market. By all means, we believe it is important to have a bucket that is safe with liquid assets to fund your short-term needs.  But with interest rates at historical lows, it does not make sense to keep a lot of money in buckets 1 and 2 tied up in non-productive assets (cash, Cds, Treasury bonds).  I don’t believe that one size fits all is appropriate and careful consideration needs to be given as to how these buckets are structured and when they are liquidated. 

What are the benefits to the bucketing approach? 

I think the main benefit to this strategy is the psychological benefit.  Just like the envelope method described earlier, it can help take a larger issue and break it down into more manageable components which may lead to better self-control and minimize excess withdrawal risk.

Hengehold Capital Management is a Cincinnati Financial Planning firm specializing in retirement planning. Written by Greg Middendorf CFP® CCPS® Partner | Wealth Advisor | Certified College Planning Specialist 

Content in this article is not intended to be financial advice. Instead, we think of it as educational, and financial education is important to us.

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