The "Three Bucket Strategy" is a popular retirement income planning method. The first bucket covers immediate expenses in retirement. Listeners John and Donna are seeking advice on constructing their first bucket. With $1.6 million in assets and pension incomes, they aim to retire in 2026.
James analyzes their needs, income sources, and portfolio and lays a foundation for their Bucket #1. It's crucial to bridge the gap between expenses and income, considering risk capacity and tolerance.
Questions Answered:
How do you divide assets into the three buckets, and what is the purpose of each?
What role do risk capacity and risk tolerance play in determining portfolio allocation?
Timestamps:
0:00 - John and Donna
3:36 - The bucket approach
5:50 - Start with expenses
8:53 - Non-portfolio income sources
11:23 - Identify and bridge the gap
13:06 - Assessing their portfolio
14:53 - Portfolio dividend yield
16:49 - Do you need Bucket 1?
19:16 - What is the specific need?
21:07 - Risk capacity
23:22 - Test contingencies
Create Your Custom Strategy ⬇️
The "Three Bucket Strategy" is a popular retirement income planning method. The first bucket covers immediate expenses in retirement. Listeners John and Donna are seeking advice on constructing their first bucket. With $1.6 million in assets and pension incomes, they aim to retire in 2026.
James analyzes their needs, income sources, and portfolio and lays a foundation for their Bucket #1. It's crucial to bridge the gap between expenses and income, considering risk capacity and tolerance.
Questions Answered:
How do you divide assets into the three buckets, and what is the purpose of each?
What role do risk capacity and risk tolerance play in determining portfolio allocation?
Timestamps:
0:00 - John and Donna
3:36 - The bucket approach
5:50 - Start with expenses
8:53 - Non-portfolio income sources
11:23 - Identify and bridge the gap
13:06 - Assessing their portfolio
14:53 - Portfolio dividend yield
16:49 - Do you need Bucket 1?
19:16 - What is the specific need?
21:07 - Risk capacity
23:22 - Test contingencies
Create Your Custom Strategy ⬇️
Welcome back to another episode of Ready for Retirement. I'm your host, james Kanol. On today's episode, we're going to be addressing a question from longtime listeners, john and Donna. John and Donna have a question about the bucket strategy with regard to investments. Specifically, how do you construct or how do you invest that bucket number one of the three bucket strategies that's very popular amongst those who are retiring? This is another episode of Ready for Retirement. I'm your host, james Kanol, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. I'm excited to tackle this today because, for those of you who are unfamiliar with the three bucket strategy, it's a popular approach to retirement income planning. It involves dividing your assets into three different buckets, with each serving a specific purpose and time horizon. So bucket number one is that one that is designed to cover immediate expenses when you retire, in those first few years of retirement, and that's what's supposed to provide that peace of mind and flexibility as you phase into this new chapter of life. So in today's episode, we're going to be discussing just that. To start, though, let me kick us off by reading the question that John and Donna submitted. They said hi, james, we're longtime listeners and we love your podcasts. My wife and I are hooked and discuss every episode over dinner and walks. Thank you.
Speaker 1:My wife, donna, and I, john, are planning to retire on July 1st of 2026. We have about $1.6 million in pretty slash, post slash Roth accounts with an 80-20 allocation. We will both be receiving a pension. Mine will be about $39,500 per year till the end of our lives, with a 2% cost of living adjustment, and my wife should be $20,000 per year until she reaches age 65, which is in 2033. I will also be receiving a lump sum pension of about $163,000 that can be rolled over to a tax deferred account. My personal slash sick accumulation will be cashed out at about $60,000 when I retire. We have an emergency fund that ranges between $20,000 and $40,000 and we pay off our home in less than one year and the payment is currently $1,400 per month, so we will have no debt when we retire.
