Phasing Retirement with a Bucket Drawdown Strategy

We all have our own visions and hopes for our retirement years, such as traveling the world or pursuing hobbies you never had time for. But retirement also may include making an important psychological adjustment as you shift from accumulating assets through earned income, investing, saving, etc., to spending that money in retirement.

When it comes to withdrawal strategies, there are many choices beyond the traditional 4% rule. Just as every retirement is different, withdrawal strategies don't come in a one-size-fits-all approach either.

One idea to consider is the "bucket approach," a drawdown strategy that involves holding three different buckets of money, or separate asset accounts, with each one covering a different segment of your retirement.

There can be a psychological benefit to the bucket approach because it can provide investors with more confidence, knowing they have certain assets and income sources set aside for their anticipated future expenses. Of course, this does nothing to guarantee that the investor will have enough for the retirement they envision.

With the bucket approach, investors divide their retirement assets into separate buckets of assets based on periods of time. Those time horizons can be flexible as can be the number of buckets, but three is a common choice. Here are a couple examples.

Depending on your priorities and preferences, you may wish to add additional segmentation, or at least keep a greater number of assets in the third bucket, especially if you plan on a long retirement. The number of centenarians as a percentage of the U.S. population has continued to grow, which means more people may be enjoying 30 or more years in retirement.

The bucket approach (illustrated below) could work for anyone drawing down a nest egg over time and may need to liquidate their investments to pay living expenses. The bucket approach allows you categorize which assets you plan to liquidate over various periods of time without assuming you'll use one particular asset allocation plan for all your buckets.

To create the first bucket, calculate your budget for yearly living expenses and then add in extra cash for an emergency fund in case you encounter a surprise expense. Create a projection of your expenses during the next several years, factoring in inflation and any one-time events, such as paying for a child's wedding.

You may wish to invest the different buckets in a mix of assets. Liquidity and low risk are the hallmarks of bucket number one. That first bucket could include a mix of cash, a ladder of CDs, and money market funds. Depending on your level of risk tolerance, the second bucket could include what are usually seen as lower risks investments, such as a mix of bonds and income focused equities, and the third bucket could be focused on growth because it has the longest time horizon.

The idea behind putting certain types of assets into each bucket is that it allows you to put more aggressive assets in your long-term bucket with the risk tolerance to ride out market ups and downs. By having other buckets to cover your near-term expenses, you hopefully don't need to worry about being pressured to sell some long-term investments from the third bucket in case of a market downturn because you won't need to tap into them for several more years.

When building your bucket strategy, make sure you understand something called the "sequence of returns risk." This is a phenomenon that involves the order and timing of poor investment returns and the timing and size of your withdrawals.

The risk presents itself if your portfolio takes a major hit in the first few years of your retirement. If you tap into your portfolio for living expenses while it's losing value, you have to sell a greater proportion of investments to raise a set amount of cash. Besides depleting your retirement funds faster than you planned, it also leaves you with fewer assets to generate growth during any future market recoveries.

If a big market drop takes place later in your retirement, you may not need your portfolio to last as long or to continue growing to fund a long retirement, which can leave you in much better shape to fund your withdrawals.

One approach to a big loss at the start of retirement is to simply reduce your withdrawals, whether that involves cutting your living expenses or cashing in other types of assets. You could also forgo inflation adjustments or postpone large expenses. In short, anything you can do to avoid selling investments when the market is down could potentially benefit your portfolio later on. But not every retiree has those choices.

This is where the bucket strategy can help. Your first bucket of short-term, low-risk liquid holdings of cash equivalents and cash can allow you to cover your expenses while you avoid tapping into your stocks and other investments. One approach is to fill that first bucket with a year's worth of expenses in cash investments and another three to five years' worth of expenses in high-quality cash equivalents. With that kind of padding helping to insulate you from market volatility, you can hopefully ride out market losses while waiting for stocks to potentially recover and maybe even generate growth later.