The 3 Buckets Strategy of Retirement Planning

Updated : Aug 27, 2019 in Articles

The 3 Buckets Strategy of Retirement Planning


Not all retirement withdrawal strategies are
created equal. And that makes perfect sense because not every
retiree’s goals are the same. Some people are retiring well into their 70s,
they realize that they likely don’t have many years left to go and they’re not too worried
about outliving their money. They just want to enjoy life to the fullest
for the time they have left. For those people, more dynamic withdrawal
strategies such as the 1/N method may be a viable option to fit their needs and goals. Other retirees are retiring at a more normal
age or perhaps slightly early and expect to be needing to withdraw from their nest egg
for 20 or 30 years. These people may have a little bit more concern
when it comes to outliving their money, but in comparison to a bare-bones early retiree,
maybe not so concerned that they would be willing to forgo too many of the lifestyle
perks that they have become accustomed to over the years. As such many of these retirees may want to
adopt a more moderate to conservative withdrawal strategy. Still, others are retiring incredibly early
or just wish to leave a lot of money to their heirs or to a charity or cause when they pass
on. For these individuals, a truly conservative
strategy may be in order. As you can tell in today’s video we are going
to be continuing our series on retirement withdrawal strategies. Today we’re going to be covering a strategy
called the three buckets of retirement withdrawals. As always we’re going to be going over what
the three buckets strategy is, why we would use it, who it would work well for, and, of
course, it’s pros and cons in comparison to other popular strategies. Let’s get started. Hey everyone Daniel here and welcome to Next
Level Life a channel where you can learn about investing, debt, retirement, and many other
financial topics besides, because, let’s face it, the school’s aren’t going to teach
it for us. So if any of those topics sound interesting
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with a friend, and leave a comment below letting me know what topics you’d like me to cover
in future videos. So the three buckets strategy is a fairly
simple strategy to understand on the surface, even if the calculations can get a bit more
complicated when it is put into practice. The basic idea is that you divide your investments
into three sections, or buckets, each with different purposes. The first bucket is usually any money that
you will need in the near future (just for the sake of this video let’s say it’s
2 years, but just know that there isn’t really a standard time frame for this. It all depends on your situation, goals, and
risk tolerance). This bucket usually contains very safe investments
like cash and cash equivalents such as treasury bills, money market funds, and the like and
should be enough to cover all of your ongoing expenses (that aren’t already covered by
things like social security, pension checks, or side hustle income) including the major
ones that come up from time to time like vacations, car and home repairs, and so on. This bucket won’t make you much money, but
in this strategy that’s not its purpose. After all, when you get fire insurance you
aren’t going to get mad when your house doesn’t burn down. This is sort of like your market crash insurance. It’s the money that protects the money that
makes you money, by giving you another option for income that doesn’t involve selling
your investments when they’re at their lowest point. The second bucket is for any money that you
will not need in the next 2 years (if that’s the time frame you used for the first bucket)
but will need sometime within the next 5 or 10 years and generally contains slightly more
risky, or sometimes just less liquid, investments than the cash bucket such as bonds, and sometimes
the fairly safe blue-chip type dividend-paying stocks. The major purpose of this bucket is to earn
enough money through the interest and dividends as well as hopefully some small appreciation,
that it can refill the first bucket as time goes along. The third and final bucket is used for long-term
investments that you won’t need to touch for the next 5-10 years or more and are generally
more of the high risk, high reward variety. Some examples of investments that may go in
this bucket are stocks (normally the ones with high growth potential), real estate,
and sometimes alternative investments like commodities also go here. And again, don’t get hung up on the time
frames I’m using for the buckets in this video. They aren’t hard and fast rules, some people
will use longer or shorter time frames for the buckets depending on what they are trying
to accomplish. Now you may be thinking to yourself, well
that all sounds fine and good, but why exactly would we need this strategy when we could
just use something like the 4% rule? Well some of us won’t need it (as we’ll
discuss later with the pros and cons), but it is true that some people don’t like the
idea of systematic withdrawals systems, like the 4% rule, because of the risk factors that
are involved with using them. For example, if you’re retired and following
the 4% rule and the market crashes, you still money to live on, and unless you have income
coming in from other sources like social security, pensions, or some form of side hustle or other
part-time work, you’re going to need to sell your investments, potentially at a significant
loss, in order to put food on the table. This can have a tremendous effect on your
chances at success as I detailed in my video on whether or not the 4% rule is actually
safe. Just think about it. If you have a $1,000,000 nest egg invested
in the stock market when you finally decide to hang up your boots for good, but the market
has a gigantic crash like the one that we experienced back in 2008, that nest egg could
look suspiciously like $500,000 when you go to withdraw money from it later that year. And if it takes the market, say three years
to recover its original value, you could still be looking at a significantly smaller nest
egg if you were following the 4% rule to a T. Here’s how it could look. You retire with $1,000,000 as your nest egg
invested in a stock with a share price of $100. This means you have 10,000 shares of the stock
when you retire. And on a side note, yes I know how unrealistic
it is to have your entire retirement savings in one stock or mutual fund, this is just
to illustrate the example. However, your investment falls by 50% during
your first year of retirement and you withdraw $40,000 that first year because that’s what
the 4% rule told you to do. This leaves you with a nest egg worth $460,000
at the end of the year. In your second year of retirement, your investments
start to recover, gaining 20% for the year as a whole, bringing the share price back
up to $60 per share. This raises the value of your nest egg up
to $552,000 and since you still need money to live on you withdraw some more for the
year. In order to keep your buying power the same
as it was last year, you withdraw $40,800 to account for inflation, which for the sake
of simplicity we’ll say is about 2% each year. This leaves you with a nest egg of $511,200
at the end of the year. In your third year of retirement, the market
continues to recover, growing by another 20% and raising the share price all the way to
$72. This brings the value of your nest egg up
to $613,440. But again, you still need money to live and
in order to maintain your standard of living, we again must adjust the withdrawal for inflation. This time you withdrawal $41,600 to account
for inflation. This leaves you with a nest egg of $571,840
at the end of the year. In your fourth year of retirement, your investment
fully recovers with the share price reaching $100 per share. This brings the value of your nest egg up