Speaker 1:We're trying to get ahead of things as much as possible. One task we have on our list in preparing for retirement is to start constructing our bucket number one of the three bucket strategy that will hold the first five years of our expense needs. We know our approximate year to year needs and, after backing out our pensions, we'll need to fund bucket number one with about $350,000. We're currently maxing out our 401k, hsa, 403b and 457B accounts, as well as contributing $18,000 to our after tax account, totaling approximately $100,000 per year of savings. We can occasionally contribute to our Roth accounts, depending on our adjusted gross income at the end of the year. The problem is we don't know how to best fund bucket number one. We can divert the money from our mortgage once the house is paid off, but that will amount to about $25,000 by the time that we retire. We have our pre and post tax contributions, but we're not confident this is the best route to go.
Speaker 1:We are so confused, james Donna, and I love how you were able to break down even the most complex topics. Could you please help by providing us with some best practices regarding the construction of bucket number one of the three bucket strategy? We appreciate all that you do. John and Donna. Okay, so long question there. But John, donna, number one. Thank you very much for being longtime supporters of the show. Love to hear that the episodes get discussed over dinner, so that's kind of fun. We can absolutely go through this and just as a reminder any time we go through this. This is never designed to be a recommendation. This is not specific advice, as much as it is a way of thinking about things that can help to unravel some of the mysteries or help to make clear some of the complexities of retirement planning.
Speaker 1:Here's one of the things I'd like to start with. One of the quote unquote problems with a bucket strategy is that that term bucket means different things to different people. So I want to start by making sure that we're on the same page, even with just the terminology, because for some people they say, yeah, there's three buckets there's my pre-tax money, there's my Roth money and then there's my taxable money or my brokerage account money. To some people, that's what they mean by buckets. Other people they think, in terms of how it graphs of the money is, they have their conservative bucket, their moderate bucket in their growth bucket, and then other people it's kind of sort of a conservative or aggressive conversation, but it's more of a. Bucket One is the money I'm going to live on first. Bucket Two is the money I'm going to live on next. Bucket Three is the money I'm going to live on last and that's a.
Speaker 1:There's a lot of overlap between that approach and thinking of bucket. One is conservative to his moderate, three is growth, but they're still not the exact same thing. There's some nuances that, I would say, distinguish each of those from one another. So here's the thing there is no hard and fast rules about how you should divide your buckets or about exactly what you should invest in. As we're thinking about this, really think of the bucket approach as a way of minimizing risk in a way that makes sense for a lot of people.
Speaker 1:But there's not one universal way to do this. There's not some scientific approach that says John and Donna or any other person getting ready to retire, here's exactly how much you need to put in each bucket, here's exactly what accounts it should be funded with and here's the exact investments you should use to do so. All of this is just kind of a basic framework to say let's minimize a risk in our retirement plan and do so in a way that makes sense. The nice thing about the bucket approach is and I'm going to use it more from the framework of having kind of conservative money and growth money. The nice thing about that is okay, that makes sense. We're going to have enough conservative money to protect against downturns and we're going to have enough growth money to make sure that we're keeping up with inflation to meet all of our needs throughout retirement.
Speaker 1:You could have all of this money, all these buckets, so to speak, in one account or two accounts, or three accounts and 10 accounts. So it doesn't necessarily look different on paper, it's just a way of thinking about it. It's kind of a way of mentally accounting for what do you have, what investments do you have and what role are they serving in your portfolio. So I'm going to do this Instead of just jumping in right away, john and Donna, to hey, here's how I think about this and this is what to do. I want to think of this from the perspective of all of you who are listening, all of you who are listening, trying to figure out yeah, how much should I have in various buckets? Let's walk through almost an order of operations, or what question should you ask first? What answer should you have first and kind of build the foundation here to say do this first, then this, then this, then this, and by the time you come away from that, then, whether you're John and Donna or anyone else, you can have a good way of thinking through this that makes most sense for your situation. So here's the first thing that I would do If you are like John and Donna and contemplating this type of a question of how should you be invested and what should your buckets look like, don't start with the investments.
