Should I Use a Bucket Strategy in Retirement?

When you hear the term “bucket,” do you get a far-away look and daydream about climbing Mt. Kilimanjaro, learning to play the flamenco guitar, or communing with century-old Galapagos tortoises?  Or do you furrow your brow and try to recall what that financial adviser you met with a year or so ago was talking about?  While it behooves us all to consider what we’d like to do while on this earthly realm, this post focuses on the second, more prosaic question – the use of buckets as a way to manage a retirement portfolio.

What exactly is a bucket strategy? 

There are many variations on the bucket theme (approximately as many as there are financial planners), but the essence of the strategy goes something like this:

• Divide your money into three pots, or buckets: near-term, medium-term and long term.
• Put three years’ worth of anticipated expenses (withdrawals) in the first, or near-term, bucket.  Invest this money in safe, cash-like investments (savings, money market funds, CDs).
• Put anticipated needs for years four through ten in the second, medium-term bucket.  Invest this in bonds (slightly higher risk than cash, but also potentially higher return).
• Put the remainder of your funds in the third, or long-term, bucket.  Invest this money in stocks.

Why do planners and retirees like this strategy? 

The bucket strategy is appealing because it addresses the gnawing fear of many retirees: that a stock market crash will come along after they stop working and decimate their savings.  By using the bucket strategy, retirees have the comfort of knowing that they have three years of completely safe money for the near term, and up to ten years of money to ride out even an extended bear market, before they have to liquidate their stocks at depressed prices.   

The strategy is easy to explain and makes intuitive sense to most people.  Financial advisers report that it helps them keep their clients calm during market downturns, thus avoiding unfortunate mistakes such as selling stocks when the market goes south.  Although this calming effect is a psychological benefit, it has a real financial impact if it keeps folks from making financial moves in a panicky state.  And if you’re the one living off your savings, sleeping well at night is also a real, if intangible, good.

But before you rush off to divide your savings into buckets, consider some possible shortcomings of the bucket approach. 

Downsides of bucket strategies

One potential problem is that bucketing drives your asset allocation, which may or may not result in what you want.  Consider someone who has $1 million and plans to withdraw $40,000 a year, consistent with the 4% Rule.  This person might establish the following buckets:

Buckets – Example #1

Bucket	Calculation	Amount	Percent of Total
Short-term (Cash)	4% of total ($40,000) x 3 years	$120,000	12%
Medium-term (Bonds)	4% of total ($40,000) x 7 years	$280,000	28%
Long-term (Stocks)	$1,000,000 – $400,000	$600,000	60%
Total		$1,000,000	100%

The resulting allocation is 60% stocks, 40% bonds and cash – a reasonable allocation at the beginning of retirement, when savings need to be invested in a way that provides long-term growth.  Consider, however, what happens if the same retiree instead needs to withdraw $60,000 per year:

Buckets – Example #2

Bucket	Calculation	Amount	Percent of Total
Short-term (Cash)	$60,000 x 3 years	$180,000	18%
Medium-term (Bonds)	$60,000) x 7 years	$420,000	42%
Long-term (Stocks)	$1,000,000 – $600,000	$400,000	40%
Total		$1,000,000	100%

Admittedly, this retiree is taking a risk by violating the 4% rule (she plans to withdraw 6% per year, which historically would work about 50% of the time).  While the stock allocation in this case is a not unreasonable 40%, it may be too low to provide the growth needed for such a high withdrawal rate.  Moreover, the cash allocation seems high and will, over time, reduce portfolio returns due to “cash drag” (money set aside as cash not earning much in the way of returns).   If this retiree seeks to maintain her 3 and 7-year buckets, the stock allocation will decline over time, making things worse.  The bucket strategy is driving the portfolio allocation, potentially increasing the risk of running out of money. 

Another problem with the bucket approach is that its appealing simplicity starts to break down when it comes to withdrawing money and replenishing buckets.  One financial planner explained it to me this way:  withdraw spending money each year from the cash bucket, replenish that from the bond bucket, which in turn is replenished by the stock bucket.  It doesn’t take a lot of thought to realize that this is the equivalent of withdrawing directly from the stock bucket.  Holding the first two buckets constant and withdrawing from stocks each year seems to defeat the purpose of having the short-term buckets and will have the effect of reducing the stock bucket as time goes on.  This is not an optimal strategy for the long term.

Some advocate the opposite approach – withdrawing first the cash, then the bonds, allowing the stock bucket to grow for ten years, at which point you start drawing on it.    There are obvious problems with this approach, too.  You’re left with an all-stock portfolio at a point (ten years into retirement) when this is unnecessarily risky; if stocks crash at the ten-year mark, you have no choice but to sell them at bear market prices. 

Most planners advocate some version of selling from whichever bucket has gained the most in the past year and/or drawing down cash if both stocks and bonds are down.  But what do you do if stocks and bonds are essentially flat?  And what if stocks go down a lot – do you ever replenish the stock bucket from the bond bucket?  (This would seem to violate the premise of maintaining ten years’ worth of fairly safe money.)  You see the problem: there are any number of rules you could make up to withdraw from and/or replenish your buckets.  After a number of years, your bucket management will almost inevitably become tangled and confused.

