This article is the second in a three-part series on the “Bucket Strategy.”

The bucket strategy is a good one, but it’s not perfect. I have been using a version of the bucket strategy since I retired in 2018, structured in what I would call a “strategic growth and income” portfolio. Overall, I still think it is a good strategy, especially in maintaining a cash bucket for spending during a falling stock market.

The best strategy is the one that is right for you and your situation. So, first, you have to get the information you need to understand your options, and also get wise advice and counsel from others as needed:

Proverbs 15:22: Without counsel plans fail, but with many advisers they succeed. (ESV)

Then, even after you choose a strategy, including any of the bucket approaches, you need to anticipate that there might be problems and prepare accordingly:

Proverbs 27:12: The prudent sees danger and hides himself, but the simple go on and suffer for it. (ESV)

The bucket strategy’s strengths seem to outweigh its weaknesses, but there are weaknesses nonetheless. We’ll look at some and then variations of the strategy you may want to consider.

Potential Weakness #1: Low-Interest Rates and Stock Dividends

As we have seen, the bucket strategy’s primary goal (and potential benefit) is to mitigate market volatility. It can also reduce the adverse effects of a sharp, prolonged downturn near the beginning of retirement (sequence risk) by spending from Cash Bucket #1 instead of selling income-generating or growth assets in Bucket #2 or #3. This graphic from the last article illustrates this:

Most who use the bucket strategy will prefer to replenish Bucket #1 with interest and dividends from Buckets #2 and #3. That leaves the assets in both buckets to grow, hopefully, at least enough to beat inflation.

As I pointed out in the last article, low-interest rates mean less interest income from Buckets #2. That may make it challenging to keep Bucket #1 refilled unless stock dividends make up the difference.

Yet, in extreme recessionary times, companies may reduce stock dividends as well. Low-interest rates and reduced dividends have a “double-whammy” adverse effect on retirement income.

In a worst-case, extended-down-market scenario, you could mostly deplete Bucket #1, especially if Bucket #2 doesn’t generate enough income to refill it. You may also deplete Bucket #2 if you must sell income-producing assets to fund Bucket #1.

These risks alone would be a good reason for some to shy away from this strategy.

Potential Weakness #2: Prolonged Down Market

The main advantage of the bucket strategy is that it may help you hang tough and not sell depreciated assets during a down market. But what if the market doesn’t rebound in two to three years or longer?

You might have to do some severe spending “belt-tightening” if Bucket #1 is significantly depleted. During the 2008-2009 recession, many experienced this, but the market has rebounded relatively quickly from the pandemic-related crash earlier this year.

In this scenario, if Bucket #2 has not been able to keep up, you may have to draw from Bucket #3, which has also gone down in value due to the market downturn. That forces you to move assets targeted for use ten years or more later from Bucket #3 to Bucket #1 and/or #2.

So, before implementing this strategy, make sure you understand this potential risk, however unlikely a scenario you think it might be. Consider this: How would you feel if you had to sell stock assets in Bucket #3 that had depreciated 30% in value to add to Bucket #1 so that you can pay your bills?

If this gives you pause, you’re not alone. It’s one of the reasons more and more retirement planning professionals are urging us to consider a more “safety-oriented” income strategy, which is one of the alternatives we’ll discuss later in this article.

Potential Weakness #3: Sacrificing Growth for “Safety”

The Bucket Strategy is different from typical strategies that focus on the optimal stock versus bond allocation in your portfolio based on risk tolerance (i.e., the greatest loss a retiree believes he or she can stand in a market downturn). Tradition risk-based strategies are also tied to the optimal asset allocation to prevent premature depletion of the savings portfolio based on a 4% “safe withdrawal rate.”

Many retirees may find that setting aside three years of cash in Bucket #1 and seven additional years of low-growth assets in Bucket #2, comprises almost half of the assets in their portfolio. Such a high allocation to bonds and cash may differ from the more aggressive stocks versus bonds allocation they have been accustomed to during the “accumulation phase” (e.g., 80/20, 70/30, 60/40 percent stocks to bonds).

Therefore, in a prolonged down market scenario, the “safety” of having a large cash bucket can come at the cost of long-term growth.

Many financial planning professionals say that being too conservative (that is, too much in cash and fixed-income securities in Buckets #1 and #2) can result in a less sustainable portfolio over the long term. In other words, increasing the security of your income for the next ten years should we get hit with a long-term recession may come at the expense of less security in the ten or twenty years after.

