Three-Bucket Strategy for Withdrawals
A couple of months ago I wrote a piece about a three-bucket strategy for managing taxes on your investments.
In summary, I covered how to use taxable, tax-deferred, and after-tax (Roth) accounts to control one’s tax liabilities.
Well, to the best of your ability, anyway.
In the opening of that article, I was inclined to point out that there are a couple of “three-bucket” strategies I’ve heard referenced from time to time by other financial planners and I needed to be clear about which one we were covering.
As I did that, I was reminded that hadn’t ever written anything about the other one, a three-bucket strategy for timing the use or withdrawal of funds from investment accounts.
So, why not do that now?
I’ll refer to this approach as a Three-Bucket Timing Strategy which is another way of saying that we’ll be addressing a strategic approach for investing based on when investments will be liquidated, and withdrawals made from the accounts.
Those three buckets are short-term (0-2 years), intermediate-term (2-5 years), and long-term (5-7+ years). Herein, we’ll discuss the differences for each one of these periods and why it’s important to think about these three categories strategically.
The Importance of Time
To begin, let’s explain why the timing of the sale of an investment would matter in the first place.
As you probably know, there are a near-infinite number of ways to invest money and all of them come with varying levels and types of risk.
Our goal as investors is to find the best-performing investments that don’t extend beyond our ability to tolerate the risk that comes with them.
For example, it would be foolish to use your rent or mortgage money to buy a handful of GameStop stocks on a whim because you might lose your home if the stock price takes a hit while you own it.
Odds are, you would set aside money for needs like rent or a mortgage in a checking or savings account each month because you know you’re going to need it soon. Your risk tolerance for that money is low.
But what if you had no immediate need for the money? What should you do then?
In that case, you could look into investments that may produce higher returns, even if they might come with more risk, which brings me to another important point.
For many “riskier” investments, like stocks, risk and volatility tend to be mitigated or smoothed out over time.
As a completely random example, I pulled three pricing charts from Google for Apple stock. These were all captured within a few minutes of each other.
Here’s what AAPL looked like today…
Here’s what it looked like over the last month…
And here’s what it looked like over the last 5 years…
Notice how the trend over five years (the long-term in this case) shows a steady incline while the one-month and one-day charts have larger fluctuations in price relative to the length of time in the graph?
To put it into perspective, here are the annualized returns for each time range:
1 day: -229.32% (There wouldn’t be an Apple if this happened)
1 month: +94.44% (impressive, but likely not sustainable)
5 years: +53.72% (I wish I had bought APPL in 2019)
Apple probably wasn’t the best choice for this example, but it still supports the point that long-term ownership of stocks tends to overshadow the day-to-day volatility of stocks.
Taking this example a step further, if you purchased an S&P 500 index ETF at the close of one trading day and sold it at the close of the next trading day, there’s a 53% chance that you will receive a positive return from this investment and a 47% chance that you won’t.
That’s better odds than a coin flip, but not by much.
If you held that same S&P 500 ETF for a full year, you’d have a 76% chance of earning a positive return.
And, finally, if you had bought that S&P 500 index fund at any point since 1978 and held it for at least 7 years, it never would have lost money.
Never is 0% of the time which means 100% of S&P 500 investors who have bought an held for at least 7 years made money (again, since 1978).
To be clear, this doesn’t mean you are guaranteed to make money if you buy and hold an S&P 500 index fund for seven years. After all, there are no guarantees in investing.
However, it does mean the odds grow in your favor when you hold stocks for long periods.
Now the point this illustration is meant to make is that we can probably afford to buy and hold more volatile investments that produce higher returns, like stocks, if we have the capacity to own them for a long time.
Like 5 or more years.
It also shows us that owning stocks for shorter periods, say anything under five years, is very risky.
In other words, there are compelling reasons to strategically align the timing of our monetary needs with the investments we own.
Identifying Two Primary Timing Risks
We covered all the previous information about market risk to lay the foundation for two other key types of risk that our investment portfolios are constantly exposed to.
The first is inflation risk.
Inflation risk is exactly what you probably think it is. It’s the risk that the value of our money or assets will be reduced by the steadily increasing cost of the things we want to buy with it.
Said another way, inflation risk is the risk that our dollars will buy less in the future than they can today.
The other primary timing risk I want to discuss is Sequence of Returns Risk.
Sequence of Returns Risk is the risk that you will need to liquidate your invested assets (typically for retirement) during a significant market downturn.
Having to sell invested assets at a low point can have a devastating effect on your portfolio and its ability to last through your expected retirement.
