How Do I Use the Bucket Approach for Retirement Income?

Q.: When using the bucket approach to retirement investing, what is the timing and strategy for replenishing the money market bucket? How do you do this and try to avoid moving money from the more risky buckets during a market downturn? C. Hill, Hoover, Ala.

A.: The goal of the bucket approach is to “immunize near-term expenses from market fluctuations,” says Michael Falk, partner at Focus Consulting Group in Chicago, which advises investment firms. In other words, if you’re living off your investments in retirement and the stock market tanks, you want to make sure you can keep paying your bills.

To accomplish this, Falk, the author of Let’s All Learn How to Fish…to Sustain Long-Term Economic Growth, recommends keeping two to three years’ worth of living expenses—reduced by your guaranteed income—in cash or cash equivalents. For example, if you need $4,000 per month to live on and you receive $2,000 per month from Social Security, that's a net $2,000 a month or $24,000 a year. Put at least $48,000 into your near-term fund to start—let’s call it bucket No. 1.

The intermediate bucket—bucket No. 2—should hold three to seven years’ worth of expenses in a balanced portfolio with investments that give off a yield, such as dividend-paying stocks and bonds or bond funds. The yield from these investments should flow directly into bucket No. 1, adding to it automatically throughout the year.

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As you dip into bucket No. 1 to pay expenses, it will eventually need to be replenished. Think about doing this annually, Falk says, topping off bucket No. 1 so it once again holds your target amount.

You’re absolutely right that you don’t want to be forced to sell securities in a bear market to raise the necessary cash. The best option in a bear-market scenario is belt-tightening, Falk says. See if you can stretch a year’s worth of funds in bucket No. 1 to last closer to two years. Maybe by postponing big purchases you can give the market time to recover.

If that’s not possible, then sell the relative winners in bucket No. 2, Falk says. Most securities will have lost value in a bear market, so just sell the ones that have lost the least to give the biggest losers more time to recover.

By the way, the strategy is the same in a bull market: Sell the biggest winners in bucket No. 2 if bucket No. 1 needs replenishing. In good years, any “overflows” can be spent on discretionary fun, Falk says.

Bucket No. 3 holds longer-term funds that may not be needed for several years. It can be invested in riskier assets, such as 100% stocks. As bucket No. 2 replenishes bucket No. 1, bucket No.3 will eventually need to replenish bucket No. 2. Wait until a bull market to do this, Falk says. Given the relatively big range of assets that bucket No. 2 can hold—enough to cover between three and seven years’ worth of expenses—you usually will have time to wait out a bad market cycle before the asset level in bucket No. 2 dips dangerously low.