A Basket Case
Retirement planning geeks are well-acquainted with the Bucket Strategy. In short, the idea is to segregate your investment portfolio into three buckets, based on when you will need to draw down funds (short term, medium term, and long term). Then, you invest the three buckets differently, based on each timeline. (Cash in the short-term bucket, bonds in the middle tier, stocks in the long-term bucket). And like a champagne fountain at a high-priced wedding reception, as the bottom short-term tier is spent, it is replenished from the upper tiers.
Now as much as I love that visual, I am very much taken with the argument that mathematically the bucket investment strategy does not yield a different end result than taking distributions from a single balanced investment fund. But it is a strategy that addresses a real need in retirement income planning (managing sequence of return risk). Just as importantly, it responds to the behavioral preferences of many retirees.
Which is where my basket strategy picks up. One thing that we know from research is that spending down your savings in retirement can be difficult emotionally for many people because of the all-consuming Fear of Running Out of Money. What I propose is creating different baskets with your retirement nest egg that will allow you to spend responsibly but also joyfully. Here’s how it works:
To start with, imagine that you begin the year with a healthy $500,000 balance in your retirement account. (Naturally, it is invested in a very reasonable balance of stocks and bonds.)
Now let’s assume that you have determined that your must-have spending will total $48,000 for the year. (I will return to that definition of “must-have” spending later.) Lacking a pension, you have one guaranteed source of income: Social Security. That will total $36,000. You have a gap of $12,000 for the year that needs to come out of your savings. [1]
Now let’s employ the well-trod “4% Rule.” That guideline proposes that you can withdraw $20,000 annually (4% of your $500,000 balance, adjusting as you go for inflation) and be in little danger of running out of money. It’s not an end-all-be-all rule, but it’s very helpful for broad strokes.
So, at the start of the year, you put $12,000 — the amount needed to fund your must-have spending gap — in one basket. And you place the remaining $8000 in another basket. And by “basket,” I mean different bank accounts. For example, you could place the $8000 in a bank savings account, and the $12,000 in checking. (Or perhaps better, you could “drip” the $12,000 into your checking account over the course of the year through automatic monthly or quarterly withdrawals from your retirement account.)
The reason why I think this construct is useful is that it gives you the freedom to spend that $8000 on lumpy expenses, both the good and the bad (travel, auto repair), without worrying that you will run out of your regular lunch money.
A household with a much larger retirement portfolio might create additional baskets for long term care costs (if not otherwise insured), future inheritance or support to their children, or charitable giving.
But here’s the caveat: You can’t cheat by undercounting your estimate of must-have spending. If your diet is not one of ramen noodles and beans, don’t pretend that it is. If you have an expectation of significant out-of-pocket medical expenses, include that in your must-have calculation. And if you know that your car is likely to need a costly repair, add that into the must-have basket as well. The “free spending” basket must be funded honestly, okay?
Having said that, thinking of your spending this way may prompt you to make changes on the must-have side. If your discretionary spending basket is skimpier than you would like, are there meaningful changes that you can make to the must-have side of the equation that will endure? This is where downsizing housing costs may come in. But this is also an opportunity for pre- and early retirees to consider if there are lifestyle changes that they can make now that could reduce non-negotiable medical costs as they age.
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[1] In this illustration, I am ignoring taxes to keep the math simple.