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.
While some advisers rely on three buckets, others use a greater number. Nationwide Financial Services has been promoting its RetireSense program, which employs five or more buckets. Under the system, the client starts by covering essential costs, such as food and rent. Say the annual essential costs total $30,000. Social Security provides $24,000. To cover the rest, the client should obtain a reliable income source, such as an immediate annuity, which provides guaranteed income for life. For other expenses, the saver uses buckets. Each bucket covers a 5-year period. So for an expected retirement of 30 years, there would be six buckets. The first bucket would have enough cash to cover five years of expenses. The second bucket would have a mix of cautious stocks and bonds that could cover expenses from years five through 10. The bucket for years 10 to 15 could hold more stocks and include a variable annuity with an income guarantee. The annuity would invest in stocks. If the market soared, the investor could keep the profit. If markets sank, the annuity could provide the minimum guaranteed income. Other buckets would include more aggressive mixes of stocks and bonds. Because of its soothing effect, the bucket system has become increasingly popular with financial advisers since the financial crisis. But many advisers shun the new approach, preferring traditional portfolios that hold mixes of stocks and bonds. A classic strategy puts 60% of assets in stocks and 40% in bonds. To obtain income from the standard portfolio, a retiree sells assets. Brad Davis, a vice president of Nationwide, concedes the 60-40 portfolio might deliver better long-term returns than a bucket system. But he argues the buckets can provide special security when retirees need it most. "During the working years when you are accumulating assets, the main goal may be to maximize returns," Davis says. "But in the retirement years, you may decide to focus on getting protection from potential disasters." This article was written by an independent contributor, separate from TheStreet's regular news coverage.