to just over $794,000 before your withdrawal and roughly $751,750 afterward. So while your investments have technically
fully recovered from what would’ve been one of the worst crashes in the history of
the stock market, you are sitting with a mere 75% of the money you had when you first retired
thanks to being forced to sell some of your shares during a market downturn. Not ideal to say the least, but it is an absolute
eventuality for those strictly following the 4% rule in retirement (assuming, of course,
that they have no income coming in to support themselves outside of their investments. If they do then they can live off that during
the hard times). And while you can certainly do some things
to somewhat mitigate this disaster of a situation from harming your nest egg, even without other
income, such as figuring out ways to lower your burn rate and lower your standard of
living during market downturns, but neither of those solutions will stop the damage entirely. They will just lessen it. This is why some people prefer to use the
three buckets strategy. It’s all done in the interests of avoiding
that eventuality entirely. I like to think of it as the debt snowball
of the retirement withdrawal strategies. It may not be the ideal mathematically (which
I’ll come back to in a minute), but it can be the thing that helps someone mentally and
emotionally become comfortable with the idea of retiring if worry and stress is the only
thing realistically holding them back. So, now that we know what the three buckets
strategy is and why some people would use it, how exactly does it work in practice and
what are the pros and cons? The implementation of this strategy can vary
a bit from person to person, but generally, it works something like this: Let’s say that John and Jane have decided
to retire. They want to maintain their current standard
of living spending $40,000 a year, as we saw in the example earlier. And this is entirely doable thanks to the
fact that they are retiring debt and mortgage free with a nest egg of $1 million. That means that they could, if they wanted
to, follow the 4% rule for their withdrawals, however, in an effort to avoid having to draw
from their investments during a down market, they will be using the three buckets withdrawal
method instead. And because of this, they don’t actually
have $1 million invested in stocks and bonds. They have decided to have 2 years worth of
their expenses, or $80,000 in their case, invested in their short term, cash and cash
equivalents bucket. They have 10 years worth of expenses, or $400,000,
in their income bucket, which is mostly comprised of high yield bonds that are generating them
roughly 2.5% per year in interest, or about $10,000. The last $520,000 of their savings is in their
long-term investments bucket and is comprised of several higher risk, but higher reward
stocks. These are mainly growth stocks that are early
on in their growth cycle and as such aren’t paying out any dividends to their shareholders. So, unfortunately, no extra income here, it’s
all about stock price appreciation. John and Jane currently make nothing from
social security, and like most of us, won’t have any pension or side hustle income to
speak of in retirement so they will have to replenish their spending bucket entirely with
their income bucket as time goes along. And since we’re comparing this method to the
4% rule it only makes sense to go with a scenario that tests the 4% rule to its limits. So let’s go back to the example we used earlier
were John and Jane’s investments (specifically those riskier investments that are in their
third bucket) start out at $100 a share but dropped to $50 a share in the first year and
didn’t recover until the end of the fourth year of their retirement. We saw what happened using a very systematic
safe withdrawal rate strategy under those conditions, however, the same thing does not
happen with the three buckets strategy thanks to the focus on having cash on hand as well
as income producing assets. However, since they’re income bucket is only
giving them $10,000 a year and they’re pulling out $40,000 a year from their cash bucket
to live on, they’re going to need to cash in some of their bonds as time goes along
to make up the difference. And this difference will increase over time
thanks to inflation, which to keep things consistent with the previous example we will
again assume is 2% per year. So when we plug in all the numbers, adjusting
for inflation and cashing in bonds when needed to get our cash bucket up to that two years
worth of expenses at the end of each year we see that our ending net worth is about
$841,600, which is nearly $90,000 more than it was in the previous 4% scenario. At the end of the scenario John and Jane’s
money is split up like this: $80,600 in the cash bucket. $241,000 in the income bucket. And thanks to the fact that we didn’t have
to sell off any of our investments during the crash John and Jane still have $520,000
in their investment bucket. So the biggest pro to using the three bucket
system is obvious it gives you some peace of mind if a major market crash should happen
at some point during your retirement. And let’s face it if your retirement is
long enough there’s going to be a crash at one point or another. However, the downside to using the three buckets
method is equally as obvious. As I’m sure many of you have already been
thinking to yourself, the fact is that since you’re keeping possibly one, two, or even
three years worth of your expenses in cash or cash equivalents, you aren’t making very
much money from that portion of your savings. And unless your expenses are incredibly low,
having your growth potential limited like this could make a huge difference in your
net worth, especially over a longer retirement, compared to using different retirement withdrawal
strategies. I mean, we looked at a fairly short scenario
today simply to quickly illustrate the difference that these two strategies could have in less
than ideal times. However, it’s not exactly common for the
market to lose 50% or more of its value in a single year. It’s actually quite rare in the grand scheme
of things. And over the long haul, the market has averaged
returns of roughly 8% per year. Say if John and Jane lived for 30 years in
retirement, and over that time averaged a rate of return of 8% per year, but instead
of using the buckets strategy and leaving $80,000 of their savings in cash, they took
the risk and put everything into their actual investments. $80,000 at 8% per year for 30 years is about
$805,000! Even at a more conservative 6% return, it
still ends up netting John and Jane an extra $460,000 over the course of their retirements! So depending on how long your retirement goes,
how much you have saved, to begin with in relation to how much you spend, and how many
crashes you experience during that time this may end up being the difference between having
enough money to live out your full retirement and outliving your money. So where exactly does this leave us? Who would this strategy work for? Well, I personally feel that it is well suited
for those people who are maybe a little extra worried about having to sell off their investments
during a crash, are willing to work a little bit longer so that they can still have enough
invested in their second and third buckets to make up for what the potential growth their
losing by keeping that money in cash, and those who won’t likely have any income outside
of their investments during retirement. But what do you think about this strategy? Do you think that this would be a good strategy
for you to take advantage of, either throughout your whole retirement, or maybe just a part
of it? Let me know in the comments section below. But that’ll do it for me today once again
if you enjoyed this video be sure to smash that like button if you haven’t already,
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11 Comments

