The Simplest Way to Pay Yourself in Retirement
Dear Rich Lifer,
When everyone was panicking during the 1987, 2000, and 2008 market crashes, a small group of retirees went about their days unconcerned.
They weren’t worried because they knew where their grocery money was coming from every month, thanks to a simple strategy I’m going to show you today for building guaranteed retirement income.
Before we get to the how-to, let’s talk about some advice you’re probably familiar with.
The 4% rule, also known as Bengen’s rule states that if you retire at 65, you can safely withdraw 4% of the starting value of your investment portfolio (adjusted for inflation) for 30 years without running out of money.
That’s based on looking at the worst historical market performance over 30 years.
But where the 4% rule falls flat is when you have to sell off stock during a bear market. Finance nerds like me call this sequence-of-returns risk.
“Sequence risk is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall rate of return available to the investor. This can have a significant impact on a retiree who depends on the income from a lifetime of investing and is no longer contributing new capital that could offset losses.” – Investopedia.
Basically, if you don’t have a cash buffer going into retirement and you have the unfortunate luck of retiring during a market downturn, you risk losing a significant portion of your portfolio having to sell stock to cover basic living expenses, which kills the 4% rule.
To avoid this common problem, one financial advisor named Harold Evensky came up with a simple two-bucket strategy.
Since pioneering his strategy 35 years ago, many retirement “bucket” strategies have been proposed.
But the focus of today is on the original two-bucket strategy, which in my opinion, is still one of the best ways to guarantee retirement income.
History of the Two-Bucket Strategy
Before the Great Recession, brokers and financial advisors prized market-beating performance and short-term gains, says Evensky.
But after the recession, advisors realized their clients’ risk tolerance wasn’t as good as they’d assumed.
Between job losses and the housing crash, retirees were concerned — and rightfully so — about their plummeting stock portfolios.
This led to more advisors trying to better align with clients’ goals and time frames of those goals.
Goals-based investing wasn’t new, but it spread quickly. The two-bucket strategy was originally called the cash-flow-reserve distribution strategy.
It wasn’t until 1985, when Evensky and his firm developed the “two-bucket strategy” as we know it today that would help their clients weather the 1987, 2000 and 2008 market crises.
After each of those disasters, more advisors started to pay attention to Evensky’s methods.
The Two-Bucket Strategy
How the two-bucket strategy works is like this…
The portfolio is split into two parts: a cash reserve and long-term investments.
The cash reserve funds your next five years of cash needs, and the latter is typically filled with higher risk, higher return investments.
Why five years?
Evensky says that’s roughly an economic cycle. From peak to peak or trough to trough, a cycle lasts around an average of five and a half years.
Your five year cash reserve should be enough to get you through a bear market, correction, or recession, without risking your portfolio.
Keep in mind the cash bucket is meant to complement Social Security, your pension, and any other guaranteed income you receive.
How most retirees set this up is with a monthly payment from their cash reserve, usually through a custodian or bank. This way you get a check, just like a salary, for that income.
Depending on how well your investment portfolio performs, you may decide to replenish your cash reserve before the five year mark. This is typically the case when your portfolio performs above average.
Evensky recommends reviewing your investment portfolio quarterly and rebalance only when the current allocation is off kilter from your allocation policy.
Where Should You Keep this Cash?
Under your mattress is probably not the best spot. Money market accounts, high-interest savings accounts or short term bond funds are all good places to start.
If you’re financing goals three to five years out, Evensky suggests considering a certificate of deposit (CD) that will mature when you’ll need the money.
What About Your Long-Term Investments?
The biggest knock on the two-bucket strategy is potential for opportunity cost (i.e. not having some funds invested in the market).
Evensky says, “Our research shows that [opportunity] cost is more than offset by avoiding the risk of having to sell assets in a down market. Also, the behavioral advantages, although not measurable, are potentially significant.”
He believes investors can offset some or all of the opportunity cost of the cash reserve by increasing the equity allocation of their long-term investment portfolio.
One other drawback to the bucket strategy is critics say it places too much responsibility on the investment bucket.
For example, a retiree with $1 million saved and an income need of $4,000 a month on top of SS and pension, would place 5 years of spending needs ($240,000) into his cash flow bucket.
That’s nearly 25% of his savings in a cash reserve, while the remaining 75% is fully invested. With five years of cash set aside, the retiree will likely invest the remaining 75% more aggressively and expose the portfolio’s capital to larger declines.
If a bear market were to wipe out 40%, or about $300,000, how do you think this retiree would react?
Evensky recalls, “Nobody was happy after crises, such as 1987, the tech crash or the great recession.” But he says he didn’t lose any clients after those declines.
“Those clients weren’t happy but they understood they were prepared for the consequences,” he says.
Evensky also claims that he didn’t receive any phone calls from distressed investors on Black Monday — when the Dow average fell nearly 23%.
Surprised by this he and his team made phone calls to check in, they learned that their clients were emotionally fine with the extreme market volatility.
The beauty behind the two-bucket strategy is it does a great job of mitigating risk and it’s really easy to follow.
If you want to set up a regular paycheck in retirement without overcomplicating things, consider Evensky’s approach and build your two buckets.
To a richer life,