The following is adapted from Income for Life.
When George and Irene retired on February 28, 2020, they had over $2 million in their 401(k) account. Just a few weeks later, the coronavirus pandemic caused the markets to take a historic tumble. Not even a month into retirement, the couple watched as their portfolio’s value plummeted.
Anyone in their situation would understandably be panicked: Can we still take that trip we planned? Do we have enough money to pay our bills? Are one or both of us going to be forced to go back to work?
Yet when they called us, George and Irene were totally calm. They were disappointed and a bit nervous, but neither of them were consumed with anxiety or worry over their situation.
As Irene explained, she knew they would be taken care of because we had put a plan in place years ago that would take care of their income in retirement. With George and Irene, we used what we call the “Buckets of Money” strategy to generate paychecks from their savings regardless of what markets are doing.
After working with George and Irene to determine what they would need coming in the door on a monthly and annual basis, we determined they would require an income of $80,000 per year from their investments. With this strategy, we had set aside $240,000 ($80,000 x 3) into George and Irene’s income bucket to cover three years of their planned income needs in retirement. Not only was that money unaffected by the market downturn caused by the coronavirus pandemic, but having a steady stream of income allowed their other buckets (which we’ll cover in a moment) enough time to recover.
As we’ll discuss in this article, the Buckets of Money strategy is the best we have found to manage two short-term risks of the distribution phase (when you need to withdraw money from your investments): market risk and withdrawal risk.
- Market risk: dealing with the short-term volatility of prices
- Withdrawal risk: withdrawing from a portfolio that is declining
This method also helps manage two long-term risks: inflation risk and longevity risk.
- Inflation risk: how inflation increases the money you need for retirement
- Longevity risk: not knowing how long you’ll live or if you’ll have unexpected expenses
If you’re concerned about the risks involved in retirement, read on to learn more about this strategy. We’ll explain how the Buckets of Money strategy can ease your mind, mitigate the different risks retirees face, and help you manage your finances to live the life you want.
Bucket 1: Short-Term—Income
In Bucket 1, we keep anywhere from one to three years of planned cash flow in investments that are highly conservative and highly liquid. This is money that you know you need to pay the electric bill, buy food, and maintain your lifestyle. You need this income regardless of what the markets are doing; therefore, it should not be subject to the volatility of the markets.
Why do we recommend having three years’ worth of income in this bucket? Because historically speaking, bear markets typically do not last three years.
Withdrawal risk has to do solely with the need to take money out of your investment portfolio when the markets are down. If you have to take out money when the market is down, you’ll be forced to sell pieces of your portfolio to do so—and you’ll need to sell them at a loss. And, while beyond the scope of this article, the mathematics of getting back to even after you have locked in these losses is extremely challenging!
When George and Irene called us, they said they felt secure despite all the uncertainty.
“I know we have the income bucket,” said Irene, “and that gives us peace of mind right now.”
They both know their income will be flowing monthly. It’ll be consistent and stable, so no matter what happens with the markets during this pandemic, or what happens to it during future downturns, they can enjoy their retirement instead of worrying about their income. But had they not done this planning beforehand, they would be in a very difficult situation right now.
Bucket 2: Mid-Term—Growth and Income
Bucket 2 is where the bulk of your money will go. It will be fully invested in accordance with your asset allocation decision (i.e., 60% stocks/40% bonds or 70% stocks/30% bonds, etc.).
This bucket has two very important roles:
- It needs to grow over the long-term to help manage inflation risk. Over the course of thirty years, inflation can double or triple the amount of money you’ll need in order to buy the same goods and services.
- At appropriate times, it has to re-fill bucket 1, the income bucket, so that there is always adequate money available to flow out income that is needed.
Refilling Bucket 1, the income bucket, is not an exact science, and is perhaps the most critical component of the bucket process. It is a balance between refilling buckets when markets are on the upswing and not letting your Bucket 1 get under one year’s worth of income.
For example, at the end of 2019, a year of spectacular returns in the stock market, we refilled the buckets of all clients who were taking an income distribution out of their portfolio. We weren’t trying to time the market; we had no idea if it was at a high or if markets could still go higher. We knew there was growth in Bucket 2 and we utilized some of it to refill Bucket 1.
Bucket 3: Long-Term—Liquidity
This bucket is all about longevity risk, which includes managing healthcare costs—which are impossible to predict and which also rise at a rate that is higher than inflation—and other unplanned expenses that could pop up during a thirty-plus year retirement.
As a general rule, we calculate what we would need to invest in today’s dollars, where, if it is properly invested, it will have the best chance for it to grow to the client’s original principal amount over thirty years. Typically, most retirees have a desire to never touch their principal.
In reality, rarely is that an option over a multi-decade timeframe.
We view this bucket as the “Life Happens” bucket. We don’t know what, if any, unforeseen healthcare crises there may be in the future. We don’t know with any degree of certainty how long someone will live. We don’t know what unexpected events may happen. Regardless of how well-thought-out and executed your plan might be, the only certainty is uncertainty!
Although most find the concept of these buckets simple to understand, simple doesn’t equate to easy. The bucket system isn’t magic. It doesn’t completely eliminate market, withdrawal, inflation, and longevity risk, but it will provide a reliable framework with which to manage them. And it requires maintenance that some may not feel confident in executing.
However, if set up and managed properly, the buckets will reduce much of the stress of uncertainty that many retirees feel heading into their distribution phase.
By segmenting your money into buckets, you’ll plan for the major risks of the distribution phase: volatility risk, withdrawal risk, inflation risk, and longevity risk. You’ll also create a consistent flow of income that you can rely on, regardless of what markets are doing. Without a bucket strategy, it’s difficult to account for these risks that arise in your retirement.
When you know that your income is not subject to the volatility of the market, you can react to downturns like George and Irene: enjoying retirement instead of worrying about cancelled trips or going back to work.
For more advice on the Buckets of Money strategy, you can find Income for Life on Amazon.
Joseph DiSalvo, ChFC, AIF and Marie L. Madarasz, AIF of Quest Capital & Risk Management, Inc. are committed to bringing their clients the clarity that will promote and enhance confidence in the future. For more than two decades they have used a proven process that helps clients think through how best to structure and manage their resources in order to produce a growing stream of retirement income for life. As experts specializing in all aspects of Retirement Income Planning, they are passionate about the coordination and integration of their clients’ income, investment, and tax planning strategies in order to help clients live the life they’ve worked hard for. Joseph and Marie are strong advocates of financial education, seeking to teach others how to achieve sustained success and lifelong prosperity.
We are happy to present this collaborative post to offer valuable information to our readers.