The goal of a Three-Bucket strategy is to mitigate both inflation and sequence of returns risk by thoughtfully constructing an asset allocation that will produce steady enough returns to outpace inflation, while not simultaneously exposing your assets to a sudden, devastating market correction.
Let’s talk about how the three buckets will allow us to do that.
Short-Term (0-2 Years)
The purpose of this first bucket is liquidity. The funds in bucket one must be accessible quickly to cover immediate needs like emergencies or expenses in retirement.
No matter where you are in life, you need some money in bucket one.
The amount you need to keep in this bucket will vary depending on a number of factors, but it all starts with calculating your monthly or annual spending needs.
If you haven’t done a budget in a while or at least kept track of your regular spending, you’ll need to do that in order to accurately fund bucket #1.
Once you pinpoint your regular spending, you need to evaluate how many months of those expenses you may need to cover with bucket one.
If you are working and have a stable job with no plans to retire anytime soon, 3-6 months of expenses should do the trick.
If your work and your income fluctuate because you own a seasonal business, work in sales, or some other reason, you should plan to hold up to one year of expenses in this bucket in case your business has a bad year.
For those of you who are retired, two years of expenses is the minimum I would keep in bucket number one.
Of course, if you have regular dependable income from another source (like social security, a pension, or other business) then you can reduce the amount you keep in this bucket by the amount of regular income that source provides, assuming it is reliable.
For example, if you spend $100,000 each year but $30,000 of that is covered by social security, then only $70,000 of each year would need to be covered by bucket one because social security is considered a reliable source of income*.
The primary object is to ensure you either have income diversification or a full bucket number one to ride out extended periods of unemployment, low cash flow, or high expenses.
So, where to put this cash?
With an emphasis on liquidity, the options for putting this money in a place that will generate substantial returns is basically zero.
You’ll want to look at savings accounts, short-term treasuries (90 days or less), money market accounts or funds, or certificates of deposit for bucket one.
Personally, I have mine in a money market fund offered by my investment custodian. It holds a basket of short-term treasuries and other bonds with an average maturity of just 10 days.
It is highly liquidable and easy to access but still provides at least a little return for the cash I put into it.
(*Yes, there is valid concern about the long-term sustainability of social security, but I don’t feel that any concern is warranted for those who are already receiving payments. For those of us who are under 50, I’m a bit more concerned.)
Intermediate-Term (2-5 years)
Bucket number two or the intermediate-term bucket is for monetary needs anywhere from two to five years into the future.
The strategic goal of bucket two is to find a happy middle ground between the unimpressive returns available in cash equivalents and the more exciting earnings obtained through stock ownership.
With this money, we can afford to limit our ability to liquidate the balance for some time, but we can’t afford to expose it to a downturn in the stock market or the economy at large.
Retirees or those who are approaching retirement stand to benefit most from this bucket as it will be used to provide income two to five years down the road.
However, almost everyone will have a major expense that they can see coming two to five years in advance like the purchase of a home, a renovation, or paying for your child’s education.
Once again, the amount you keep in this bucket should be driven by your expense needs in this 2 to 5 year window.
If you are retired and want to put income here, then set aside three or four years of living expenses in this bucket.
If you plan to buy a home, then you will probably want to aim to put 20% or more of your purchase budget here.
Whatever the need is in that timeframe, it should drive your decision about how much money to set aside in bucket two.
The assets you hold in bucket two will be a little different than those in bucket one.
The overwhelming majority of the time, the bulk of assets in bucket two will be high-quality bonds.
Bonds provide access to sufficient yields, while also uncoupling you from many (but not all) of the market risks that are inherent in stocks.
High-quality dividend-paying stocks are also an option for bucket two but do note the condition that these be “high-quality” stocks. Look at companies with extensive track records, stable and secure markets, and a long history of regular and/or increasing dividend yields.
Finally, if you find yourself in an interest rate environment similar to the one we have in the Spring of 2024, where short-term bond yields are higher than long-term bond yields, then there’s not really any harm in owning short-term bonds in this bucket assuming you move back to longer-term bonds when yields revert to normal.
No matter what you own here, don’t take chances with low-quality or junk investments that you hope will produce higher yields. You don’t have time to expose this bucket to a difficult price depreciation scenario.
We’re not really looking to introduce more risk in bucket two, but we can give up some of the liquidity if it provides better returns.
It’s also worth noting that the securities I’ve described above tend to also be seen as income-producing investments.
Dividend-paying stocks and bonds that produce regular payments to investors could trigger a taxable event.
