I think many retirees, especially those with fewer savings, should strongly consider the "cash bucket with income floor" strategy that I discussed in the last article. If you have a pension or annuity income, or cash value in a permanent life insurance product, in combination with Social Security, then you already have an "income floor."
Those with more savings but who are highly risk-averse and are concerned about low-interest rates and relatively low market returns in the future are also good candidates.
In this final article in a three-part series about the "bucket strategy," I will describe the general approach I use. It's not perfect, and it won't appeal to everyone. Like many retirees, I am trying to find the optimal approach while learning and sharing as I go.
This strategy applies mainly to those like me who have the bulk of their retirement assets in a traditional tax-deferred IRA (or 401(k), 403(b), etc.) and aren't ready to commit to the "bucket with a floor" (i.e., with an annuity) approach.
The example I will use is illustrative and intended to show my overall thought process and how I implemented the bucket strategy. That said, I wouldn't want anyone to do something just because I do. You need to do what is best for your situation and should seek professional advice if you need it.
Before getting into the details of the strategy, we need to discuss "RMDs." I say that because I use RMDs to help guide my bucket strategy. Plus, everyone with a taxable retirement account will have to deal with them someday.
Required Minimum Distributions (RMDs)
I recently had a birthday and hit the ripe 'ole age of 68. It's not significant in terms of any retirement milestones (though I am grateful for another year of life during a global pandemic). However, it is one year closer to my Required Minimum Distributions (RMD) age of 72.
Notice that I said "age 72." The Setting Every Community Up for Retirement Enhancement (SECURE) Act, which became law on December 20, 2019, changed the RMD age from 70 to 72 for those who don't turn 70 until after July 1, 2019, or later. (There has been some talk in Congress about extending it further, to age 75.)
Your "Required Minimum Distribution" is the minimum amount you must withdraw and pay taxes on from your taxable retirement account each year. After the IRS lets you take a tax deduction on your contributions and grow your savings tax-deferred while you're working, it's their way of getting their bit of the apple, a nibble at a time, when you retire.
Roth IRAs are not taxable (since contributions are after-tax) and do not require withdrawals until after the owner's death. But traditional (pre-tax) IRA owners are required to withdraw and pay Federal and State taxes on a minimum amount each year beginning at age 72. (You can, of course, withdraw more and pay more tax.) There are also penalties for those who don't.
As someone who is withdrawing from their taxable IRA account, I can tell you that it isn't any fun paying the taxes. However, we are instructed in the Bible to render to Caesar what is Caesar's and to pay our taxes with gratitude (Mark 12:17).
Figuring out your RMD used to be a complex calculation. Now it's your account balance at the end of the previous year divided by a specified distribution period from the IRS's "Uniform Lifetime Table," a life expectancy table. (But as we all know, no IRS table can tell us what our life expectancy will be—only God knows since he has already determined it—Job 14:5).
For example, for someone age 72 with a spouse who is not at least ten years younger, the divisor is 25.6, which means they must withdraw 3.9% starting the year after they turn 72 (72 ÷ 25.6 = 3.9). Notice how it aligns with the generally accepted "safe withdrawal rates" of 3 to 5%.
There are different tables for different situations since RMDs also apply to surviving spouses who are beneficiaries. For information on RMDs and other IRA rules, see IRS publication 590. To calculate RMDs, try the handy little calculator on Investor.gov.
Growth and Income Bucket Strategy
I have mentioned before that I use a "growth and income strategy" for investing my portfolio, which is well-suited to a bucket approach. In other words, I am looking for some growth (at least enough to keep up with inflation), income (preferably enough to keep bucket #1 filled), and preservation of capital (I don't want to run out of money).
My portfolio is a mix of stocks and bonds, and as I wrote previously, I am evaluating ways to generate more income from my investments without taking too much more risk.
If you are too conservative and put most of your money into short-term, high-quality investments, your portfolio is unlikely to return much more than 2% a year. However, with wise risk management and an appropriate asset allocation, you may achieve higher returns.
