Phasing Retirement with a Bucket Drawdown Strategy

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 two examples. 

Depending on their priorities and preferences, an investor may wish to add additional segmentation—or at least keep a greater number of assets in the third bucket—especially if a long retirement is planned. 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 those drawing down a nest egg over time who may need to liquidate their investments to pay living expenses. This approach allows investors to categorize which assets will be liquidated over various periods of time without assuming one particular asset allocation will be used for all buckets. 

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

Investors may also 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 risk tolerance, the second bucket could include what are usually seen as lower-risk investments, such as bonds and income-focused equities, while 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 investors to put more aggressive assets in their long-term bucket while maintaining other potentially less-risky positions in order to ride out market ups and downs. By having other buckets to cover near-term expenses, investors can hopefully avoid feeling pressured to sell long-term investments from the third bucket in case of a market downturn because these funds won't need to be accessed for several more years. 

When building a bucket strategy, make sure to understand 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 withdrawals. 

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

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

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

This is where the bucket strategy can help. The first bucket of short-term, low-risk liquid holdings of cash equivalents and cash can allow retirees to cover expenses while avoiding tapping into 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 to help insulate from market volatility, new retirees can hopefully ride out market losses while waiting for stocks to potentially recover and maybe even generate growth later.