The bucket strategy and other buffers against sequence risk

A market fall early in retirement does more damage than the same fall later. If you sell investments while they're down to pay the bills, those losses become permanent. That's sequence-of-returns risk.

One popular answer is to keep a buffer of safer money to spend while markets recover. A common version is the bucket strategy. This guide explains how it works, what it does and doesn't change, and some other ways to build a buffer.

How the bucket strategy works

You split your savings into groups by when you'll spend them:

1. Bucket one: cash for the next one to two years. A savings account or money market fund. This pays your bills.
2. Bucket two: bonds for roughly years three to seven. Short- and intermediate-term bonds. This refills bucket one.
3. Bucket three: stocks for the long run. Money you won't need for seven years or more. This refills bucket two over time.

When stocks do well, you sell some to top up the safer buckets. When stocks fall, you leave them alone and live on cash and bonds until they recover.

A worked example

Joan and Pete have $1,200,000 saved. They spend $90,000 a year. Social Security pays $40,000, so their savings must supply $50,000 a year. All figures are invented for the example.

A bad first year. Stocks fall 30%, and bucket three drops to $595,000. Joan and Pete take their $50,000 from cash. They sell no stocks. Bucket one now holds two years minus one, and bucket two is untouched.

The following years. If stocks recover over the next few years, they refill cash from stock gains. If stocks stay down, they draw on bonds and still sell no stocks for up to seven years.

What the buckets really change

Here's the part that's easy to miss. Add up Joan and Pete's buckets and they hold about 71% stocks and 29% cash and bonds. A single portfolio with that mix, rebalanced once a year, has the same investments.

So the buckets mainly change two things:

• Which assets you sell, and when. Buckets sell stocks only after good years. Plain rebalancing sells whatever has done well, which after a crash means selling bonds to buy stocks.
• How the plan feels. Seeing several years of spending set aside makes it easier to sit through a downturn without panic selling. For many people this is the real benefit.

When the two approaches hold the same overall mix, their results tend to be close. The rules for refilling usually matter more than the number of buckets.

Refilling rules to choose from

• Refill once a year. Each January, top bucket one back up to two years from whichever bucket has gained most.
• Refill only from gains. Sell stocks only when they're above their last high. Otherwise draw on bonds.
• Refill on a trigger. Top up cash when it falls below one year of withdrawals.

Write your rule down before you need it. The point of a buffer is to avoid deciding under pressure.

The cost of holding cash

Cash and short bonds usually earn less than stocks over long periods. A large buffer is a steady drag on growth.

Suppose Joan and Pete held five years of withdrawals in cash instead of two. That's $150,000 more earning cash rates instead of stock-like returns. Over a 30-year retirement the difference can be large in good markets. It helps only in the minority of futures with a long, early slump.

There's a middle ground. Many retirees keep one to two years in cash and treat their bond holdings as the deeper reserve.

Other ways to buffer sequence risk

Buckets are one tool. Several others aim at the same problem:

• Flexible spending. Cutting withdrawals by 5% to 10% after bad years does a lot of the work. See spending guardrails.
• A rising stock share. Starting retirement with fewer stocks and adding more over the first decade reduces the damage from an early crash.
• Delaying Social Security. A larger lifelong benefit means smaller portfolio withdrawals later. See Social Security claiming age.
• An income floor. Covering essentials with guaranteed income from Social Security, a pension or an annuity means a crash only affects extras.
• Part-time work early on. Even a little income in the first years reduces withdrawals when sequence risk is highest.

How the app handles buffers

In the plan's Saving and withdrawal order section, you choose how many months of essential spending to keep in cash, up to 36. The app keeps that buffer in your main cash account. In retirement, when the buffer runs low, it refills it from investments using your withdrawal order.

With Rules, a Plus feature, you can tell the plan to live on the buffer after a fall. One ready-made rule is called "If investments fall 25% from their peak, pause travel and spend from the cash buffer". While it's active, the app lets the buffer run down for 12 months instead of selling investments to refill it. Because rules run in every simulated future, you see how often the rule fires and what it changes.

To compare buffer sizes, change the months of cash and check Outlook. Its stress tests replay your plan through difficult historical starting years. Asset allocation shows your overall mix, which is what the buckets add up to.

Frequently asked questions

How big should the cash bucket be?

Common choices are one to three years of withdrawals. More cash means less growth. Test a smaller and a larger buffer on your plan and compare the trade-off.

Do I need separate accounts for each bucket?

No. Buckets are a way of thinking about your holdings. Many people hold all three inside the same accounts, often keeping bonds in tax-deferred accounts.

Is a bond ladder the same as bucket two?

It's one way to build it. A ladder holds bonds that mature in each of the next several years, so each year's spending is known in advance. A bond fund is simpler but its value moves with interest rates.