Should You Use a Bucket Strategy For Your Retirement Portfolio?

I recently received the following reader comment:

“In regards to spending in retirement, I wonder if you could educate your readers, including myself, about differences between a 60/40 asset allocation and a bucket system. When I read about them separately they seem to make sense, but when I try to compare them, I sort of feel stumped.”

Let’s dive into this question which can have important implications for retirement portfolio design and management.

A Case of Semantics

To a degree, the difference between a traditional asset allocation approach and a bucketing strategy is largely one of semantics. Let’s consider an example of two separate single retirees, Steven and Sally. 

Steven and Sally each has a million dollar portfolio heading into retirement. Each plans to spend $40,000, or 4% of their portfolio, in year one of retirement. Each plans to maintain that spending, adjusted for inflation, over their respective 30 year anticipated retirements (i.e. following the 4% rule).

Fixed Asset Allocation Approach

Steven determines that a reasonable asset allocation given his risk tolerance and capacity is 60% stocks and 40% fixed income (bonds and cash equivalents). This 60/40 portfolio leaves him with $600,000 stocks and $400,000 fixed income at the start of his retirement.

Bucketing Approach

Sally decides that she will utilize the bucket approach. She’ll take the $40,000 she plans to spend in year one of retirement and put it in cash. This way, she won’t have to spend from volatile assets if they are down in value.

She has read that the worst bear markets for stocks can last a decade. So she decides to bucket out another nine years worth of expenses ($360,000). These dollars will be allocated to fixed income investments. They should be less volatile, keep up with inflation, and hopefully not be highly correlated to her stocks while providing a little extra return compared to cash.

This approach provides Sally the ability to ride out all but the worst case scenarios in the stock market. She feels comfortable investing the remainder of her portfolio in stocks. So that’s what she does.

Different Roads to the Same Destination

Steven divided his $1M portfolio 60% stocks and 40% fixed income. This left him with $600K in stocks and $400k in bonds/cash.

Sally took the bucketing approach to design her portfolio. At the end of the day, she ends up with $600K in stocks and $400K in bonds/cash.

Steven and Sally went about allocating their investments differently. At the end of the day, they are starting retirement with identical portfolios. The difference is an example of mental accounting.

Mental Accounting

Mental accounting was defined by Richard Thaler as “the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities.” This is generally considered a cognitive bias that causes more harm than good.

Bucketing may be an exception where there is more benefit than harm. Let’s explore the pros and cons of this approach.

Pros of a Bucketing Strategy

The biggest advantage of a bucketing strategy is the level of intentionality it creates when allocating your dollars. When bucketing out your money, you are giving each bucket a purpose and “use-by date.”

Duration Matching

This is important on the fixed income side of the portfolio. I wrote earlier this year that I’ve been having recurrent conversations with clients around a common theme. They wonder whether bonds have a place in a portfolio as a diversifier to stocks after a rough year for both asset classes in 2022.

That’s likely because many investors lump bonds into one big pile. A 3-month treasury and a thirty year treasury are both considered “safe” from the standpoint of default risk. However, they have extremely different sensitivities to changes in interest rates.

Related: Investment Risk — What You Don’t Know CAN Hurt You

A bucketing strategy is conducive to thinking about when you may need specific dollars. You can then fill buckets aligning different fixed income durations to corresponding timelines. For example, you could build a bond or CD ladder. Each “step” matures in the year you will likely need the money. 

Alternatively, you could bucket your dollars into cash and other short-term instruments or funds vs. intermediate term instruments and funds. The short-term buckets buy you time to ride out a scenario like that which occurred last year when stock and most bond values fell simultaneously. This provides intermediate term buckets and stocks time to recover.

Asset-Liability Matching

A bucketing strategy is also conducive to asset-liability matching. In the example I created, I assumed spending would be constant aside from inflation adjustments in every year of retirement. This approach is common in retirement modeling research. That’s not how spending works in the real world.

We can’t know exactly what our spending needs will be decades or even just a few years in the future. We can make reasonable guesses and assumptions. 

You may know you have a big trip you want to take in 3 years. The need for a new roof on your house is likely in 4-6 years. You can create larger buckets to correspond to those time frames with these anticipated spending needs. Then you know money will be available to meet those needs when they are likely to arise.

Permission to Spend

Bucketing may provide a psychological boost as well. Many natural savers find it hard to spend from investment portfolios.

Having a set bucket of money set aside that can be spent in a given year may make it easier for some people to actually spend those dollars specifically allocated for that purpose.

Cons of a Bucketing Strategy

Bucketing can be helpful when designing a starting retirement portfolio. It is not a cure all for the many challenges of portfolio decumulation.

At the end of the day, it is mental accounting. It doesn’t actually change what you have to work with.

When Will You Use and Refill the Buckets?

The biggest challenge to a bucket strategy is developing a system to determine when to refill your buckets.

Imagine starting with a plan to have ten years of fixed income bucketed out, and you spend the first bucket in year one of retirement. You no longer have ten years of fixed income. You now have nine years bucketed and a need to refill one. 

Does it matter if you are selling off stocks at the beginning of the year or periodically throughout the year to create income as you need it vs. at the end of the year to refill the cash bucket you spent? Are any of these approaches better than rebalancing at a fixed frequency as is common to stay at a fixed asset allocation?

It almost certainly will make a difference. Unfortunately, the best we can do is make educated guesses as to which would be optimal without the benefit of hindsight.

Prolonged Bear Markets

What if the market is down and you choose not to refill the spent bucket? What if this happens five straight years or you have a “lost decade” for stocks? Would you actually be willing to spend down all of your fixed income assets while waiting for stocks to recover until you arrive at a 100% stock portfolio? Or was this bucketing all a thought exercise?

These are all potential challenges and actual questions you should be able to answer if utilizing a bucket strategy. There are no knowable “right” answers in advance.

Decumulation Is Hard

I hope in the course of addressing this reader question, I didn’t make an already challenging topic even more daunting. That said, it is important to understand that there is no single perfect solution to the challenge of building a retirement portfolio and spending from it.

We would all like that simple and perfect solution. But the best we can do is acknowledge the challenges of creating income from a retirement portfolio, create a reasonable plan, monitor our results periodically, and make adjustments as needed.

Using a bucket approach certainly qualifies as a reasonable strategy. It can lead to more intentionality when building a retirement portfolio. Just recognize that like any other portfolio strategy, it requires ongoing effort and the need for flexibility.

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to chris@caniretireyet.com. Financial planning inquiries can be sent to chris@abundowealth.com]

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