Not all retirement withdrawal strategies are created equal.
And that makes perfect sense because not every retiree's goals are the same.
Some people are retiring well into their 70s, they realize that they likely don't have many
years left to go and they're not too worried about outliving their money.
They just want to enjoy life to the fullest for the time they have left.
For those people, more dynamic withdrawal strategies such as the 1/N method may be a
viable option to fit their needs and goals.
Other retirees are retiring at a more normal age or perhaps slightly early and expect to
be needing to withdraw from their nest egg for 20 or 30 years.
These people may have a little bit more concern when it comes to outliving their money, but
in comparison to a bare-bones early retiree, maybe not so concerned that they would be
willing to forgo too many of the lifestyle perks that they have become accustomed to
over the years.
As such many of these retirees may want to adopt a more moderate to conservative withdrawal
strategy.
Still, others are retiring incredibly early or just wish to leave a lot of money to their
heirs or to a charity or cause when they pass on.
For these individuals, a truly conservative strategy may be in order.
As you can tell in today's video we are going to be continuing our series on retirement
withdrawal strategies.
Today we're going to be covering a strategy called the three buckets of retirement withdrawals.
As always we're going to be going over what the three buckets strategy is, why we would
use it, who it would work well for, and, of course, it's pros and cons in comparison to
other popular strategies.
Let’s get started.
Hey everyone Daniel here and welcome to Next Level Life a channel where you can learn about
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So the three buckets strategy is a fairly simple strategy to understand on the surface,
even if the calculations can get a bit more complicated when it is put into practice.
The basic idea is that you divide your investments into three sections, or buckets, each with
different purposes.
The first bucket is usually any money that you will need in the near future (just for
the sake of this video let’s say it’s 2 years, but just know that there isn’t
really a standard time frame for this.
It all depends on your situation, goals, and risk tolerance).
This bucket usually contains very safe investments like cash and cash equivalents such as treasury
bills, money market funds, and the like and should be enough to cover all of your ongoing
expenses (that aren’t already covered by things like social security, pension checks,
or side hustle income) including the major ones that come up from time to time like vacations,
car and home repairs, and so on.
This bucket won’t make you much money, but in this strategy that’s not its purpose.
After all, when you get fire insurance you aren’t going to get mad when your house
doesn’t burn down.
This is sort of like your market crash insurance.
It’s the money that protects the money that makes you money, by giving you another option
for income that doesn’t involve selling your investments when they’re at their lowest
point.
The second bucket is for any money that you will not need in the next 2 years (if that’s
the time frame you used for the first bucket) but will need sometime within the next 5 or
10 years and generally contains slightly more risky, or sometimes just less liquid, investments
than the cash bucket such as bonds, and sometimes the fairly safe blue-chip type dividend-paying
stocks.
The major purpose of this bucket is to earn enough money through the interest and dividends
as well as hopefully some small appreciation, that it can refill the first bucket as time
goes along.
The third and final bucket is used for long-term investments that you won’t need to touch
for the next 5-10 years or more and are generally more of the high risk, high reward variety.
Some examples of investments that may go in this bucket are stocks (normally the ones
with high growth potential), real estate, and sometimes alternative investments like
commodities also go here.
And again, don’t get hung up on the time frames I’m using for the buckets in this
video.
They aren’t hard and fast rules, some people will use longer or shorter time frames for
the buckets depending on what they are trying to accomplish.
Now you may be thinking to yourself, well that all sounds fine and good, but why exactly
would we need this strategy when we could just use something like the 4% rule?
Well some of us won’t need it (as we’ll discuss later with the pros and cons), but
it is true that some people don’t like the idea of systematic withdrawals systems, like
the 4% rule, because of the risk factors that are involved with using them.
For example, if you’re retired and following the 4% rule and the market crashes, you still
money to live on, and unless you have income coming in from other sources like social security,
pensions, or some form of side hustle or other part-time work, you’re going to need to
sell your investments, potentially at a significant loss, in order to put food on the table.