Delicate Balancing Act

The bucket strategy isn’t a no-maintenance approach; managing it is a delicate balancing act.

On the one hand, you need to withdraw cash to help cover your monthly expenses. On the other, you need a suitable plan to ensure that Bucket #2 generates sufficient income to fill Bucket #1 and that Bucket #3 grows to provide for future spending and at least enough to keep up with inflation.

The greatest challenge comes when a bucket fails, especially Bucket #1. Increasing the cash bucket by selling assets in Bucket #2 or #3 to avoid failure may reduce expected long-term portfolio returns. And the income for future years funded by growth stocks is put at risk.

You now see the inherent “tension” in the bucket-oriented portfolio: long-term success hinges on the performance of Buckets #2 and #3.

Variations

It begins to become clear that the fewer savings you have, the less likely the bucket strategy will be optimal for you. Those with lower total savings may need to keep less in Bucket #1 and #2, so they have enough in Bucket #3 (the growth bucket) to make their savings last as long as possible. The challenge comes in accepting the stock-market-risk that comes with it.

Also, in a prolonged economic slump, you may be drawing down Bucket #1 and replenishing it from Buckets #2 and #3. If those buckets are also down, then your overall portfolio value is declining.

If you tap Bucket #3, you are using funds intended for ten or more years out. Premature tapping of Bucket #3 increases the risk that you will fully deplete your savings before you leave this world for eternity.

I must confess that I am having second thoughts about this strategy for many of the reasons I have listed. Fortunately, a couple of “modified bucket strategies” at least partially address these potential weaknesses.

Variation #1: The Bucket Strategy with an Income Floor

The “bucket strategy” is not an “income floor” strategy, but most people already have a “floor” in the form of Social Security and perhaps a pension. A modified approach, which adds more “guaranteed income” to Buckets #1 and #2 to ensure that, in combination with Social Security and perhaps some pension income, to provide reliable lifetime income for your essential expenses is called the “income floor” strategy.

Bucket #1

Creating this income floor could completely replace Bucket #1 since you don’t have to replenish it with the income from other assets. Or, you could still have a cash bucket and supplement it with an income floor “bucket” (although it’s not technically a bucket since you can’t deplete it and don’t refill it regularly).

With this approach, rather than relying only on interest and dividends from Bucket #2 (and perhaps #3), you would use something like a single-premium-immediate-annuity (SPIA) combine with your social security income to cover your essential expenses.

Most people will need to fund the annuity purchase with some percentage of their retirement savings. Most financial professionals suggest that you not allocate more than 25 to 35 percent to this purchase to leave yourself some flexibility in the future. Remember, you hand over a pile of money to an insurance company when you buy an immediate income annuity.

Since most immediate annuities are not inflation-protected, you want to retain some growth assets as well, primarily in Bucket #3. You can get graduated annuities that increase a certain percentage each year, but they are not based on inflation.

For most people committing to an annuity is a tough decision. The idea of taking a bunch of money out of their savings to do so is the primary inhibitor. You may be concerned about trusting an insurance company with all that money. If so, you might spread your SPIA purchases across a few high-quality companies and stay within your state’s insurance guaranty program limits.

You can purchase annuities with a joint survivor benefit and even with a (limited) guaranteed payment to our beneficiaries.

Bucket #2

The bottom line is that to the extent that you secure enough income to cover your essential expenses, you will not need to rely on income from bucket two for that purpose. Whatever you have in Bucket #2 can then be used for discretionary spending (travel, charitable giving, etc.) and future Required Minimum Distributions (RMDs) once you turn age 72. (The RMD age was changed from 70 1/2 by the recently passed SECURE Act. There is also some talk in the current congress about increasing it to age 75.)

A detailed discussion of RMDs is outside this article’s scope (I’ll look at RMDs in more detail in a future post). So for now, suffice it to say that these amounts are pre-determined by the IRS based on your age, estimated remaining lifespan, and your portfolio balance. For most, they start in the 3 to 4 percent range. Everyone with a taxable retirement savings account, regardless of whether it’s a 401(k), 403(b), or IRA, is subject to RMDs.