As you can see from the table below, if you only withdraw your RMD from a year-end portfolio balance (PYE Balance) of $500,000, with 2% asset growth per year, at age 80, your portfolio will have about $110,000 less than if you average at least 4% growth each year. In fact, at 4%, you will have almost as much as you started with.
The table assumes a constant RMD for age 66 to 70 based on the IRS distribution period for age 70, which I labeled the "Withdrawal Factor" (WF). It then uses the increased distribution period RMD from the IRS for each year after that. (The IRS tables go up to age 115—optimistic, aren't they?!)
The strategy I use seems to do a pretty good job of balancing income with capital preservation and asset maintenance/growth. I can capture some market gains while still ensuring that I have enough cash or cash-equivalents for regular withdrawals. My strategy, which I'll call the "Wise Retirement Stewardship Strategy (WRSS)," aims to balance safety and capital preservation with a long-term return.
I have been withdrawing from it for about two years, and despite the extreme market volatility during that period, my total account balance is higher than when I started two years ago.
Wise Retirement Stewardship Strategy (WRSS): The Basics
There is some math involved here, so bear with me—once you read through the entire article, things will hopefully become a little less confusing.
The very first thing that I did (and that everyone who implements a bucket strategy has to do) is to figure out how much you need to withdraw from your savings each year for the next seven to ten years. Because I tend to be conservative, I used ten years. (Remember, this amount is supplemental to any Social Security, pension, annuity, or other income you will have.)
For each year, this figure will be the higher (the "max value") of:
- Your RMD (Required Minimum Distribution), which is based on your previous year-end account balance.
- The amount of income you think you will need above and beyond other sources (pensions, annuities, Social Security, etc.). I will call this number the "Estimated Withdrawal Amount" (EWA).
I would recommend that you be conservative with the EWA calculation in #2—better to be a little "too cautious" rather than not cautious enough. Also, when coming up with this number, remember that you also have to account for taxes. If you expect to be in the 12% tax bracket, and you need an after-tax withdrawal of $3,000/month, you would actually need to withdraw $3,360 to cover your $3,000 income requirement and the resulting $360 tax bill ($3,000 x .12 = $360).
The next table is an example of what the calculations look like for someone who retires at age 66, as I did. In my calculations, I started with a 3.5% EWA (.035 x $500,000 = $17,500) with an annual increase of 2% for inflation, which is a little lower than the age 70 RMD of 3.6% I applied at age 66, but less than the 4% "safe withdrawal rate." Many financial professionals say that 3 to 4% is the "new" safe withdrawal rate.
The "Max" values vary in the early years, and they tend to be the RMD in years 7 thru 15. That's because I used the same RMD ("WF") for age 66 thru 72 (the RMD amount changes as the "PYE Balance" changes), and I started the EWA at a relatively low percentage (3.5%) and only increased it by 2% a year. Also, the RMD WFs increase at a slightly higher rate. Obviously, if your starting EWA is higher, say 4.5%, it will be the Max each year, especially if you annually adjust it for inflation.
If you'd like to use the spreadsheet that contains these tables for your situation, you can access them in Google Drive sheets HERE. I have included information and instructions for the two tables (sheet 1 and sheet 2), as well as a third sheet you'll see below. You will need to access it and then make a copy in your Google drive to edit it.
The following graphic depicts the WRSS. As you can see, I show it as four buckets instead of two or three. I didn't do this to overcomplicate things—I represent it this way to convey the right level of detail.
Bucket #1 – The Cash Bucket
The sum of the "max" value (the higher of the EWA or RMD) would be held in cash for your first two years. I use an ordinary FDIC-insured bank deposit account within my IRA (thanks, Fidelity) for that purpose. I think it pays .01% interest or something ridiculous like that. You may want to add a 10% per year buffer to this value.
In our hypothetical portfolio, the sum of the "Max" value for the first two years is $36,534. Therefore, you would hold that amount in cash (checking account, short-term CDs, saving account, money market, etc.). Doing so ensures that you have enough money for withdrawals for at least the next two years.