This can have a tremendous effect on your chances at success as I detailed in my video
on whether or not the 4% rule is actually safe.
Just think about it.
If you have a $1,000,000 nest egg invested in the stock market when you finally decide
to hang up your boots for good, but the market has a gigantic crash like the one that we
experienced back in 2008, that nest egg could look suspiciously like $500,000 when you go
to withdraw money from it later that year.
And if it takes the market, say three years to recover its original value, you could still
be looking at a significantly smaller nest egg if you were following the 4% rule to a
T.
Here’s how it could look.
You retire with $1,000,000 as your nest egg invested in a stock with a share price of
$100.
This means you have 10,000 shares of the stock when you retire.
And on a side note, yes I know how unrealistic it is to have your entire retirement savings
in one stock or mutual fund, this is just to illustrate the example.
However, your investment falls by 50% during your first year of retirement and you withdraw
$40,000 that first year because that’s what the 4% rule told you to do.
This leaves you with a nest egg worth $460,000 at the end of the year.
In your second year of retirement, your investments start to recover, gaining 20% for the year
as a whole, bringing the share price back up to $60 per share.
This raises the value of your nest egg up to $552,000 and since you still need money
to live on you withdraw some more for the year.
In order to keep your buying power the same as it was last year, you withdraw $40,800
to account for inflation, which for the sake of simplicity we’ll say is about 2% each
year.
This leaves you with a nest egg of $511,200 at the end of the year.
In your third year of retirement, the market continues to recover, growing by another 20%
and raising the share price all the way to $72.
This brings the value of your nest egg up to $613,440.
But again, you still need money to live and in order to maintain your standard of living,
we again must adjust the withdrawal for inflation.
This time you withdrawal $41,600 to account for inflation.
This leaves you with a nest egg of $571,840 at the end of the year.
In your fourth year of retirement, your investment fully recovers with the share price reaching
$100 per share.
This brings the value of your nest egg up to just over $794,000 before your withdrawal
and roughly $751,750 afterward.
So while your investments have technically fully recovered from what would’ve been
one of the worst crashes in the history of the stock market, you are sitting with a mere
75% of the money you had when you first retired thanks to being forced to sell some of your
shares during a market downturn.
Not ideal to say the least, but it is an absolute eventuality for those strictly following the
4% rule in retirement (assuming, of course, that they have no income coming in to support
themselves outside of their investments.
If they do then they can live off that during the hard times).
And while you can certainly do some things to somewhat mitigate this disaster of a situation
from harming your nest egg, even without other income, such as figuring out ways to lower
your burn rate and lower your standard of living during market downturns, but neither
of those solutions will stop the damage entirely.
They will just lessen it.
This is why some people prefer to use the three buckets strategy.
It’s all done in the interests of avoiding that eventuality entirely.
I like to think of it as the debt snowball of the retirement withdrawal strategies.
It may not be the ideal mathematically (which I’ll come back to in a minute), but it can
be the thing that helps someone mentally and emotionally become comfortable with the idea
of retiring if worry and stress is the only thing realistically holding them back.
So, now that we know what the three buckets strategy is and why some people would use
it, how exactly does it work in practice and what are the pros and cons?
The implementation of this strategy can vary a bit from person to person, but generally,
it works something like this:
Let’s say that John and Jane have decided to retire.
They want to maintain their current standard of living spending $40,000 a year, as we saw
in the example earlier.
And this is entirely doable thanks to the fact that they are retiring debt and mortgage
free with a nest egg of $1 million.
That means that they could, if they wanted to, follow the 4% rule for their withdrawals,
however, in an effort to avoid having to draw from their investments during a down market,
they will be using the three buckets withdrawal method instead.
And because of this, they don’t actually have $1 million invested in stocks and bonds.
They have decided to have 2 years worth of their expenses, or $80,000 in their case,
invested in their short term, cash and cash equivalents bucket.
They have 10 years worth of expenses, or $400,000, in their income bucket, which is mostly comprised
of high yield bonds that are generating them roughly 2.5% per year in interest, or about
$10,000.