What some experts say about bucket strategies

Even as they acknowledge its psychological benefits, a number of financial planning experts have critiqued the bucket strategy.  According to Wade Pfau and Jeremy Cooper:

“…it must be emphasized that on a theoretical level, income bucketing cannot be a superior investing approach relative to total returns investing.” 

Michael Kitces has written several interesting posts on buckets, concluding that:

“… ‘bucket’ strategies…  may be more of a mirage than a reality for protecting clients from selling out in severe downturns.”

He goes on to demonstrate that the process of portfolio rebalancing itself ensures that retirees withdraw from whichever asset class has done better over the previous year.  Buckets are unnecessary if the goal is to avoid selling stocks when they’re down.  Corollary benefits to the approach Kitces suggests  are that the retiree (rather than the mathematics of bucketing) determines his desired portfolio allocation, and maintenance of that allocation through rebalancing is a simple, straightforward process.

Walter Woerheide and David Nanigian studied the impact of having a cash set-aside (bucket #1) on the long-term success of a retirement portfolio.   They tested the success of maintaining cash “buffers” (one to four years of expenses) combined with various stock/bond allocations, using historical returns.  Their findings?  In the great majority of cases, the portfolios with cash buffers had a higher failure rate than the straight stock/bond portfolios with no such buffer – presumably because of the “cash drag” effect.   Their results support the importance of “putting money to work;” it’s counterproductive to set too much aside in safe (but low-return) accounts — such as a short-term cash bucket. 

A cautionary note on these findings: their methodology pulls a cash buffer out of a portfolio and treats the remaining stock/bond allocation as a separate, complementary investment.  Thus (as I read their paper, anyway), their portfolio with a three-year (12%) cash buffer and 50/50 stock/bond allocation would really be 44% stocks/44% bonds/12% cash.  They demonstrate that such a portfolio will have a higher failure rate than a straight 50% stock/50% bond portfolio.  A different approach would be to hold the stock percentage constant at the desired level (50% in this case) and carve the cash bucket out of the “bond” portion, resulting in a 50% stock/38% bond/12% cash portfolio.   I suspect their results would be far less dramatic.

Notwithstanding these criticisms of the bucket strategy, there’s an undeniable psychological benefit from knowing you have some safe, secure money in the bank.  Indeed, this is one of the reasons the bucket strategy has such intuitive appeal.  Interestingly, this issue has been studied by academic researchers.  Ruberton, Gladstone, and Lyubomirsky studied 585 UK bank customers and found that liquid wealth – money in their bank accounts – was correlated with both “financial well-being” and “life satisfaction” more strongly than other factors such as income, spending, investments or debt.  You read that right – money in your checking account is actually more important to your sense of well being than income or wealth!  Some atavistic urge is at work here; we’re simply happier when the shed is full of wood and the storehouse stocked with food for the winter.

Where does this leave us? 

To sum up: a classic bucket strategy can lead to problems with cash drag and less than optimal portfolio allocation.  Managing the buckets as time goes on can be downright confusing.  Still, if dividing money into buckets allows a retiree to allocate some money to stocks but still sleep soundly (and not sell when the market goes down), it’s probably not a bad approach. 

As Michael Kitces and others argue, a better (and ultimately simpler) approach would be to decide on an asset allocation for your portfolio and then stick with it through annual rebalancing.   

What about that primal desire to have some money in the bank?  I like Jane Bryant Quinn’s recommendation in How to Make Your Money Last: keep two or three years’ worth of funds in cash, and an additional two or so years’ worth of money in short-term bonds.  This gives you five years’ worth of money to draw down in a bear market.  Be sure you count your cash and short-term bond money as part of the bond (non-stock) part of your portfolio.  This allows you to have that comforting money in the bank while maintaining an overall portfolio with your desired allocation to stocks.

It appears Mr. Banks (Michael Banks’ father in Mary Poppins) was onto something:

“Tuppence, patiently, cautiously, trustingly invested in the…Bank…”

…in addition to building the British Empire, really does buy happiness!

References

Kitces, Michael.  (2012, June 6).  Research Reveals Cash Reserve Strategies Don’t Work – Unless You’re a Good Market Timer?, The Kitces Report.

Kitces, Michael.   (2012, April 18). Are Cash Reserve Bucket Strategies for Retirement Really Necessary?, The Kitces Report.

Kitces, Michael.  (2017, April 26).  Buying Happiness and Life Satisfaction with Greater Cash-On-Hand Reserves, The Kitces Report.

Pfau, Wade and Cooper, Jeremy.  The Yin and Yang of retirement income philosophies.  Challenger.

Quinn, Jane Bryant.  (2016). How to Make Your Money Last.  New York: Simon and Schuster.

Ruberton, P. M., Gladstone, J., & Lyubomirsky, S. (2016, April 11). How Your Bank Balance Buys Happiness: The Importance of “Cash on Hand” to Life Satisfaction. Emotion.

Woerheide, Walter, and Nanigian, David.  (2011, December 6).  Sustainable Withdrawal Rates: The Historical Evidence on Buffer Zone Strategies, Journal of Financial Planning.