Dividend stocks generally pay out quarterly, bonds every six months, but many bond mutual funds see dividends on a monthly basis.
If possible, hold these assets within a tax-advantaged retirement account instead of a taxable brokerage to avoid the tax obligation they will generate.
Of course, in normal circumstances, you’ll have to be 59.5 to access assets in a retirement account, so this could be challenging or impossible if you are filling bucket two while you’re younger.
Personally, I’ve found it easier to just overstuff bucket one than to fill bucket two outside of a tax-advantaged account.
Long-Term (5-7+ years)
Bucket three is for investing money that you won’t need for 5-7 years or more. Some would argue that you should expand bucket two to a 2 to 10 year range and push bucket three out to 10 years plus.
There’s nothing wrong with being more conservative if you want, but I think 7 years is plenty of time to protect yourself against a market downturn for a few reasons.
1) While there have been market recoveries that have taken more than 7 years, they are rare and generally only applied to market segments that a broadly and properly diversified portfolio would avoid. Here is a table from a helpful article about this from Morningstar:
If you take nothing else from this table, do yourself a favor and avoid over-investing in gold.
2) Market downturns are measured from a single point in time to another single point in time and they are always measured to show the longest possible recovery period. You would have to have astonishingly bad luck to buy all of your long-term invested assets on the worst possible day.
Odds are, you will accumulate many of your investments over a period of months or years. Whether you mean this as a dollar-cost-averaging strategy or not, spreading out purchases reduces the risk that you will buy at the worst possible time.
3) The only timeline long enough to guarantee yourself that you will avoid a market downturn altogether is the one that never begins.
If you are that concerned about the stock market running into the ditch with your assets and never getting out again, you should just stop at bucket two. But don’t cry to me when all your friends have more money than you.
Do you know what else is great for bucket three? Assets you won’t ever need.
There are a few of you out there who have done such a stellar job saving that you can’t possibly spend everything you’ve managed to accumulate. There are even more among you that could spend it, but you won’t because it doesn’t make you any happier to do so and you’d rather leave the money to your kids, or charity, or some other beneficiary.
Since the timeline of these assets is indefinite, you might as well leave them where they have the greatest potential for growth.
As for what assets to hold in this bucket, you should own a globally diversified group of stocks in some form.
Mutual funds and Exchange Traded Funds (ETFs) are the most convenient way to acquire and hold these assets, but be sure you buy low-cost index funds and ETFs so expense ratios aren’t eroding your earnings away.
Which funds is up to you. The easiest approach would be to buy a total stock market fund like VTSAX or VTI and be done with it.
You could also buy a variety of large cap, mid cap, small cap, and international funds to provide broad exposure.
As you check on your buckets every once in a while, you are probably going to enjoy watching bucket three the most since it has the greatest chance of growing, but don’t forget about buckets one and two.
Be sure you are using strong years from bucket three to refill buckets one and two, if necessary.
Rebalancing every once in a while will ensure that you are taking gains off the table when the market is up, while also ensuring that you won’t have to sell from bucket three when the market is down.
Buckets & Asset Allocation
So, as you read through this, you may have thought to yourself, “This looks a lot like basic asset allocation.”
Well, astute reader, you’re right. Because that’s exactly what this is.
The typical approach to asset allocation is a simple ratio of stocks to bonds like 60/40 or 80/20. Slightly more sophisticated approaches include a number for cash (55/35/10) or even commodities (50/30/10/10 – not recommended by me).
Another common rule of thumb is to subtract your age from 100 and, whatever the remainder is, you should own that percentage of bonds in your portfolio.
Honestly, you could do a lot worse than this, but the two best justifications I can make for selecting ratios like these are 1) they force one to rebalance, and 2) they’re both simple.
If that’s the type of asset allocation you want, go for it. In many cases, less is more, and simple is better.
I’m really not being critical of the approach. It’s a challenge to get people to invest anything, much less think about an asset allocation that is appropriate for their unique spending needs.
But it’s also true that you only need the amount of stocks or bonds that match your expectations for when you will spend the money.
If you want something that fits your situation specifically (that is to say, you want a portfolio of assets that is more precisely arranged to address your real needs for the money) then this three-bucket approach is a great way to go because the liquidation and use of the assets matches your expectations for using it.
It’s customized for you. What could be better?
Wrap Up
Truthfully, you can geek out on financial strategies in perpetuity. Money is fungible and time is always introducing change.
This approach may or may not be for you, but by all means, please have an approach.
For more about investing, please check out our YouTube channel and investing playlist.
