We hope you enjoy this excerpt from our book Income for Life, Chapter 5.
We’ve mentioned how the unique risks of the distribution phase—market, withdrawal, inflation, longevity, and tax—can be mitigated with a well-structured and properly sequenced distribution plan. But what does this actually look like in practice?
George and Mary, a couple in their late fifties, were beginning to plan for retirement. George had recently been downsized at work very abruptly, but Mary was still working. Their concerns around retirement were very similar to what we usually hear: Do we have enough? How do we go about creating an income? What happens if the markets go down? Can we afford to take on market risk? George’s situation had changed so quickly they hadn’t really thought through what their income needs were going to be in retirement. One of the first things we worked with them on was their retirement budget. How much income were they going to need coming in the door in order to maintain their lifestyle? This amount was going to drive a whole host of other decisions: when and how to claim social security, how much longer Mary was going to work, and how were they going to structure their investment portfolio?
After reviewing their budget, they established that they needed $40,000 of additional income from their investments. The first thing we advised them to do was to move between two to three years of this needed income into a very conservative, very liquid account. We call this bucket 1, or the income bucket. We explained to them that this would eliminate the short-term risks of market and withdrawal risk as we discussed earlier in this chapter. As fate would have it, we had this conversation in late 2007. This one decision turned out to be a game changer. As we illustrated in the last chapter, had this income bucket not been established, they would have been forced to sell some of their investments to create needed income in a market that was rapidly declining. That would have left George and Mary with both significantly fewer assets and markedly less retirement income.
In the next section, we will further explain how structuring your savings into different “buckets” will be an effective way to manage risk, not only market and withdrawal risk, but for inflation and longevity risk as well!
Time-Segmented Buckets of Money
First, stop and review: what is most retiree’s biggest goal? To maintain their lifestyle in retirement. In order to do this, they will need to receive a steady, stable, predictable. and growing income. A portion of that income, for most people, will need to be generated from savings. In order to keep that income predictable and consistent, we must have a plan in place to manage the five risks we’ve outlined earlier. The best way we have found to manage these unique risks, and the method we have implemented in our client’s accounts for decades, is a process we call “Buckets of Money.”
Your money throughout your retirement will be divided into three buckets, each representing a period of time: short term, medium term, and long term. Each bucket is responsible for managing a specific risk(s).
Bucket 1: Income—Managing Market and Withdrawal Risk
In bucket number one, we keep anywhere from one to upwards of three years of planned cash flow in investments that are highly conservative and highly liquid. For example, with George and Mary, they need $40,000 per year from their investments. We would keep anywhere from $40,000 to upwards of $120,000 in this bucket. Why? This is money that we know we need to take out to pay the electric and buy food and maintain their lifestyle. We need this income regardless of what the markets are doing; therefore, it should not be subject to the volatility of the markets. We can withdraw our $40,000 each year and not have to worry about market risk or withdrawal risk. Why do we recommend having three years’ worth of income in this bucket? Because we have not experienced a market downturn where it has not begun to recover within three years.
Bucket 2: Growth and Income—Managing Inflation Risk and Tomorrow’s Income Needs
Bucket 2 is where the bulk of your money will go. It will be fully invested in accordance with your asset allocation decision, i.e., 60 percent stocks, 40 percent bonds or 70 percent stocks, 30 percent bonds, etc.). This bucket has two very important roles: (1) It needs to grow over the long-term to help manage inflation risk (remember, we have to have a plan in place to double and possibly nearly triple our income over a thirty-year retirement) and (2) At appropriate times, it has to re-fill bucket 1, the income bucket, so that there is always adequate money available to generate income that is needed. Refilling bucket 1, the income bucket, is not an exact science, and is perhaps the most critical component of the bucket process. It is a balance between refilling buckets when markets are on the upswing and not letting your bucket 1 get too depleted. As an example, at the end of 2017, a year of spectacular returns in stock, we refilled all of our distribution clients’ bucket 1. We weren’t trying to time the market; we had no idea if it was at a high or if markets could still go higher. What we knew was that there was growth in bucket 2 and we utilized some of it to refill bucket 1.
Bucket 3: Long-Term Liquidity—Managing Longevity Risk and Handling The Unexpected
This bucket is all about longevity risk, which means healthcare costs and unplanned expenses that could pop up during a thirty-plus year retirement. As a general rule, we calculate what we would need to invest in today’s dollars in order to have it grow to the client’s original principal amount over thirty years. Typically, most retirees have a desire to never touch their principal. In reality, rarely is that an option over a multi-decade timeframe. So, what we advise is if you were to come to us with $1,000,000, we would put the amount in bucket 3 today that would provide you with the best chance of growing that initial investment back to $1,000,000 in thirty years. Now, depending on how this money is invested, the amounts can vary, but many clients are surprised by how small the amount is. Remember, we have no plan to touch this account for many years to come! We view this bucket as the “Life Happens” bucket. We don’t know what, if any, unforeseen healthcare crises there may be in the future. We don’t know with any degree of certainty how long someone will live. We don’t know what unexpected events may happen. Regardless of how well-thought-out and executed your plan might be, the only certainty is uncertainty!