A while back, I described the “4% rule.” This is a popular way to think about portfolio withdrawals in retirement—but it isn’t the only way. Another approach, called the “bucket” system, is also worth understanding. Below is some background on this alternative approach.
What is the bucket system?
As its name suggests, with the bucket system, an investor divides his or her portfolio into multiple segments. Each segment, or bucket, is then assigned a different role.
The most popular implementation of the bucket system today involves three segments: The first is earmarked for a year or two of spending and is held entirely in cash. The second is earmarked for another five to ten years of expenses. Because of the longer time horizon, this can be invested with somewhat more risk—in high-quality bonds, for example. Finally, the third bucket is earmarked for expenses beyond ten years. Because of that, it can be invested entirely in stocks.
What is the purpose of the bucket system?
In constructing a portfolio, retirees face a fundamental dilemma: If a portfolio is too conservative, meaning that it holds too little in stocks, then inflation can erode its buying power over time. On the other hand, if it’s too aggressive, with too much in stocks, then there’s the risk of a large and sudden loss. The bucket approach is designed to help balance these risks. The first two buckets—the more conservative ones—won’t provide much long-term growth, but they protect against short-term stock market risk. That, in turn, allows the investor to take lots of risk with the third bucket. Thus, the purpose of the bucket system is to help an investor thread the needle between too much and too little risk.
The bucket strategy is a lot like the asset-liability matching system used by insurance companies. To cover future claims, insurers also set aside funds using buckets. As I’ve noted before, this has contributed to making insurance companies very durable.
What are the benefits of the bucket system?
In very simple terms, the bucket system can help retirees sleep at night. This is especially true when the market drops. Retirees who have a year of spending money in cash, plus another seven years in bonds, will have a much greater ability to tune out the news of the day, knowing that they can survive a multi-year stock market downturn. This can go a long way toward relieving anxiety when there’s bad news in the headlines.
Buckets can be particularly helpful to those in the early years of retirement, when sequence-of-returns risk is greatest. Because funds are earmarked so clearly, a new retiree need not worry about a nightmare scenario in which they retire on Monday, and the stock market drops on Tuesday. With buckets, that kind of scenario might be unnerving, but it wouldn’t derail the new retiree’s plans.
What are the disadvantages of the bucket system?
Critics cite two disadvantages. The first is that the system can be complicated to manage. If you search online for illustrations of the bucket strategy, you’ll see they involve a fair amount of maintenance. Interest and dividends need to be moved periodically from Bucket 2 and Bucket 3 to Bucket 1. And each year, the retiree needs to be monitoring the market, to determine which bucket to withdraw from and which to refill. Especially during periods of extreme market volatility, like last year, the bucket system can send retirees scrambling as they work to maintain their buckets. For that reason, the bucket system, which seems so straightforward, actually isn’t so simple.
Another potential issue with the bucket system: Some studies have found that bucket portfolios, on average, might underperform. Why? A 2014 paper identified a key weakness in bucket portfolios: They don’t enforce rebalancing. Specifically, there’s nothing in the bucket system that would lead an investor to buy more stocks when the market is down. In contrast, a traditional investor, following rebalancing rules, would buy more stocks when the market is down. Take last year for example: When the market dropped more than 30%, a bucket investor would have simply been withdrawing from his or her cash bucket, but not necessarily adding to stocks. A traditional investor, on the other hand, would have been rebalancing and adding to stocks when they were on sale. And that would have resulted in a performance boost as the market recovered. More recently, another study came to the same conclusion—that bucket portfolios may have a performance disadvantage. The difference isn’t dramatic, but it’s measurable.
On balance, is the bucket system a good idea?
Yes and no. If you’re trying to decide on an asset allocation, I think the bucket idea provides an excellent starting point. Suppose, for example, you’re heading into retirement with a $4 million portfolio and plan to withdraw $100,000 per year for expenses. Under the bucket system, you might set aside eight years of spending, or $800,000, in bonds and cash. That would translate to an asset allocation of 20% in bonds and cash ($800,000 ÷ $4,000,000), and thus 80% in stocks. Would that be the right asset allocation? In my view, that would be aggressive for someone entering retirement, but it’s not totally unreasonable. It’s at least a good starting point for discussion. And it’s better, I think, than starting with an arbitrary allocation, like 50%/50%, that doesn’t have any relationship to the investor’s spending needs. That’s why, in setting asset allocations, I always start with a calculation like this. In that sense, buckets are, conceptually, a very useful idea.
Still, I’m not sure I’d rigidly follow the bucket system. That’s because the ongoing maintenance of buckets takes work. Instead of managing a single portfolio, a bucket investor needs to manage three. That can make a bucket portfolio harder to manage, not easier. It’s much simpler, in my opinion, to manage a portfolio the traditional way—with assigned percentages for each asset class. In addition, I see a lot of value in rebalancing and agree with the research cited above that calls this out as a weakness of the bucket system.
For those reasons, I don’t recommend strict adherence to the bucket system. But I don’t want to be too critical. Conceptually, I see a lot of value in the way the bucket system uses an investor’s spending need as the all-important yardstick. For risk management, I see no better way to assess a portfolio than to measure an investor’s withdrawal needs against a portfolio’s holdings in bonds and cash. So I recommend a hybrid approach: Use bucket calculations to help settle on an asset allocation. But then apply some judgment and translate those calculations into percentages that you can use to monitor and to rebalance your portfolio going forward. That way, I think, you can enjoy the peace-of-mind benefit of buckets while also benefitting from the simplicity and potential performance benefit of a traditionally-managed portfolio.