Where will my income come from and how can I manage the risk of running out of money in retirement?
These are two of the more common questions and concerns we encounter as financial planners, and we address them with an approach that we feel helps alleviate some of the uncertainty for our clients. It is called the Bucket Strategy. Here’s how it works!
It all begins with a comprehensive financial planning process during which we’ll analyze your total retirement income needs in retirement, taking into account things like inflation and taxes. Once we’ve estimated the total income amount you’ll need to maintain the standard of living you desire in retirement, we’ll assess what fixed income sources are available. Fixed income sources include things like social security benefits, pensions, and annuities. We total up and subtract those fixed income streams out from your estimated total income need to determine the net income needed from other assets to produce the total income you need to maintain the lifestyle you desire. This net need from assets is our starting point for developing your bucket strategy.
Using the information we gather through the planning process about your net income need, we can establish 2 to 3 buckets of assets. The first bucket, which is used to fund near-term expenses, is generally going to be invested more conservatively in short term assets that are highly liquid. The primary goals for this bucket are liquidity and capital preservation while hopefully generating a nominal return. This is the bucket from which you will draw your net income need. The other bucket(s) will be invested with the goals of longer term growth and periodically being used to replenish our first bucket. So how do we determine how much goes in each bucket?
If we look back at past recessions or bear markets, we see that most market downturns recover within 4 to 5 years. If we look back at the most recent recession, one of the worst in history, we see that the pre-recession S&P 500 peak occurred in the fall of 2007. It wasn’t until the spring of 2013 that the S&P 500 index returned to and surpassed its 2007 peak. If you had been retired during this time and were invested heavily in equities, you were likely having to draw income from your assets while they were down and locking in investment losses for a period of about 5.5 years. Having to sell assets throughout a bear market is a precarious scenario for the long-term sustainability of your portfolio as it deepens the hole from which you have to grow out of. This is exactly the situation we want to avoid using our bucket strategy.
So, while past performance does not indicate future results, we aim to keep 4-5 years’ worth of your net income need in bucket #1. If we enter into a bear market, our goal is to have enough assets invested in this bucket to sustain you through the market downturn and avoid dipping into your long-term investments while they’re down. This allows the bulk of your assets to stay invested for a longer time period, hopefully long enough to recover their losses.
We meet periodically to evaluate the performance of our different buckets and determine if-and-when we may need to shift some assets between buckets. If we experience positive returns on our longer-term buckets, we can use those gains to replenish or “spill over” into our income bucket to try to maintain that 4 to 5 year income buffer.
Let's look at a hypothetical example:
John and Mary are 65 and entering retirement and have $500,000 saved up in retirement accounts. Through comprehensive planning with their advisor, they've determined they have a monthly income need of $5,000. They have $3,000 of income from Social Security, leaving them a net need from assets of $2,000 per month. This amounts to $24,000 a year they need to draw from their assets. Based on the bucket strategy, we would place about $100,000 in bucket #1, representing 4+ years of income. The other $400,000 would be invested in a longer-term portfolio. Because we are assuming they won't need to draw from that bucket for 4 years, they have the flexibility to remain more growth oriented with the investment approach to the $400,000.
From time to time, they meet with their advisor to assess their buckets. If after year one the long-term bucket has grown to $420,000, the advisor may take a portion of that growth and move it into the first bucket to replenish the withdrawals John and Mary have made and maintain the level they need there to keep the strategy in place.
Remember, without thorough financial planning to help determine the timing and amount of your retirement income needs, it's impossible to tailor this strategy to fit your situation. We believe the first step is to meet with a planner to prioritize your goals and clearly identify your needs. From there, you can begin to develop a strategy built specifically for your family.
This is meant for educational purposes only. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.
The Standard & Poor's 500® Index (S&P 500®) is comprised of 500 stocks representing major U.S. industrial sectors. The index is unmanaged and cannot be directly invested into. Past performance is no guarantee of future results.
The hypothetical example is for illustrative purposes only, does not represent any specific investment and should not be deemed a representation of past or future results. Investing involves risk, including the potential for loss of principal.