Some may fill Bucket #2 with bonds and dividend stocks, just as they did with the standard bucket strategy. Others may go with CDs or bond ladders. If you have a cash-value or dividend-paying whole life policy, you can use it for this purpose.

At the very least, you want to cover your RMDs for at least five years or so. The main reason is to ensure that you don’t have to sell the growth assets in Bucket #3 to fund RMDs in the event of a prolonged market downturn.

Bucket #3

Bucket #3 would contain the remainder of your assets. If you used 25 percent for your income floor, and Bucket #2 comprises at least five years of RMD withdrawals (perhaps another 25 percent), Bucket #3 may include 50 percent or more of your assets.

With the modified income floor strategy, depending on how many growth assets you have in Bucket #2, you may not want to have much less than 50 percent of your holdings in Bucket #3. You need them for growth and to protect against inflation.

Therefore, the investments in this bucket would be a diversified mix of stocks (small, medium, and large-cap, and International and emerging markets).

Variation #2: Total Return Approach

Another strategy is to structure your portfolio with only two buckets—the “cash bucket” and the “investments bucket.”

With this strategy, the cash bucket is more crucial than ever. It would hold at least 3 to 5 years of living expenses in ultra-safe accounts (checking, savings, CDs, or ultra-short-term bonds).

The remainder of the portfolio would be in the “investments bucket.” It would contain between 40 and 70 percent in stocks for those following the “4% safe withdrawal rate rule.” The rest would be held in “safer” investments not closely correlated to equities, such as intermediate-term treasuries and TIPS.

Bucket #1

Like the other approaches, the cash bucket would hold three to five years’ worth of living expenses in cash or cash-like accounts (checking, savings, CDs. etc.).

You can calculate the amount to put in this bucket by deducting any other retirement income (social security, pension, annuity) from your targeted living expenses. The difference is your annual cash bucket requirement. For example, if you need $60,000/year before taxes, and social security provides $25,000, a 5-year cash bucket would contain $175,000 (($60,000 – $25,000) x 5 years).

Bucket #2

You then put the remainder of our retirement funds in a diversified stock and bond portfolio in this bucket—the “growth bucket.” You’ll need to determine what the exact allocation will be. Should it be 100% stocks, a 50/50 allocation to stocks and bonds, or something in between? Many financial professionals recommend a 50/50 or 60/40 allocation to growth stocks and intermediate-term bonds and treasuries.

The stock/bond portion of such a portfolio wouldn’t produce much income, even if it contains dividend-paying stocks or stock funds. It will be more volatile than the traditional bucket strategy due to the higher overall allocation to stocks. Therefore, it will take more of a “total return” approach to generating retirement income over the long-term.

Refilling Bucket #1

With this approach, you may only refill your cash bucket once or twice a year. If your target is 50% stocks and 50% bonds, you will rebalance the portfolio by rebalancing it back to that allocation. You would do so by selling assets that have appreciated and buying those that have gone down in price.

The result is you are “selling high and buying low,” which is a key to long term success.

You spend from the “cash bucket” and only rebalance the asset allocation in the risk-based portfolio. The proceeds from the sale of appreciated assets are added to the cash bucket to replenish it. At age 72, you could move your RMDs to the cash account since the IRS will tax them. If you do that once a year, you would then rebalance what remains in the investment bucket.

If you follow the 4% Rule, you will want your overall portfolio to consist of 50% to 75% stocks. (We are taking into account both buckets—cash and investments—to determine our overall asset allocation.)

Your withdrawal rate and this modified bucket strategy work together in some critical ways. As with all bucket strategies, the cash bucket is used for everyday expenses and acts as a buffer against prolonged down markets that negatively impact the investment bucket.

That second aspect, which was the whole premise of the last article, “Cash Bucket….pandemic,” is of the utmost importance. You want to have enough cash to live on so that you don’t panic and sell during sudden market declines. If five years isn’t enough to give you that comfort level, then up to to 6 or 7. You also need to ensure that your stock allocation is on-target, which is why rebalancing once or twice a year is so necessary.

Choose One if You Can

Likely, one of the three “bucket” strategies we have discussed will make sense for you. I am using a version of it myself, which I will describe in greater detail in the third and final article of this series: “My Bucket Strategy.”

No matter which one you choose, be sure to do your homework and seek out professional advice if you need it. Then move forward in faith and with the confidence that you are stewarding your retirement financial resources well.