By Faron Daugs, CFP
I previously had a client who worked at a Fortune 100 company for 30 years and he eventually decided to step back, but he was still too young to hang it up forever. He wasn’t quite ready for retirement but didn’t want the day-to-day stress of the current position. This put him into what I call the “red zone” of retirement: that two, three, or five-year timeframe when you want to slow down but aren’t completely ready to stop. Many people struggle with this retirement zone, but there is a way to plan for today, tomorrow, and future retirement. It’s called bucketing.
What Is Bucketing?
Bucketing is a way to think about and compartmentalize your portfolio. In essence, there are three buckets and each one carries a different level of risk and investment based on your goals, risk tolerance, timeframe, and need for funds. Depending on where you are in your financial journey, you will allocate different percentages of your portfolio assets into each bucket. But as you move closer to retirement, those percentages will change.
- Bucket one: The first bucket is for immediate cash needs. These assets will not have a significant amount of growth (think of a savings account), but they are readily available when money is needed soon.
- Bucket two: The second bucket is geared toward the first phase of your retirement needs. The purpose of this bucket is to have it accessible when you need it without penalty. This can be for the “red zone” years of retirement when you might be consulting or doing freelance work. It should have conservative growth to offset inflation and produce income in the form of interest or dividends.
- Bucket three: The third bucket is to support the later years of your retirement and any assets you might want to pass on to family members or charity. These assets are focused on long-term growth to help offset inflation. While they might carry the most risk, they should provide higher long-term returns than the other two buckets.
How to Establish Your Buckets
Knowing how and when to fill your buckets is the first step to positioning yourself for expected retirement. We can break this up into four investment stages: accumulation, transition, preservation, and distribution. The longer you have to reach your goals, the higher percentage of funds you can allocate to buckets two and three. But as you move closer to retirement, the percentages can change depending on timeframes and the need for funds.
During the accumulation years, bucket number one is generally a small percentage of the portfolio assets to get you through this phase, whether it’s for college or home renovations. The transition phase happens between five and 15 years from retirement. Within this window, you will want to start to transition more from bucket three to bucket two. As you get within five years of retirement, you’ll want to expand the transition from bucket three to two while increasing bucket one. As you get closer to retirement, you’ll want to have a smaller percentage in bucket three to reduce market exposure.
These bucket portfolios are usually a combination of taxable, tax-deferred, and tax-free investments. Buckets two and three typically make the most of these tax advantages, especially during the accumulation and transition phases. If you’re planning on using taxable accounts, look to tax-free bonds, ETFs, or low turnover accounts. No matter how you are splitting your funds, make sure to review gain and loss opportunities every year.
Responding to Volatility
Prior to 2022, we experienced an exceptionally long bull market, making it challenging for investors to believe they need to reduce the risk in their portfolios. For example, moving their funds from buckets three to two and some cases, to bucket one. Given low-interest rates and returns, this has been difficult to do; however, the risk is that we continue to see a significant decline in the market. Investors that didn’t reallocate their assets and are looking to retire within two to three years are seeing a significant decline in their portfolios compared to those who were more disciplined about the bucketing process.
When the market is volatile or experiences a period of decline, it’s important to reassess your allocations on a regular basis. Investors that were fortunate enough to have nice returns in bucket three could protect those gains by moving them closer to safer investments as they move toward their retirement goals. Otherwise, it may be too late to transition and then they take on too much risk when they cannot afford to do so. That might mean working longer or reducing income goals for retirement.
From Allocation to Distribution
When you move into distribution, I typically recommend that you have 18 to 24 months of expected distribution in bucket one. Bucket three can then absorb any potential market volatility. Any dividends or interest generated from bucket two will also go into bucket one to help keep it full. This helps to prevent the need to sell assets in a bear market to provide the desired level of income.
Occasionally investors feel that the assets in bucket one are not having an impact, and while that might be true from a return perspective, the process allows the other buckets to absorb the ebbs and flows of the market without impacting immediate cash needs. Cash is an asset class, and it may underperform in the long term because of inflation and market forces, but it does provide stability during market volatility.
Adjusting After a Bull Market
The days of just using stock dividends and bond interest for monthly income are long over. Given the recent low interest-rate environment since the credit crisis of 2008, bonds have underperformed in the majority of investors’ portfolios. As a result, this has skewed the perception of how much income they will have in their portfolios when they retire. Some have taken on more risk and reached for dividends they might not have in the past. Therefore, they might have a little bit more in buckets two and three than are commonly considered reasonable given their timeframe to retirement.
Candidly, this bull market has made many investors overconfident. They shunned stable value and guaranteed accounts in their 401(k)’s. Over the past 20 years, these haven’t performed so well, making around 2-3% returns. Until recently, this helped to keep up with inflation, but now that is underperforming because of higher inflation. If you are in the “red zone” nearing retirement but still need some additional funds, there are steps to take to preserve investments while still maintaining your current lifestyle. A few of these steps include:
- Consider consulting for a few years for additional retirement income.
- Review your portfolio exposure to a long-term care stay and determine whether you should fund an LTC policy while still working.
- Go remote. By pulling back from meetings, travel, and a reduced workload you could have the opportunity to work remotely and get a head start on retirement by downsizing housing.
- If you’re a business owner, consider potential cash flow and tax-saving ideas for your exit strategy.
- Invest in passive income opportunities such as a rental property.
With generally low-interest rates and a volatile market, it’s necessary to get creative with your assets in a way that might not correlate to the broader market.
Taking the Next Steps Before Retirement
If you are nearing retirement and feel that you are being squeezed by this market decline, dissect your portfolio and determine what percentages you need in each bucket. To navigate the market, successfully plan for your retirement, and make sure you have enough for the transition period, you will need to carefully put a bucket plan into action:
- Review your cash needs annually and reposition to appropriate buckets.
- Be disciplined about your bucket percentages and rebalance as needed, especially as markets rally and you can lock in gains.
- Review how much revenue is being generated in your second bucket on an annual basis. Given your current phase, either continue to put that revenue in bucket one or reinvest for future returns.
- Allocate up to 24 months of cash in bucket one if you are taking distributions.
- Periodically review the holdings in buckets two and three. It’s good to understand where the money is being invested and adjust accordingly.
- Make sure to run annual tax projections to determine a comfortable ratio of taxable and tax-deferred accounts so that you can withdraw cash but maintain a reasonable tax bracket.
If the markets potentially rally, be aware of repositioning your portfolio to these buckets. It might be tempting to give in to the “fear of missing out” lifestyle and look for big returns. But be disciplined. Take the emotion out of investing and prune holdings that might not be the best candidate for recovery and position those assets for potentially better choices. The best part of retirement is being able to live worry-free without having to check emails, go to meetings, and stress about the state of your portfolio. By leveraging a bucketing process and remaining disciplined, you can help ensure that you’ll have enough resources to enjoy the best of your retirement.
About the Author: Faron Daugs, CFP®
Faron Daugs is a Certified Financial Planner and Wealth Advisor with more than 30 years of industry experience. As the Founder and CEO at Harrison Wallace Financial Group, he serves as a go-to source and trusted advisor for his clients. To learn more visit https://www.harrisonwallace.com/ or follow Faron on LinkedIn.