The last $520,000 of their savings is in their long-term investments bucket and is comprised
of several higher risk, but higher reward stocks.
These are mainly growth stocks that are early on in their growth cycle and as such aren’t
paying out any dividends to their shareholders.
So, unfortunately, no extra income here, it’s all about stock price appreciation.
John and Jane currently make nothing from social security, and like most of us, won’t
have any pension or side hustle income to speak of in retirement so they will have to
replenish their spending bucket entirely with their income bucket as time goes along.
And since we're comparing this method to the 4% rule it only makes sense to go with a scenario
that tests the 4% rule to its limits.
So let's go back to the example we used earlier were John and Jane's investments (specifically
those riskier investments that are in their third bucket) start out at $100 a share but
dropped to $50 a share in the first year and didn’t recover until the end of the fourth
year of their retirement.
We saw what happened using a very systematic safe withdrawal rate strategy under those
conditions, however, the same thing does not happen with the three buckets strategy thanks
to the focus on having cash on hand as well as income producing assets.
However, since they're income bucket is only giving them $10,000 a year and they’re pulling
out $40,000 a year from their cash bucket to live on, they're going to need to cash
in some of their bonds as time goes along to make up the difference.
And this difference will increase over time thanks to inflation, which to keep things
consistent with the previous example we will again assume is 2% per year.
So when we plug in all the numbers, adjusting for inflation and cashing in bonds when needed
to get our cash bucket up to that two years worth of expenses at the end of each year
we see that our ending net worth is about $841,600, which is nearly $90,000 more than
it was in the previous 4% scenario.
At the end of the scenario John and Jane’s money is split up like this:
$80,600 in the cash bucket.
$241,000 in the income bucket.
And thanks to the fact that we didn't have to sell off any of our investments during
the crash John and Jane still have $520,000 in their investment bucket.
So the biggest pro to using the three bucket system is obvious it gives you some peace
of mind if a major market crash should happen at some point during your retirement.
And let’s face it if your retirement is long enough there's going to be a crash at
one point or another.
However, the downside to using the three buckets method is equally as obvious.
As I’m sure many of you have already been thinking to yourself, the fact is that since
you're keeping possibly one, two, or even three years worth of your expenses in cash
or cash equivalents, you aren't making very much money from that portion of your savings.
And unless your expenses are incredibly low, having your growth potential limited like
this could make a huge difference in your net worth, especially over a longer retirement,
compared to using different retirement withdrawal strategies.
I mean, we looked at a fairly short scenario today simply to quickly illustrate the difference
that these two strategies could have in less than ideal times.
However, it’s not exactly common for the market to lose 50% or more of its value in
a single year.
It’s actually quite rare in the grand scheme of things.
And over the long haul, the market has averaged returns of roughly 8% per year.
Say if John and Jane lived for 30 years in retirement, and over that time averaged a
rate of return of 8% per year, but instead of using the buckets strategy and leaving
$80,000 of their savings in cash, they took the risk and put everything into their actual
investments.
$80,000 at 8% per year for 30 years is about $805,000!
Even at a more conservative 6% return, it still ends up netting John and Jane an extra
$460,000 over the course of their retirements!
So depending on how long your retirement goes, how much you have saved, to begin with in
relation to how much you spend, and how many crashes you experience during that time this
may end up being the difference between having enough money to live out your full retirement
and outliving your money.
So where exactly does this leave us?
Who would this strategy work for?
Well, I personally feel that it is well suited for those people who are maybe a little extra
worried about having to sell off their investments during a crash, are willing to work a little
bit longer so that they can still have enough invested in their second and third buckets
to make up for what the potential growth their losing by keeping that money in cash, and
those who won’t likely have any income outside of their investments during retirement.
But what do you think about this strategy?
Do you think that this would be a good strategy for you to take advantage of, either throughout
your whole retirement, or maybe just a part of it?
Let me know in the comments section below.
But that'll do it for me today once again if you enjoyed this video be sure to smash
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