As more and more of your baby-boomer clients enter retirement and start drawing down the assets you’ve helped them accumulate, how can you effectively service their distributions? Arguably, one of the best methods for managing retirement assets for longevity is the bucket strategy. In addition to strategically investing your clients’ assets for different time frames and needs, this approach can help reduce your clients’ fears about outliving their savings.

Here, I’ll walk you through why this strategy is so effective, as well as how to set it up correctly based on goals and objectives.

How the Bucket Strategy Works

The bucket strategy has become popular because it eliminates the risk of having to sell when investments are down to meet income needs during retirement—a main drawback of the more traditional systematic withdrawal strategy. Plus, advisors gain a framework for planning the distribution phase.

Here’s how it works: When clients are approximately one to three years away from retirement, you divide their assets among several portfolios (or buckets), each with different time horizons, asset allocations, objectives, and risks. By segmenting monies into buckets that each have their own purpose, you enable clients to tap into some assets for income while letting other assets grow. The three buckets are as follows:

• Bucket 1 provides income for clients in the 1 or 2 years leading up to retirement and likely the next 3 to 4 years in retirement.

• Bucket 2 covers the income needs for retirement years 5 through 15.

• Bucket 3 covers the income needs for year 15 and beyond.

The strategy, by design, is effective in dealing with the major risks to retirement income: outliving one’s savings (i.e., longevity risk), having expenses that outgrow savings (i.e., inflation risk), and experiencing a down market during retirement (i.e., market/timing risk).

Getting started. The first step in the process is estimating your clients’ income needs throughout their retirement years (as well as the year or two before they retire). This can be done by determining the cash inflows and outflows during each retirement year and calculating the difference between them. Then, set up the buckets with the correct amount of monies to match these income needs.

Running the strategy. There are two ways to run the overall strategy. The sequential approach involves using up the monies in each bucket in order. The clients would take the income and principal from the first bucket in the years assigned to it and do the same with the second and third buckets as time goes on.

The second way—the one that I prefer—is to constantly refill the first bucket so that it exists during the clients’ entire retirement period. This can be accomplished by doing the following:

• On a periodic basis, usually yearly, sell down the investments in Bucket 3 that have appreciated. Take the proceeds and either invest in the securities in Bucket 2 or move the cash directly to Bucket 1.

• On a periodic basis, usually yearly, sell down the investments in Bucket 2 that have appreciated. Take the proceeds and move them to Bucket 1.

• Instead of reinvesting the dividends, interest, and capital gains from Bucket 2 and Bucket 3, have them flow directly into Bucket 1.

By having a consistently full or partially full Bucket 1, your clients will feel more assured that their retirement—present and future—is in a good place.

Breaking Down the Buckets

Now, let’s break down how to structure each bucket to meet each client’s needs and goals, as well as how to solve for any problems that may arise.

Bucket 1

Goals and objectives. The main goal of Bucket 1 is to provide immediate income and cash for emergencies. It’s meant for alleviating liquidity and market/timing risk, as the investments are conservative enough that they won’t be significantly affected during a decline.

Investment choices. Because this is “safe money” that must meet the retirees’ income needs regardless of market conditions, securities that have a high risk of loss of principal don’t belong here. Appropriate investments should be relatively stable and high quality in nature, such as money market funds, ultra-short-term bonds, and short-term bonds. Other suitable investments include CDs, CD ladders, and bond ladders. Last, as interest rates have crept up, single-premium immediate annuities may be a viable option as well.

Potential issues and solutions:

• An emergency during early retirement exceeds assets in the bucket: You could take the funds from the other buckets and, when feasible, try to reestablish all the buckets to get back on track.

• Clients are spending too quickly: Try to get them to reduce their spending or borrow from the other buckets for the time being.

• Interest rates are too low to support conservative investments: Move more money into Bucket 2 and Bucket 3 to maximize earnings until rates normalize.

Bucket 2

Goals and objectives. This bucket holds money that is either waiting to be tapped for income when Bucket 1 runs out (if you are using the sequential approach) or that will be used to refill Bucket 1. Its investments help mitigate liquidity, timing, and inflation risks. They are riskier than those in the first bucket but more conservative than those in the third bucket. The primary investment objective is producing income (yield), with a secondary focus on preserving capital.

Investment choices. Appropriate investment vehicles include individual bonds, bond funds, laddered bond portfolios, dividend-paying stocks, and other yield-focused products. For high-net-worth clients, separately managed account solutions may be considered. In addition, other income-focused strategies, such as those that target a 30/70 to 50/50 equity-to-fixed income ratio, may be appropriate.

Potential issues and solutions:

• Interest rates are low, and achieving a higher yield is difficult without taking on too much risk: You can either “reach” for yield (i.e., buy those riskier/higher-yielding securities on the belief that clients will have time to recover lost principal) or build a lower-yielding portfolio that produces less income and doesn’t give you the ability to move as much over to Bucket 1. Once rates normalize, you can send more over.

• Interest rates rise, and fixed income and higher-paying equities get hit: Because this bucket does not need to be tapped until year five, you can wait out this temporary hit. Or, if it is happening during the time when you need to draw from this bucket, you can take from the principal or rely more on gains from Bucket 3.

Bucket 3

Goals and objectives. This bucket represents the long-term growth allocation piece of the retirement income plan. The goal of Bucket 3 is to help alleviate timing, inflation, and liquidity risks, as well as to further estate planning objectives. The profile of this bucket is the riskiest, as it has the longest time horizon and will have a better chance of recovering from any market downturn. Typically, assets in this bucket are invested in a portfolio that seeks some degree of capital appreciation.

Investment choices. Appropriate investments include equities, commodities, real estate, and deferred annuities that offer guaranteed income for life. Portfolio asset allocations typically range from 70/30 to 100/0 equity-to-fixed income.

Potential issues and solutions:

• We’re headed into a recession: In this case, you have several choices:

  1. Ride it out, because the client won’t need to touch the monies for a long while, if ever. Just wait for the principal to bounce back.

  2. Take a lot of gains off the table, and reduce the equity exposure slightly. Take the sales proceeds and move them into Bucket 2 and Bucket 1.

  3. Introduce some liquid alternatives to your allocation to protect to the downside a bit more.

• Clients are at risk of not having enough money to cover lifetime income needs: You can try to convince them to lower their expenses, or you can become more aggressive by adding more equity exposure during down markets to have a chance at higher returns in the future.

Downsides of the Bucket Strategy

While this strategy can be incredibly effective, there are some downsides to consider. The strategy can become difficult to monitor and analyze because investors typically have more than one retirement account with varying balances; these might not easily match up with the recommended amounts for each bucket. Generally, clients also will have a mix of taxable, tax-deferred, and tax-free accounts. To solve this issue, you could set up a separate account for each bucket, although this approach is sometimes costly. Instead, you could combine all the buckets in the same account and track each one on a spreadsheet, or you might put the tax-free (Roth) accounts into the third bucket, the taxable accounts in the first and second buckets, and the tax-deferred account in both the second and third buckets.

Achieving the End Goal: An Ideal Retirement Lifestyle

With the topic of retirement income planning gaining traction in our industry, baby boomers will be looking to you to help them generate income that’s appropriate for their lifestyle. By linking asset buckets to specific time horizons and goals and investing them in the appropriate vehicles, you can implement a more efficient and effective way of managing retirement assets for longevity and generate a steady stream of income for retirees.