  • Love your video πŸ™‚ What about just 2 buckets? Have 2 years expenses set aside as a giant emergency fund, and not draw money from investment at that one year when the market crash 20% plus? And slowly refill that bucket back up as I never spend all the withdrawal every year anyway? (And follow the regular 4% rule otherwise) How does that sound to you? I am retiring soon and that will be my plan I think πŸ™‚

  • You're comparing a portfolio of 100% stocks for the 4% rule, to something close to 50/50 stocks/bonds for the 3 buckets strategy. Apples and oranges…

  • i use this rule because it makes lots more sense to me except i make the cash bucket 5 years and the rest of my money wih 40 bond 60 stock allocation. my experince told me it can take 5 to 7 years to recover from market crash

  • Hey Daniel, I have a question. At about 10:30 in the video should the 10 years bucket have been $320,000 as I thought it would be covering years 3-10? Great video, really enjoyed it. One of the best channels out there that I recommend to friends!!!

  • Maybe consider a blend of the 4% rule and the bucket strategy, such as when your investments in bucket #3 have a surge. You can then pull some extra money beyond 4% out and put them into buckets 1 and 2 so that you are prepared for a market down turn. Love you videos.

  • So if I use a 2% cash back credit card (I pay it off every 2 weeks) for the majority of my expenses, doesn't that mean I'm helping myself mitigate inflation? Lol just thought about that 😁

  • Great video, I just cannot except that it is common practice to retire in your mid 60's who ever thought that was a good idea lol if there is a time to enjoy and be active it's early and decrease your burn rate when you're 60+? Makes more sense to me.

  • Did I miss something? Wouldn't the first bucket be gone at the end of the 4 years? If so, there is only a 10K improvement over the 4% example.

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