Making your money last: The two-bucket investment approach

Preparation for retirement is a crucial component of the financial journey. It entails careful planning, strategic investing and prudent asset allocation. Most people work for several decades, seeking enough savings to sustain their retirement for 25 years or more. Achieving genuine comfort requires a financial plan that accounts for various factors.

Here’s a “two-bucket” strategy that has been proven to help one’s money last through retirement.

Understanding the two-bucket investment approach

The two-bucket investment approach is a fundamental asset-allocation technique that strikes a balance between stability (Bucket #1) and growth (Bucket #2). Each bucket represents a different investment objective, and each plays a critical role in safeguarding your financial future.

Bucket #1: Stability and liquidity

Bucket #1 is designed to provide you with readily accessible funds that cover your near-term living expenses without exposing your savings to the volatility of the market. This bucket typically consists of stable, liquid assets such as money-market funds or short-term bonds.

Bucket #2: Growth and long-term investing

Bucket #2, on the other hand, seeks growth and invests in stocks. Given that stocks have historically outperformed bonds and money-market funds in the long run, the purpose of the second bucket is to allow your savings to grow over time.

Balancing risk and return with the two-bucket approach

Why shouldn’t you place all your money into bank accounts or a money-market fund? Because asset growth is needed to protect against the nearly constant rise of living expenses (i.e., Inflation). Your money needs to maintain its purchasing power over the full length of your retirement.

Determining the right allocation

The key to a successful two-bucket investment approach lies in determining the right allocation between each bucket. One recommendation is to have approximately four years' worth of spending money in Bucket #1. The goal is keeping enough liquid assets to prevent yourself from having to sell stocks from Bucket #2 during market downturns. If the period in Bucket #1 is shortened to three years, there would be a somewhat increased likelihood of having to sell stocks before they fully recover from a market pullback. While stocks have fallen in approximately 20% of all years since 1945, they’ve risen over the long run. In reviewing stock-market history, we’ve found that after a down year, stocks usually returned to a new high within two to three years.

Moving money between buckets

At the end of each year, allocations to each bucket are reviewed and adjustments potentially made.  If stocks are at a new performance high, money is moved from Bucket #2 to Bucket #1, refilling Bucket #1 with assets for spending or withdrawal.

Creating a financial plan for retirement

To develop a financial plan that ensures your money lasts throughout retirement, you must make reasonable assumptions about four key variables:

1. Initial withdrawal rate: This refers to the percentage of your total savings that you plan to spend in your first year of retirement. For example, if you have $2,000,000 in savings and would like an additional $100,000 per year to supplement your income (pension, Social Security, etc.), your initial withdrawal rate would be 5%.

1. Years of spending money in Bucket #1: This variable determines how long Bucket #1 will hold your spending money when it’s full.
2. Assumed inflation rate: An assumed inflation rate estimates how much your living expenses will increase each year during retirement.
3. Expected after-tax returns: To project your portfolio's performance, you need to consider probable after-tax returns for both stocks and cash/bonds.

By considering these variables and using reasonable assumptions, you can model how long your money is likely to last in retirement.

Maintaining the proper time horizon

As famed investor Warren Buffett once said, "Rule #1 is never lose money. Rule #2 is never forgetting Rule #1."  While stocks have historically outperformed bonds and money-market funds over the long term, their returns can be unpredictable in any single year.

The two-bucket investment approach helps investors maintain the right mindset and time horizon. By acknowledging the inherent volatility of stocks in the short term, this strategy ensures that essential spending money is protected in Bucket #1 while allowing your investments to grow in Bucket #2.

When planning for retirement, it’s essential to have a financial strategy that protects and grows your assets. With its focus on stability and growth, the two-bucket investment approach offers a resilient solution for the stewardship of your money. By thoughtfully allocating your assets and making reasonable assumptions about key variables, you can create a financial plan that aligns with your goals, risk tolerance, and desired retirement lifestyle.

Alan Ebright is vice president, senior investment officer at Check Capital Management. Contact him at [email protected].

 

 

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