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What is the 3 Bucket Retirement System?

The 3 Bucket Retirement System is a popular strategy that divides your savings and investments into three general categories. Each bucket has a distinct investment objective based on the planned duration of the funds in a particular bucket. In theory, it provides greater flexibility and helps protect your retirement funds from volatility.

Bucket #1: Immediate Needs / Emergency Fund

In this bucket is the cash you will need for at least the following year, though many proclaim up to five years of reserves may be necessary. The funds should be highly liquid, safely parked in a savings account or another accessible low-yield account, and pulled from for everyday needs, such as grocery shopping, utilities, your mortgage, and the car payment. The point is to not gain returns, but provide stability in the fact that you have hard cash on hand to spend as needed, providing peace of mind that not all of your funds are exposed to the whims of the market.

Breakdown into 2 Buckets

We can break this bucket down into two buckets for those who want to earn a more generous return than a typical savings account can provide. A year’s worth of funds can be kept in cash, and another year or more’s funds can be held in laddered brokered CDs or treasury bills that can be sold on the secondary market at nearly anytime if necessary. That way, if calamity transpires, you have a sizeable amount of funds to pull from without touching your second or third bucket, where it is vital you let funds sit to make the best use of compound gains. In the meantime, these funds will earn a higher interest rate than a regular savings account.

Bucket #2: Intermediate-Term Investments

Next we go to intermediate-term needs. About 5-10 years of future expenses should be wrapped up in this bucket, invested in safe, higher-interest investments such as bonds and asset allocation funds. The point is to invest in assest that at least keep up with inflation, but that are generally safe from decimating bear markets. As the reserves of your first bucket start to dwindle, you refill it with interest earned from this bucket.

Bucket #3: Long-Term Investments

This is the final bucket, consisting of long-term, volatile and aggressive investments that potentially make up the bulk of the growth of your nest egg. It consists of riskier stocks, ETFs, mutual funds and REITs that provide either high growth or dividends that produce compound gains. Since this bucket is highly subject to market volatility, the first two buckets provide a bulwark while the market and this bucket’s investments recover.

3 Buckets of Concerns

In an ideal and simplistic world, the 3 Bucket System would probably suffice for most retirees. The interest produced from Bucket #2 could drip into Bucket #1, and dividends from Bucket #3 could drip into Bucket #2 to purchase more bonds as the years go on. Eventually, bonds would be sold for cash to fill Bucket #1, and then stocks would be sold to purchase bonds for Bucket #2. But, life, and the markets are a bit more complicated than that.
Suppose that Bucket #1 is running dry but bonds are having a bad year while stocks are doing great. It would be quite enticing to sell some stocks to make up for the failures of Bucket #2 by either purchasing more bonds (better alternative) or just using the cash to pay for life (worse alternative).
According to strict bucket rules, those stocks will never be purchased again, losing potentially years of compound gains they could have produced. Also, having to rebalance each bucket, from within each could be located funds from a series of investing and tax-advantaged retirement accounts, could lead to confusion and suboptimal investment performance.

Withdrawals based on tax status

Investments should be pulled from based on their tax status in correlation with other retirement income streams and benefits, such as social security, pensions, and Medicare. If these investments are spread across three different buckets, it may be impossible to develop a tax-efficient withdrawal strategy that maximizes gains.
The 3 Bucket Retirement System was developed in a simpler time, just after IRAs and 401(K)s were created in 1974 and 1978 respectively and well before Roth IRAs that didn’t appear until 1997 or Roth 401(K)s in 2006. Modern Portfolio Theory, in combination with precise portfolio rebalancing and dollar-cost averaging strategies in accordance to risk profile and investment horizon, is probably the better system for most investors and retirees. It provides a better way to buy high, sell low, and keep taxes low through a withdrawal system based on tax status.

In Conclusion

The 3 Bucket Retirement System has long been a popular and seemingly straightforward investment strategy for retirees looking to protect their funds from market volatility. However, the system’s strict bucket rules can make it challenging to react to changing markets, and rebalancing requirements and implementing a withdrawal system in retirement overcomplicates things.
If you have any concerns or questions about your retirement strategy, please don’t hesitate to contact us to schedule a meeting.

About the Authors

  • Douglas Walters

    Doug is the Managing Partner of Walters Strategic Partners, LLC, a licensed Registered Investment Advisory firm. Doug is a licensed Certified Public Accountant (CPA) in the state of Florida and holds a Series 65 Investment Advisor Representative securities license. He is also a member of the AICPA. With over 28 years of experience as a CPA, he believes investment decisions should be based on decades of peer-reviewed research rather than relying on the latest “hot tip” from media outlets. This empirical evidence puts the science of investing to work for his clients.

  • Jose Joia

    Jose M. Joia is a Wealth Advisor at Walters Strategic Advisors, LLC. As a member of the team, Jose’s responsibilities involve comprehensive wealth management, planning and customer service. He has over 6 years of industry experience specializing in planning and solving unique issues his clients encounter. Jose has experience serving individual clients, business owners and non-profit organizations.