Speaker 1:Don't start with the buckets. Don't even start with how much money you have in investments. Start with what are your expenses going to be when you retire? So how much will you need coming in each year to fund all of your retirement goals? I don't know what those numbers are for John and Donna, I guessing based upon the fact that they said that some years they're able to contribute to the Roth IRA, some years they're not. Their income's probably in the low to mid 200,000s per year, just because that's kind of the cutoff for when you become eligible or ineligible to do Roth contributions. But they're also saving a lot of money every year. They're saving about $100,000 per year. They're also currently paying a mortgage. I'm sure there's some other expenses that are maybe going to change between now and retirement.
Speaker 1:So what I'm going to do is I'm just going to use a super simple number for the sake of going through this conversation. I'm going to assume we'll use John and Donna as an example. I'm going to assume that their annual living expenses are $100,000 per year in retirement, so they're no longer saving anymore to their investments or no longer paying a mortgage. Plus $100,000 is just a nice round number. I'm going to use that for the sake of this example that we go through. But I'm going to be very clear that's just a guess.
Speaker 1:John and Donna obviously go through this exercise on your own, using your actual expenses, but that's what I'm going to use. So some people they'll just jump right into the math. Then They'll say, okay, cool, we need $100,000 per year. And if you've heard this podcast before or other people talk about it in this way, I like to talk about having five years of living expenses set aside in something conservative, something that, even if the market's down 20, 30, 40%, well, we need some money that we can count on that's not going to be down 20, 30, 40%, because that's what needs to cover our living expenses. So that's where some people go right away. They say, okay, cool, john and Donna, you need $100,000 per year. Therefore, let's multiply that number by five $500,000, and they jump right into the investments you need $500,000 of your investments to be in something conservative, and the rest can then be invested for growth.
Speaker 1:It's premature, though. If you're jumping right to that, you're missing some of the steps in between that need to be taken care of first. So don't jump right into the math. Don't jump right into the okay, cool, how should the portfolio be allocated? We need to go through a couple other steps first.
Speaker 1:Step number two is understanding what John and Donna's non-portfolio income sources are. Why do we do that? Well, of that $100,000 per year, not all of that has to come from their portfolio. They'll have pensions. I don't know if they'll have social security or not it doesn't mention this in the question but they do mention pensions, so they'll have pensions that are covering a portion of that annual living expense needs. So we need to start by understanding what does that look like next? Well, we know John has a pension of $40,000 per year. Technically he says $39,500 per year, but I'm just going to round that up to $40,000 for the sake of easy math on this podcast.
Speaker 1:So John's pension, I'm assuming, is $40,000 per year. Donna's pension will be $20,000 per year. Now the question that mentions that pension would kick in until age 65, sometimes that's the case. So sometimes you'll receive a pension that kind of bridges the gap between when you retire and 65, or when you retire and when social security kicks in. Oftentimes the pension starts at 65 and then continues for the rest of your life. So I don't know if that was a typo or if that was correct. It very well could be. I'm just going to assume though, to keep this really simple, that Donna's pension will be $20,000 per year throughout retirement. Now, that's not exactly the case, and I don't know if that's $20,000 until 65, like the question said, or if that was potentially a typo and it's after 65. But I'm just going to assume $20,000 per year throughout retirement, again to keep it simple, not to give specific advice to John and Donna, but to keep it simple.
Speaker 1:Now, I'm also going to assume that there is no social security for John or for Donna. They didn't mention it. Now, chances are good. They do have social security, but because they have pensions if these were what are considered non-covered pensions, they may not have social security benefits. I would guess that at least one of them does have some type of a social security benefit, but in this analysis, I'm assuming nothing. And, by the way, a non-covered pension is a pension where you pay into it and you're not simultaneously paying into social security. So if you're not paying into the social security system, you're not going to be eligible for a social security benefit, or if you are, it's going to be reduced, depending upon what your pension looks like and how many years of substantial earnings you have, which is a topic for a different episode. But bottom line for step number two what are your non-portfolio income sources For John and Donna? I'm assuming that $60,000 per year, which is John's pension of $40,000 plus Donna's pension of $20,000. And I'm excluding any potential social security, because I just don't see it mentioned in the question.
