The two-bucket strategy is a unique implementation of behavioral finance combined with empirical evidence. By separating near-term cash flow from long-term capital appreciation, retirees can achieve the following benefits:
How the Two Buckets Work Together?
The system can operate in a cyclical manner.
- You withdraw money from your first bucket for living expenses.
- Your second bucket stays invested and buys and sells to grow over time.
- When your second bucket has grown to an acceptable amount, you transfer the gain from bucket two to refill bucket one.
- Then you begin this process all over again.
This way of managing the money you retire with gives you peace of mind to hold on to your growth investments during down markets because your short term income is covered by the money you have already taken out of your first bucket.
Determining the proper allocation
While there isn’t an absolute formula for the allocation to be used, there is a common sense of how to make that decision.
- Bucket 1 = 3-5 years of essential expenses
- Bucket 2 = Remainder of your total retirement portfolio
For example, if you require $50,000 a year in essential expenses for your retirement:
- Bucket 1 will hold approximately $150,000 to $250,000.
- Bucket 2 will hold the remainder of your retirement savings.
Its important to mention some of the factors you should consider when determining the proper allocation.
- Risk tolerance
- Pension income or Social Security income
- Your health
- Your legacy aspirations
- Current market conditions
Individuals who have guaranteed sources of income (Pension income) may use a smaller bucket one.
Benefits of a 2-bucket strategy
1. Reduces Stress From Market Fluctuations: Knowing that you have 3-5 years of living expenses sea secured will give you piece of mind during down markets.
2. Reduces Sequence of Returns Risk: If you have negative returns in the early stages of your retirement, you could by force sell your growth investments in down markets. With the two-bucket strategy, you can hold on to your investments until the market returns to its historical levels.
3. Simplifies Your Withdrawals: An organized structure for your withdrawals can reduce market volatility instead of randomly selling stock or setting a limit order on your growth investment.
4. Encourages Discipline: It keeps emotions under control when volatility comes into play.
Possible Disadvantages of this Strategy
This strategy does not assure you of anything- no strategy is foolproof:
1. Less Returns on His/Her Safe Investments: Research has shown that when compared to equities, cash and short term bonds will usually yield lower than equities will, as a result of this your overall portfolio growth may be decreased.
2. Bucket #1 may have inflation risk: Conservative investments (like cash) will probably not keep pace with rising prices (inflation) if we have an unexpected spike in inflation.
3. Rebalancing and Refilling are Required: You have to periodically replenish Bucket #1.
Despite these drawbacks, the simplicity and risk management of this method make it favorite with many retirees.
How often should a retiree(s) rebalance their portfolio?
- Generally annually.
- Flexibility is an important element to being successful as a retiree(s) using this strategy, most retirees also modify their withdrawal amounts during times of poor performance to protect their full wealth.
Who is suited for the 2-bucket method of withdrawal strategy?
The 2-bucket withdrawal strategy has been found to work extremely well for:
- Newer retirees who have concerns about high volatility
- Conservative Investors
- Retirees without significant pensions or other regular income
- Those who want a systematic approach to withdrawal of funds
Retirees with a significant amount of money guaranteed to last their lifetime may consider this method to be unnecessary to achieve their ultimate retirement objectives.
Common methods of withdrawal from retirement savings accounts;
4% rule (of your total savings account), total return approach – use only one portfolio of diversified investments
Three or four bucket systems (with intermediate buckets added). The two bucket strategy is easier to understand compared to multi-bucket systems. In contrast to investing only on the total return basis, the two bucket strategy is more structured.
Practice-based Implementation Steps
- Determine your total annual mandatory expenses;
- Save required amounts (3–5 years) in the form of cash;
- Use what is left after you save the required amount(s) as investments for growth and long-term capital appreciation;
- Define one or more ‘refill rules’ (e.g., refill on the date you reach the 10% threshold above the current market pricing level, which is also known as the MLR);
- Review the rules annually;
- If your situation is complex, consult with an advisor.