Next, let's look at years 3 and 4. For those years, the sum of the "Max" values are held in short term (1-3 years) high-investment-grade bonds. That means US Treasury Bonds, AAA or AA rated corporate bonds, or the equivalent. I cheat a little here—I use a 0-to-5-year investment-grade bond fund to get a little higher yield (to help fill the cash bucket), but it comes with a little more risk. Since I use a bond fund and not individual bonds, there is some interest rate risk, especially with current low rates. If you buy and hold individual bonds to maturity, you can reduce that risk.
Since I have two years in cash, I am comfortable with a fund that contains some five-year bonds (the average duration of the fund's bonds is 3.2 years). In the example portfolio, the total investment in short-term bonds or CDs would be $36,892 ($18,383 + $18,571 = $36,892). Again, if you wanted a little buffer, you might round it up 10% to $40,000.
This bucket contains the withdrawals for years 5 thru 10 (6 years).
We have enough cash and short-term investments to cover four years, so we know we could ride out a four-year recessionary market without having to sell depreciated stocks or stock funds. So, to this bucket, we can allocate some intermediate-term bonds with a 3 to 7-year maturity. Additionally, a good balanced fund or high-quality stock fund can be used. We have the flexibility to take a little more risk, but nothing risker than investment-grade bonds dividend-paying blue-chip stocks (or funds).
We want the income from this bucket to refill buckets #1 and #2. Of course, the challenge with rates so low is that it's hard to get much out of intermediate-term bonds.
I use a Treasury Inflation-Protected Securities (TIPS) fund for this bucket, with an average duration of about seven years, and some intermediate-term domestic and international investment-grade bond funds. I am moving up the interest-rate-risk spectrum a little. I do that for a higher yield, which translates into more income. (The TIPS fund is an exception—in return for lower yields, I get some inflation protection.)
The sum of the "Max" values for this bucket is $121,579. Our total allocated to buckets #1, #2, and #3 is $195,007, which is about 39% of the initial portfolio.
Review: What We've Done So Far
At this point, we've set aside enough money to handle withdrawals for the next four years and made moderately conservative, income-generating investments for the next six years, for a total of 10 years of relative "safety." So far, we've invested $195,007 in cash, cash equivalents, or relatively safe bonds that will not (hopefully) lose value over that time (or very little) while earning interest.
The rest of our portfolio ($304,993) can now be invested more aggressively for higher income and long-term growth. There are lots of ways to do this—some carry more risk than others.
My preference is high-dividend funds and dividend-growth funds, both domestic and international. I like them because they pay dividends, which can be used for income in retirement, and tend to be more defensive during adverse market environments. Plus, they grow over time (sometimes more than their non-dividend-pay cousins), usually at least enough to keep up with inflation.
You could invest in individual dividend-yielding stocks or take a little more risk and invest in growth stocks or funds. I am starting to invest in higher-yielding bond funds, which means taking on more credit and interest-rate risk.
I have been tweaking my investment strategy with what investment professionals call a "core and satellite" approach. That means that the investments I have had for a long time comprise the bulk of my portfolio: TIPS fund, investment-grade bond funds, and dividend-paying high-quality stock funds. But I am starting to add smaller allocations to "satellite" positions in investments that provide more income or greater growth opportunities.
So, with this part of the portfolio ( about 60% of the total), which in my case is approximately 35% stocks, I now have the rest (25%) in high-income bond funds, a preferred stock fund, and Real Estate Investment Trusts (REITs), which I recently added to my portfolio to boost income. My goal is both higher income (to help fill the cash bucket) and capital appreciation over the long term. I have learned that these investments can provide income in the 3 to 5% range with potential for growth with less volatility than stocks.
I don't have allocations of more than 5% of these new "satellite" funds. Although some can be a little less risky than certain stock funds, they are not low-risk, and they add diversification. Some may want to add commodities, such as gold or silver, to bucket #4. But remember, they don't typically pay dividends and tend to be very volatile.
This spreadsheet illustrates how the allocations across the four buckets might look using only Fidelity mutual funds. Of note is the relatively low estimated total annual income of $9,723. This points to the challenges we all have in an extremely low-interest-rate environment. However, the funds in Bucket #4 are more growth-oriented, so for his sample portfolio, annual income would likely come from a mix of interest and dividends plus capital gains from the sale of appreciated assets, perhaps through rebalancing. (More on that in the next section.)
