People often spend a lot of time calculating what they can afford in retirement based on the assets they’ve accumulated. And they spend very little time on how to manage their portfolio to provide income instead of just growth. Many financial advisers use the bucket strategy of managing retirement accounts.

The bucket method allocates funds into three separate portfolios based on time horizon. There’s a short-term portfolio, a mid-term portfolio, and a long-term portfolio. The shortest time-frame portfolio is the most conservative, with more risk being taken for longer time-horizon assets.

You can use the retirement bucket strategy no matter what your distribution requirements are. Whether you want large distributions or modest ones, the method works equally well.

The size of the distributions can be based on a variety of factors. Some people choose a fixed dollar amount based on their needs. Others choose an amount based on a percentage of their assets on an annual basis or some other method. No matter what method is used to calculate the size of the distributions, they should increase across time. Even modest inflation erodes a fixed income across time.

Components of retirement income often don’t increase with inflation, such as many pensions. Other components increase, but at a rate that is lower than the increase in costs, such as Social Security.

This means that your retirement assets need to fund the ever-increasing costs of retirement.

Hence you’ll need increasing distributions. And they’ll need to increase at a rate greater than that of inflation.

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The Individual Buckets

A typical three-bucket strategy divides your assets into three distinct and separate portfolios. The first, your short-term bucket, is for assets you'll use within the first three years. The second, mid-term bucket, is for assets you'll use between three and six years out. And the final, long-term bucket is for the remainder of your assets — those you'll need six or more years out.

Generally, you wouldn’t select shorter time frames for your buckets, but you might choose wider buckets. Some advisers will have a short-term bucket of five years, a mid-term that carries you out to 15 years, and a long-term for over 15.

The strategy works the same for whatever size buckets make the most sense in your situation. Using longer time frames is more conservative, and more conservative always requires more assets. Often, that’s not a valid option.

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The Short-Term Bucket

The short-term bucket is the bucket that you will be drawing your living expenses from. This is the only bucket that you actually receive money from.

You should invest it very conservatively, in cash or equivalents. The important thing for the assets in the short-term bucket is that they don’t fluctuate with markets, since you need this money to live on.

You set an automatic distribution for a certain period (e.g. monthly) into your checking account for you to use. This is your income. It will essentially stay fixed. You budget your living expenses, travel, and everything else from this and any other incomes you receive.

The essentially fixed part is that it does go up, typically annually. But the annual increase is to offset inflation so that your purchasing power remains the same.

The Mid-Term Bucket

The mid-term bucket holds those assets you will need three to six years out. Here you can be invested with some, but not a great deal, of market exposure. You can weather some fluctuations, but this bucket is used to fill the short-term bucket annually, so you don’t want it to fluctuate excessively. It can have some risk to get better returns than cash, but it should still be pretty conservative.

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The Long-Term Bucket

The long-term bucket is your investment bucket. Most retirees can't afford to avoid investment risk in retirement. If they do, they can be certain of one thing: They’ll run out of money.

For your long-term investment bucket, you should be invested as conservatively or aggressively as you are comfortable with to produce the returns you need to have your assets last through retirement. The most common mistake isn’t being too aggressive. Rather, it’s being too conservative.

With many retirements lasting 30 to 40 years — sometimes even longer — retirees generally need growth to offset the insidious effects of inflation on their purchasing power.

You should expect costs to triple or quadruple across your retirement — so long as inflation remains in check. Otherwise, it will be worse.

You can also change your asset allocation strategy across time. You may retire needing money for over 30 years, but probably don’t need to be as aggressive at age 95.

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Refilling Buckets

The only bucket that has money coming out automatically is the short-term one. The other two need manual adjustments to keep the two shorter-term buckets where they need to be. This has some flexibility.

Many people plan annual replenishments. They take funds from the long-term bucket to replenish the mid-term, and from the mid-term bucket to replenish the short-term.

The quantity needed to replenish the buckets will be based to a small extent on the buckets' returns, but to a large extent on your needs across these two time periods. You bring them back up to the point of having them fully able to meet your needs for the time frame designated in your design. In other words, a three-year bucket gets refilled to have three years’ worth of assets.

But you do have control of the timing. If the market’s in the tank, you may choose to wait. If the market’s done very well, you should go forward, pulling the necessary funds out to fully replenish your buckets. A good financial adviser can help with this. And a good adviser will push you to take out money when the market is doing very well — and you don’t want to sell.

The Common Alternative

A common alternative to the retirement bucket strategy has emerged with the use of target date funds. A target date fund is an asset allocation fund that alters its allocation based on the length of time remaining to some future date — the target date. Hence, the portfolio becomes more conservative across time.

The advantage touted is simplicity: You set it and forget it. In theory. In reality, it isn’t necessarily that simple.

You need increasing distributions, not level ones. And removing money systematically from a long-term portfolio is something you shouldn’t set up. Systematic withdrawals force you to sell more shares when prices are down and fewer when prices are high. It’s reverse dollar cost averaging.

And it may be overly conservative for longer life expectancies. Often the target date selected is one you could outlive. And if you do, you’ll still need your money to be working for you.

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The Bottom Line on the Retirement Bucket Strategy

The long-term popularity of the bucket method is based on two key factors. For one, it’s relatively simple to understand. Even if you have someone else do the math, seeing what’s needed for your short-term, mid-term, and long-term portfolios is pretty easy to grasp. You can see how it protects the money you need to spend from market fluctuations while allowing your other money to grow.

Plus, the retirement bucket strategy puts you in control. You can delay refilling buckets if the market is in a particularly bad place. Or you can splurge if your long-term portfolio ends up well ahead of target. You don’t eliminate your investment risk; you just isolate it. That’s something people can understand. And people love control. It’s a win-win.

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