If you are on the glide path to retirement with your target date in sight, the stock market volatility of the last couple of years may give you pause. It took your portfolio ten years to claw its way back from the steep downturn of 2008, and you are intent on avoiding a similar calamity. Conventional investment models would tell you that you should gradually reduce your exposure to equities as a way to reduce market risk. One common rule of thumb is to allocate your assets among stocks and bonds according to your age. So, according to the rule, if you’re 60, you should have 60% of your assets in stocks and 40% in bonds.
The challenge today is that the alternatives to equities, such as bonds or cash equivalents, are not performing as well as they did when the rule was created. It would be tough to argue with that approach when investment-grade bonds were yielding upwards of nine and ten percent; or when certificates of deposit returned a guaranteed five or six percent. The problem for people approaching retirement today is the yields on those vehicles are just a fraction of what they were when those rules were developed.
The Real Risks in Retirement
Nobody wants to lose money; however, market risk may be the least of your concerns as you approach retirement. With the prospect of living 30 years or more in retirement and life spans expanding by the day, the biggest fear most retirees have is the possibility of outliving their income. Then, when your longevity is compounded by inflation, there is almost a 100 percent chance your purchasing power will decrease over 20 to 30 years. When that happens you increase the need to draw down more assets, which can result in their early depletion.
It’s nice to think that having your money nestled safely in guaranteed fixed-yield investments can help you sleep more soundly. However, that won’t help you preserve your purchasing power when it’s needed most. Instead of avoiding market risk, pre-retirees should learn to embrace it because it’s what can generate the level of returns that can extend their income while maintaining their purchasing power.
Having a long-term investment plan based on an optimal diversification strategy enables you to capture the returns of the market while minimizing the overall volatility of your portfolio. With a bucket strategy, you control the amount of market risk you take while generating the income you need to meet your cash flow needs.
Preserve Your Purchasing Power with the Bucket Strategy
As the name implies, the bucket strategy involves dividing your assets into buckets – each with a specific time frame and an asset allocation designed to achieve a specific objective.
- Bucket one is filled with cash and cash equivalents to cover the first three years of living expenses
- Bucket two could be invested in short- and immediate-term government and investment-grade bonds that can generate yield without incurring much risk. These assets are earmarked for your cash flow needs four to nine years out.
- Bucket three becomes your growth portfolio allocated among equities and bonds to meet your income needs in 10 years and beyond.
Compare this strategy to having to manage one large portfolio during a turbulent market. If, for example, you start to draw down income in the midst of a steep market decline, you lose both the value of your assets and the time it takes for the market to recover.
With a bucket strategy, your immediate cash flow needs are secured by the first bucket so there is no need to sell stocks at a bad time. In the meantime, the growth bucket containing stocks and bonds has a longer-term time horizon, which gives it more time to work through market fluctuations. With the added security of the first two buckets, you should have the confidence to invest more aggressively in your long-term growth bucket, which can extend your income even further.
After the strategy is deployed, assets are shifted among the buckets as they are used. For example, when the first bucket is depleted after three years, assets from bucket two are shifted to bucket one to start a new three-year period. Assets from your growth bucket are then used to replenish bucket two. The amount moved between buckets will depend on your cash flow needs at the time and any changes in your circumstances.
Don’t Forget Tax Diversification
The other risk certainty in retirement is taxation and many people planning for retirement make the critical mistake of ignoring its impact on their cash flow. If you’re like many retirees, you will likely have multiple income streams from pre-tax, such as a 401(k) plan or an IRA, and post-tax accounts, such as an investment portfolio or a savings account. Not understanding their tax implications and when to access them in retirement could result in depleting your assets too quickly.
When Too Much Tax Deferral Could be Bad
If the goal is to maximize retirement cash flow, it requires a deliberate strategy that balances your income needs with the need to confine your taxable income to the lower tax brackets. Withdrawing exclusively from your pre-tax, IRA or 401(k) accounts won’t accomplish that. And, if you delay withdrawing from those accounts too long, it will create a bigger required minimum distribution (RMD) problem later, which will likely push you into a higher tax bracket.
The solution is to take income from a combination of sources that will generate sufficient income while paying taxes at the lowest tax rate possible. Done right, it’s possible to net $60,000 to $70,000 of income free of federal income taxes (excluding the Social Security tax).
The Tax Bucket Strategy
The key to this strategy is to think of the different tax bracket levels as tax buckets that need to be filled with income. The idea is to fill the lowest tax bucket (0 percent) with as much income as possible before it spills into the next, higher tax bucket (10 percent) and so on.
How it Works
If you are married, filing jointly and retiring in 2019, your first $24,400 of income is not taxed due to the standard deduction. You can consider that your first tax bucket where you stuff as much of your income that is taxed as ordinary income as possible. It could be withdrawals from your IRA or 401(k), or it could be half of your Social Security benefits if you expect your income to exceed the Social Security tax threshold ($34,000 in 2019), or a combination of the two. The objective is to not overfill this bucket to keep your tax rate on this income at zero.
The next bucket is taxed at 10 percent and allows for up to $9,525 on top of your first bucket. You could choose to add more withdrawals from a pre-tax account. For the next bucket (12 percent), you can add your income from capital gains and qualified dividends from your post-tax accounts. Under the new tax law, income received from these sources is taxed at 0 percent up to $77,200 for joint filers. Between the three buckets, that’s more than $100,000 of income taxed at an effective rate of 0 percent.
Today’s retirees are looking for simple solutions and greater certainty in their planning. By applying simple bucket strategies to your retirement income planning, it can be easier to manage risks while creating a more reliable income stream that you won’t outlive.