How to Transition to a Bucket Strategy Before You Retire

Chances are you’ve been saving diligently for your retirement, but have you given some thought to how you will withdraw from your investments for your retirement income?

One popular withdrawal strategy in the bucket system (not to be confused with a bucket list).  Bucketing involves splitting your portfolio into separate income buckets.  Each bucket is intended to handle a different period of time in retirement for short, medium, and long-term needs. 

You need to plan ahead a few years before retirement to get your plan in place.

How much you put into your buckets depends largely on what your fixed pension payments and other income will be and how much you intend to spend each year.

Related:  Determining a Safe Withdrawal Rate in Retirement

Here’s how a typical three bucket system is set up.

Bucket 1:  Years 1 – 5

This will be the money you live on in your first years after retirement. Since you want both stability and liquidity in this time period, the money in this bucket will be placed in cash – high-interest savings account or money market fund for year one, and cash equivalent assets such as laddered GICs and short-term bonds.

Bucket 2:  Years 6 – 15

You won’t be tapping this money until you’re a few years into your retirement. This second bucket holds your fixed-income investments generally consisting of bonds. You want to reasonably protect your principal here, but still allow your money some room for growth.

Bucket 3:  Years 16+

You can afford to be more aggressive here since you have time to let your money grow. This bucket of your portfolio will consist of higher-risk/higher-return assets, such as stocks and other types of equities. You’ll have at least 15 years to ride out market volatility plus realise potential benefits.

This strategy provides a lot of flexibility:

  • If a large portion of your portfolio is in stocks and those investments drop 20% or more, you can live on your cash instead of selling stocks which gives the stocks time to recover.
  • Cash is part of your fixed-income allocation. Moving some stocks to cash balances out your asset allocation when you are in withdrawal mode.
  • You may not be entirely certain what your retirement spending needs will be, or you may be planning some expensive trips early on.  Keeping extra cash on hand helps smooth the transition from paycheque to portfolio withdrawals.

Start planning your withdrawal strategy

Five years before retirement is the perfect time to start planning your retirement income withdrawal strategy, so you have time to make decisions.

You will be structuring your portfolio based on the amount of risk you can afford to take without having to sell out of an asset class, especially stocks, when it’s in a downturn.

Here’s how to start transitioning your portfolio into a bucket strategy a few years before you retire.

  • Take a look at the asset allocation of your portfolio

It’s likely you have several accounts – RRSP, LIRA, TFSA and taxable accounts – and they each may hold different investments.  And your spouse may have several accounts too.  What is the asset allocation of your combined accounts?  Compare your current positions with your target bucket amounts and how close you are to retirement.

Start transitioning to a lower risk asset allocation if your holdings have a large stock component.  Increase your fixed income investments.

Total up all the cash you have already in money market funds, GICs, and savings.  Then compare this amount with your target cash holding (Bucket 1) to see how much you’ll need to add.  Logically, you can start by not reinvesting your dividends and interest, selling some equities that have appreciated and steering new contributions here.  If you have a non-registered account, if necessary, gradually spread out the sale of equities, or offset capital gains with losses if you can to minimize your taxes.

Related:  Plan to Retire in a Lower Tax Bracket

Think about your future tax position also when determining the asset allocation of each of your accounts. 

  • Simplify your portfolio

This is a good time to look at how you can simplify your investments.  Do you need to reduce the number of accounts held at different financial institutions?  Reduce your holdings?  Transition away from individual stocks and into ETFs?  Make your taxable account more tax-friendly?

The bottom line

The bucket strategy starts with the assumption that retirees will have to ride out some market volatility during their retirement.  There’s a psychological benefit to knowing you have ensured the cash flow you need so you don’t have to sell equities during market downturns.  Retirees like the security this offers.

If you like this idea you need to take into account your spending, tax situation and risk tolerance.  Then make a gradual transition a few years before your retirement date.

You don’t want to be like the guy who retired at the end of September 2008.  He decided to start withdrawing from his portfolio immediately after.  That was when the stock market crash reduced his holdings by over 35% and he has yet to recuperate.

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