A portfolio of funds more focused on higher interest and dividend payouts may get us to the 3 to 4% level we are shooting for. Of course, this portfolio can be replicated using Vanguard or Schwab funds, among others, and ETFs.
(If you'd like to use these spreadsheets for your situation, you can access them as Google Drive sheets HERE. I have included information and instructions for each—labeled Sheet 1, Sheet 2, and Sheet 3. You will need to access it and then make a copy in your Google Drive to edit it.)
The selection of the various mutual funds and/or ETFs is a very individual decision. The mutual funds I have listed in each bucket are for illustrative purposes only—they are not reflective of my personal portfolio. If you're not comfortable doing it on your own, you should find a fee-only trusted financial advisor who can help.
Managing the WRSS in Future Years
So far, we've talked about withdrawals and asset allocation across the buckets. Remember, our goal is to capture market gains in up years and not sell income-producing and growth assets during down ones if we can help it. There are a couple of ways to do that.
First, we can continually refill our cash bucket #1 with interest and dividend income from buckets 2, 3, and 4. This is the approach I am using. In this scenario, given that we need to withdraw $36,534 over the first two years, we need the $463,466 in those buckets to return a total of 7.8% in interest and dividends over two years (an average of 3.9% per year) to fund those withdrawals. As the table above illustrates, this can be challenging with interest rates so low, but it's not impossible depending on what kinds of income-producing assets you put in bucket #3 and #4.
The second option would be not to use interest and dividends from bucket #4 to refill bucket #1 and instead reinvest them. This would accelerate compounding and long-term growth. Then, in any year when the market is up is we would replenish our cash by selling invested "growth" assets (high-income bonds, dividend stocks, REITs, etc.) in bucket #4.
Conversely, if the market is down, we don't want to take a permanent loss by selling assets in bucket #4. Since we have at least ten years of relatively safe investments in buckets 1, 2, and 3, we can cover our withdrawals without selling any growth assets in the short term. Meanwhile, our growth assets in bucket #4 are earning 3%+ in interest and dividends plus the potential for future growth when the market rebounds (which it invariably does). Then we can sell some of those assets to replenish cash (bucket #1) and bonds (buckets #2 and #3) used during the downturn.
At this point, you may be thinking, "what about a down market that lasts 7+ years?" Such a situation is not impossible, but it's highly unlikely. However, even if it does happen, remember that our largest bucket #4 is (hopefully) still generating interest and dividends in the 3%+ range. Thus, at the end of 10 years, we will have been paid at least 30% in interest and dividends, meaning that as long as the market isn't down more than 30% over that period, we will still break even. (This ignores dividend reinvestment, which you may have to suspend during that time. But reinvestment is a powerful force during down markets because it enables you to add more shares at a discount and thus more dividends in the future. If we factor this in, we have even more downside protection.)
As we get older, RMDs will continue to increase. And for many, the EWA will increase as well, perhaps more than inflation. Therefore, the required ten-year "safe reserve" may need to become thus grows larger over time, decreasing the percentage of capital you can keep invested in stocks/bonds/REITs. This may not be a significant issue for those with larger portfolios. Plus, the need for long-term growth in bucket #4 is a little less each year as you age.
The method I described, which I am using, is a general framework—you can customize it to your personal situation. If you have significant assets and multiple other sources of income, you may have more risk tolerance. In this case, perhaps the "safe reserve" could be reduced to 4-5 years.
Finally, it's important to note that you may need to rebalance investments each year, as your year-to-year projections of withdrawals will change. In a down market, you can use cash and bonds to fund withdrawals, but be sure to replenish these "safety holdings" as soon as market conditions permit. The safety holdings are a core part of the WRSS.
In this article, the strategy I laid out is how I currently manage my own retirement portfolio. Of course, this strategy may not be for everyone. Plus, I will probably have to tweak it in the years ahead. (One possibility is to use some of the money I have in cash and short-term bond funds to purchase an immediate income annuity to add to Social Security to increase our "floor" of guaranteed income.) If you have questions or comments, please feel free to contact me.