Speaker 1:Step number three is then to identify the gap. So this is a pretty simple step. This is pretty simple until you start factoring in things like inflation, factoring in things like taxes, factoring in things like staggered income sources, like Donna's pension actually, which doesn't seem like it's going to be there forever, but really only up to a certain time or starting at a certain time. But to start, just for the simple framework, do subtraction. So what's the gap? Well, they need $100,000 per year and $60,000 per year is coming in from non-portfolio income sources. The gap is $40,000. So what we've done so far in steps one through three is number one we've determined their expenses. We're assuming 100 grand. Step number two what are their non-portfolio income sources? We're assuming 60 grand. Step number three determine the gap, which is $40,000, just doing some simple subtraction.
Speaker 1:Step number four now we get to the portfolio piece. Now we actually start getting to the what buckets should you have to meet these needs. So step number four is invest your portfolio to bridge the gap, and what I mean by that is what does your portfolio composition need to look like? What does your asset allocation need to look like? What do those buckets need to look like to meet a very specific need which, in this example, is $40,000 per year? So I like to start by understanding what will their projected withdrawal look like as a withdrawal rate? So, instead of just looking at it as $40,000, which is what it is in this simplified example Well, does that represent 2% of their portfolio? Does that represent 5% of their portfolio? Does that represent 10% of their portfolio? Because it's that percentage, it's that withdrawal rate that I'm really interested in in determining how should the buckets be allocated. So let's, let's look at what that might look like.
Speaker 1:Today, john and Donna have $1.6 million, but what we also know is that they'll have $163,000 as a pension and it sounds like they're going to roll over when they retire. Plus John will have $60,000 of personal and sick pay. Plus they're saving a bunch over the next two and a half years, even if they really don't grow a whole lot. Let's just assume they'll have $2 million by the time that they retire. The reality is even a little bit of growth in their portfolio. It will probably be more, but let's assume that that $1.6 million turns to $2 million by the time that they retire, which is based upon $1.6 million plus pension rollover, plus sick and personal pay, plus the savings that they're doing, which is about $100,000 over the next two and a half years. So we'll use $2 million as the retirement portfolio that they have in this example.
Speaker 1:So what are we doing? We're wanting to calculate the withdrawal rate, as I mentioned. Well, if you have a portfolio of $2 million, you're taking $40,000 out per year, which is the difference between how much they have coming in from pensions and how much they actually want to spend. Well, $40,000 divided by $2 million is 2%. Now what some of you are doing some of you are thinking ahead of me is saying, okay, cool, james, we talked about or you told us. Don't go right to the math. In that first step, we said, hey, $100,000 per year.
Speaker 1:Some people are tempted to say, multiply that by five and that's how much you need in the conservative bucket, so $500,000. In that case You're getting in a step ahead of me. Some of you are thinking, okay, cool, we only need $40,000 from the portfolio, so let's now multiply that by five. In other words, we need $200,000, $40,000 times five years $200,000 in something conservative. As a starting point with this portfolio, I'm still you could go there, but I'm still not going to go there quite yet.
Speaker 1:I mean, there's one more step that I want to take and it's understanding what's the dividend yield on your portfolio. Well, I have no idea how John and Donna are invested, but if I just look at, say, the Vanguard total stock market ETF, so it's just a market cap weighted Vanguard fund. That's not a recommendation. That's definitely not what John and Donna are invested in. I would guess they just they haven't told me what they're invested in, but I'm just using that as kind of a basic benchmark as of this recording that ETF has a dividend yield of about 2.03%. What does that mean?
