When a “Bucket Strategy” Shines

Mar 25, 2020

Market reversals are unnerving for everyone. But for a person in retirement or close to it, a sudden and deep downturn can be terrifying. It’s scary to see one’s nest egg diminish by tens of thousands of dollars (or even more) in just a short period. And if the investor needs some of that retirement money soon, he or she faces the demoralizing prospect of withdrawing funds at the worst possible time.

We can be thankful that bull markets tend to be long and bear markets tend to be short, but that is scant comfort when a bear begins to prowl. And, unfortunately, many retirees and near-retirees are caught off guard when that happens.

Two years ago, we wrote about an approach to managing retirement savings that helps safeguard older investors from the impact of market reversals: the “bucket strategy.” It is in times of sudden market upheaval that a bucket approach shines.

Bucket basics

“Bucket” is a metaphor — a way of describing how to divide one’s money among different types of financial instruments, based on when the funds will be needed. Some financial advisors suggest having only two buckets; others recommend more.

The crucial bucket is Bucket One — the place for money needed for living expenses over the next year or two (or perhaps three). Bucket One money should go into an online bank savings account or a money-market mutual fund. Any Bucket One dollars that won’t be needed the first year could be held in a higher-yielding short-term CD or perhaps a short-term bond fund. (Keep in mind, however, that you can lose money in a short-term bond fund. The main point of Bucket One is to have money immediately available for essential spending, so be careful about reaching for higher yield.)

By having cash on hand, a retiree is insulated from the short-term vagaries of the stock market because living expenses are covered by cash assets, rather than withdrawals from an investing account. In effect, your cash holdings will become the funding source for your monthly “paycheck,” along with Social Security income and any guaranteed income you may have from other sources, such as a pension or annuity.

Here’s how to calculate the amount needed in Bucket One: Subtract your annual Social Security benefits and any other non-portfolio guaranteed income from your estimated annual cost of living. The result is the “gap” that you’ll need to cover from other resources in the year ahead. (If you want a two-year cash bucket, double the one-year gap amount.)

To begin, withdraw from your investments the amount you’ve determined to put in your cash bucket. Once your cash bucket is in place, you should be able to relax about what the market may be doing. A downturn, a correction (a decline of 10%), or even a full-blown bear market (a drop of 20% or more), won’t affect your immediate cash flow because you’ll be drawing monthly from safe, liquid holdings while waiting for your investment holdings to recover. (Some history: Since World War II, the average recovery time from a bear market has been 17 months, assuming dividend reinvestment. Recovery from the 2008 Great Recession bear took three years.)

Refilling your cash bucket

Perhaps the biggest challenge of a bucket strategy is knowing how and when to refill your cash bucket. The approach some investors use is to rebalance their investment holdings once a year and (assuming there have been gains) redeploy any “excess” to the cash bucket. Other investors refill the bucket by withdrawing a set amount from their investments each year.

There are pros and cons to any approach. (Also, tax considerations come into play if withdrawing from a tax-deferred account.) Still, it’s safe to say that the ideal is to replenish your cash bucket when your investment portfolio is on the upswing, selling into market strength, rather than into a decline. During bear markets, it’s better to let your cash bucket dwindle, holding off on selling investments while prices are down. As the market recovers, you can begin to refill the cash bucket.

But selling into strength presents its own particular challenge: When your investments are growing, withdrawing large amounts can be emotionally difficult. It’s crucial to keep your eye on the goal: protecting yourself from a future market reversal. As the events of recent weeks have shown all too painfully, such setbacks can happen quickly and unexpectedly.

Buckets and SMI strategies

Although we haven’t developed a specific approach to using “buckets” in conjunction with SMI strategies, remember that the whole idea of the bucket approach is segregating your financial resources by intended use.

Let’s assume you want three buckets. Bucket One is a cash bucket as described above (1-to-3 years of living expenses). Bucket Two is an intermediate-term investment bucket that earns a solid return but isn’t too volatile (money needed 4-to-9 years out). And Bucket Three is a longer-term investment bucket that can be more aggressive because its time horizon stretches out to 10 years and beyond.

SMI’s Dynamic Asset Allocation would be a good choice for Bucket Two money. Although DAA is subject to performance ups and downs (unlike a savings account), the DAA strategy likely will produce better returns than cash and yet without the volatility that can characterize a portfolio fully invested in stocks. (DAA is never fully invested in stocks, and when stocks are out of favor, DAA may hold no stock-based funds at all.)

For Bucket Three — money not needed for 10 years or more — Stock Upgrading and perhaps a small allocation to Sector Rotation may be good choices. These strategies carry a higher risk than DAA but also have a greater potential for reward. For money you likely won’t need for a decade or more, you may find the risk/reward trade-off reasonable.

Any money in Bond Upgrading can be included in either Bucket Two (intermediate) or Bucket Three (longer-term), depending on the size of the total portfolio and Bucket Two.

Again, the “bucket” idea is simply to deploy your financial resources across a range of instruments — from cash savings to stock funds — in an attempt to safeguard money needed in the shorter term and grow money not required until later.

Thinking about things this way can help retirees and near-retirees stay appropriately diversified across the risk-and-reward spectrum. Given today’s long life spans, investors in their 60s and early 70s should continue to keep some money deployed in investments that have growth potential. Completely “de-risking” too soon can undermine the potential to build wealth that may be needed in later years.

Peace of mind

Critics of the bucket strategy point out that maintaining a cash bucket carries an “opportunity cost.” They’re right. Having a significant portion of your financial resources deployed in low-earning cash investments represents a missed opportunity to capitalize on potential market gains.

However, a bucket strategy isn’t about optimizing gains. It’s about optimizing peace of mind. If you’re in or close to retirement, having cash on hand that allows you to take a bear market in stride and calmly wait for your stock-based investments to recover is nothing short of priceless.

Written by

Joseph Slife

Joseph Slife

Joseph Slife has been a news writer for the Associated Press, a college instructor, and a radio host. He and his wife Joye have three grown sons.