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NEW YORK ( TheStreet) -- People who retired in September 2000 were extremely unlucky. During the next two years, the S&P 500 dropped 38%.
The big downturn upended the careful plans of many retirees who expected to cover living expenses by selling stocks. Savers who retired in December 2007 suffered another big setback, as stocks dropped 48% in the next 15 months.
To protect against such big downturns, financial advisers have developed techniques that call for dividing portfolios into sections or "buckets." The first bucket holds cash and other safe instruments, while the other sections take on more risk. Retirees tap the cash bucket to cover living expenses.
Critics of the bucket system note that keeping a big cash stake could hurt long-term returns. That is true enough. But the bucket system may be useful because it calms nervous savers who could panic and sell during downturns.
Advisers say the approach is particularly useful for clients who might be afraid to invest in stocks otherwise. "By creating greater security with one part of the portfolio, you enable investors to take more risks with other areas," says Stephen Freedman, an investment strategist with UBS Wealth Management Research.
In a typical system, you divide assets into three buckets. Say a retiree has $1 million in assets and needs $50,000 a year to live. In the first bucket, you could put $150,000 in cash, certificates of deposit and safe instruments -- enough to cover three years of living expenses. The second bucket would hold $350,000, including 80% in high-grade bonds and the rest in stocks. The third bucket would have $500,000, including 60% in stocks and 40% in bonds.
Say stocks crash and bonds earn modest returns during the first year. The investor can wait calmly, spending cash from the first bucket. At the end of the year, the saver can sell some bonds and replenish the cash in the first bucket. The stocks in the second and third buckets remain untouched.
In all likelihood, the stocks will eventually rebound. When that happens, the investor can sell some winning stocks and use the proceeds to replenish the cash in the first bucket. The aim is to avoid selling stocks at market troughs, which is a recipe for quickly exhausting retirement savings.