Speaker 1:Well, it means, yes, that fund is investing in all these different stocks around the world and the price, the value of those stocks, on a daily basis is going to fluctuate wildly. That could be up 20, 30, 40% in a year. It could be down 20, 30, 40% in a year, but that dividend yield typically not exactly, but typically remains pretty consistent. So if you have a $2 million portfolio that hypothetically was fully invested in something generating 2.03% dividend yield, that's $40,600 per year that you can expect to receive in dividends. The wonderful thing about dividends and, by the way, I'm not saying that this is the approach that you should take or that I would even recommend, I'm just using it as a starting point or as an example the wonderful thing about dividends is, on average, they tend to increase at a greater clip than inflation. So if you're trying to say, how do I maintain my purchasing power throughout retirement, well, if your income is coming primarily from dividends, there's no guarantee that that will increase faster than inflation, but historically they've outpaced inflation by a little over 2% per year, which is pretty significant. It means, yes, you have income today and that income most likely will outpace inflation over time.
Speaker 1:So this is where I'd ask the question do you need a conservative bucket? So, john and Donnie, your question was how do we invest bucket number one In any situation? Not just this, but whether it's hey, how much should I convert, how much should I withdraw, how much should I do anything? I try to look at the opposite first. So, for this question, how much do we need in bucket one? My first question would be do you even need bucket one Now that this is the only consideration you should have? But take a look at this If you only need $40,000 per year to supplement your pension income, to give you that $100,000 per year that we're using in a simplified example, and you have $40,600 per year coming in an income from dividends on an all-stock portfolio, you might not necessarily need a conservative bucket Now, it's probably still a good idea to have some money invested conservatively just in case dividends do go down, even if it's just temporarily.
Speaker 1:However, from what I would call a risk capacity standpoint Risk capacity meaning, how aggressive can your portfolio be before you start subjecting yourself to unnecessary risk? Well, from a risk capacity standpoint, you could make a case not saying it's a recommendation, but you could make a case to consider having an all stock portfolio. If you're John and Donna and these numbers that I'm assuming the simplified numbers that I'm assuming are actually accurate, because you'd have an all stock portfolio. That sure is gonna go up and down, but it's also gonna create income. In the income, at least based on this hypothetical example that I'm giving, is enough to cover the gap between what's coming in from pensions and what they need again 100,000, which is my assumption, not theirs. So that's something to take a look at.
Speaker 1:Now. Risk capacity is what we're talking about. How much risk can you have without subjecting your portfolio to undue risk, risk that could lead to permanent loss of purchasing power? Risk tolerance, on the other hand, isn't so much a mathematical thing, or even a logical thing. It's more of a how comfortable are you with market uncertainty? It's understanding that we're all emotional beings and having a $2 million portfolio that could support all these needs and dividends hey, that's great to know intellectually and great to know that, hey, in the projections that could work. But what about you as a human? What about you as a person? How are you gonna feel when that $2 million gets cut to $1.2 million if there's a 40% downturn in the market. That's something that we have to be able to stomach if we're going to go into retirement with that type of an approach.
Speaker 1:So maybe you add some more conservative investments, even from a risk-tolerant standpoint, even if they're not necessary, just to reduce some of the wild swing deal experience in your portfolio. So that's how I would think about it is do you even need bucket one? Now, if you do need bucket one, it's to say well, what's this specific need? It's not just an arbitrary multiply your annual expenses by five. It's how might these come into play? Under what circumstances would I need to be drawing funds from this bucket? And then that's a bucket that you can use to fill with cash or bonds or CDs.
Speaker 1:Now, ideally, if you're using bonds, for example, you're using bonds that have shorter durations or shorter maturities, and I say that because, if you look at 2022, when interest rates spiked faster than they've ever spiked before, if you held, say, a 30-year bond, your bond value dropped by 30% or more in that year, depending on which bonds you were holding. So what good does that? Do you if your conservative bucket drops by 30% while your stocks are also dropping by 20% or more. Does you know good? It defeats the purpose. So that's where it's important to know.
Speaker 1:There's many different ways you can use bonds in your portfolio. Some people use them as like a ballast of okay, what types of bonds tend to go up when stocks go down? That's kind of the approach that says how do we level out, how do we smooth out returns? No guarantee that you're gonna do that every year, but that's one approach. Another approach, the bucket approach, is if you bonds more like the emergency fund of your portfolio, how can we put something here that we're gonna give up some growth potential on? But we can have a pretty good sense of certainty not perfect certainty, because we can never have that but we have pretty good odds that this money's gonna be here and it's gonna be stable for us that we can access it when stock markets are down. So that's why, ideally, you want shorter term, more conservative bonds, more conservative instruments that don't have the potential to be down 20, 30, 40% when your stocks are also down. Otherwise, that defeats the whole purpose.
Speaker 1:But what I wanna make sure that we're starting to understand as we wrap up today's episode is understand the bucket approach as a risk capacity exercise and when you're determining your portfolio allocation. Part of it is risk capacity, part of it is risk tolerance. Risk capacity again comes down to how much do you need in conservative investments to protect against market downturns? The answer could be nothing. For example, if you only need 1% 2% of your portfolio each year as a withdrawal, you don't technically need those conservative instruments to live on because the dividend yield on your portfolio try to bake in a buffer for some short term dividend cuts if necessary, but the dividends on your portfolio could continue to meet your needs. Therefore, you're not having to sell stock. You're not having to sell the principle that you own when markets decline Versus. If you're taking out a higher amount from your stock portfolio, then it's probably a combination of dividends that you're living on plus selling the principle, selling some of the actual asset, some of the stock that you own, to free up that cash. So those are two very different scenarios, but understand that the bucket approach is a risk capacity exercise.
Speaker 1:The two main buckets that I like to think of yes, some people think three buckets. To me, keep it simple the two main buckets and now within the buckets. You also want to diversify further and have a really intentional approach here. But you have your conservative bucket, which is cash, bonds, cds, assets like that. Then you have your growth bucket, which is stocks of all different varieties, the traditional 60-40 retirement portfolio. That's kind of like a default retirement portfolio, but there's not a ton of intentionality behind it as it pertains to your situation. So when some people go to retirement, they say, okay, 60-40, but don't think about it from this bucket approach. Why do you need that 40? Maybe you do need that 40, but if you do need that 40% to bonds or cash, do you go through an intentional exercise to determine yeah, that actually happens to be the amount I need in conservative assets to support my specific situation, or are you just doing that because it's more of a cookie cutter default portfolio that a lot of people have in retirement?
Speaker 1:Now, finally, other steps. John and Donna or any of you listening test contingencies. You know these numbers I'm walking through. They're simplified but they work If everything the assumption that we make comes to happen as we assume it. But what are the contingencies? Well, what if expenses are higher than we thought they would be? What if there's medical expenses? What if one of them passes away? So I don't know if Donna, for example, has a survivorship option on her pension I know John mentioned that he does. If Donna passes away right away and she doesn't have that survivorship option, well, 20,000 dollars of income goes away. So how does that change? How much needs to come from your portfolio to now meet the difference between your income needs and what's actually coming in a non portfolio income? So this isn't to say he go through this simple exercise and everything's good as much as it says. This is a good starting point to help you understand the allocation of conservative and growth investments, but understand how different changes could impact this and what you need to do to prepare for different contingencies. So, john and Donna, thank you as we wrap up for that question. I hope this makes for some exciting dinner conversation.
Speaker 1:If you are listening you've been joining this podcast and you're listening on Apple Podcasts or Spotify would really appreciate it if you leave an honest review on that platform. It does really help people find this show and the more people that find the show, the more people can be prepared for retirement, which is always a good thing. If you're watching on YouTube, make sure that you're subscribed. Make sure you hit that like button. If you're enjoying it. Make sure that if you have someone that could benefit from the show this could be a friend, a family member, a coworker, a neighbor share an episode with them. Some people, a lot of people, as they approach retirement. It is so overwhelming, it's so confusing and sometimes just some simple good information can make a world of difference. So make sure that you share this with anyone that you think could benefit. Really appreciate all of you supporting the show, tuning in week after week. John and Donna, again thanks for the question. Thank you to all of you for listening and I'll see you next time. Hey everyone, it's me again.
Speaker 1:For the disclaimer, please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how root financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom Click start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.