Everyone has their own vision of what an ideal retirement looks like. Some of us daydream about traveling the world. Others vow to learn a language, get a degree, or pursue hobbies we never had enough time for when we were working.
However, retirement also may involve a crucial psychological adjustment as you shift from accumulating assets through earned income, investing, and saving to spending that money in retirement. The same strategies, tools, and mindset that allowed you to climb up the mountain and accumulate a decent nest egg may not work when the time comes to climb down that mountain. It is at this point that many retirees and those getting ready to retire start worrying they will run out of money before they pass away. It’s a valid concern for many people, especially in an era where inflation doesn’t ever seem to slow down and the stock market is often in turmoil.
Retirees who’ve worked long and hard to achieve retirement success are often anxious about the best ways to spend down their accounts. On the one hand, they want to be able to have fun in their golden years. Most retired Americans do not want to constantly deprive themselves of things they enjoy out of fear they are spending too much. On the other hand, visions of running out of money too soon keep some retirees in such a constant state of anxiety that they can’t enjoy spending a penny of their money.
When it comes to withdrawal strategies, there are many choices beyond the traditional 4% rule. Just as every retirement is different, withdrawal strategies are not the same for everyone, either.. One popular concept to consider is the “bucket approach,” a drawdown strategy involving organizing your assets into three different “buckets” of money, or separate asset accounts, with each one covering a aspects of your retirement.
What is the “Bucket” approach to strategic spend-down?
A bucket approach allows investors to divide their retirement assets into separate buckets based on different time horizons. Your time horizons can be flexible, as can the number of buckets, but three is a common choice. A basic bucket strategy might look like this:
- Bucket 1: 0-5 years after retirement.
- Bucket 2: 6-10 years
- Bucket 3: 11+ years
Depending on your priorities and preferences, you can adjust these time frames or add additional buckets, especially if you anticipate a long retirement. It’s possible for an average American to now spend over three decades as a retiree. And. the number of centenarians as a percentage of the U.S. population continues to grow, meaning even more people may be enjoying thirty or forty years in retirement.
In addition to the monetary benefits, there’s also a psychological benefit to the bucket approach. Using a bucket strategy can provide investors with greater confidence, knowing they have designated assets and income sources set aside to cover anticipated future expenses. However, even a well-designed bucket plan does not guarantee that you will have enough for the retirement you desire.
How to fill your buckets.
To create the first bucket, calculate your budget for yearly living expenses and then add an emergency fund to cover unanticipated bills, such as medical emergencies. You can invest the different buckets in a mix of assets. Ideally, your objectives for bucket one should be liquidity and low risk. This bucket may include cash, a ladder of CDs, and money market funds.
Depending on your risk tolerance, your second bucket might contain some lower-risk investments, such as bonds, annuities and income-focused equities. This is your “safe money” bucket, providing some growth while buffering other assets against market volatility. Your third might focus on growth assets, since it has the longest time horizon.
By placing specific types of assets in each bucket, you can take on more aggressive investments in your long-term bucket with the risk tolerance to ride out market fluctuations. When you have this type of approach, you minimize the need to sell long-term investments from the third bucket during market downturns because your near-term expenses can be covered with money from bucket one.
What is the sequence of returns risk?
When building your bucket strategy, it’s essential to understand the “sequence of returns risk.” Sequence of returns risk refers to the order and timing of poor investment returns and how they can affect your withdrawals. If your portfolio suffers a significant decline in the initial years of retirement, you might be forced to sell a larger proportion of your investments to cover living expenses. Having to sell off your investments can deplete your funds faster than you anticipated, leaving you with fewer assets for future growth.
To mitigate this risk, your first bucket should contain short-term, low-risk holdings that can cover your expenses without requiring you to tap into your stocks or other investments during market downturns. Ideally, this bucket will have at least a year’s worth of expenses in cash investments and another three to five years’ worth in high-quality cash equivalents, providing a buffer against market volatility.
Could an annuity help “Insure” your retirement and bring you greater peace of mind?
Most people understand the need to have insurance to protect their homes, automobiles, and businesses. However, most of us never consider buying insurance for our retirement plans.
An annuity converts your money into a stream of income that, depending on the options you choose, lasts your entire life and the life of your spouse or beneficiary. An annuity’s payments come from the original investment, earnings, and money from a pool of people in the investors’ group who don’t live as long as forecast. Pooling is a unique feature of annuities. Pooling is what enables the annuity companies to provide guaranteed lifetime income.
When you have a fixed annuity in place, it can act as “insurance” for your retirement blueprint. Knowing that you have a guaranteed income stream that’s not affected by the market’s ups and downs can help alleviate some of your anxiety about running out of income.
Even if you are fortunate enough to have a pension, you may still be worried that potential market instability and the increasing cost of living will eat into your accounts. Having the right kind of annuity in your safe money bucket is one way to lessen your worries when you no longer get a paycheck. Although they are often under-utilized and misunderstood, annuities are worthwhile products with significant benefits, even if you have a private pensions or government retirement account.
Some benefits of using an annuity
- Guaranteed income: Annuities are customizable to meet your specific needs. You can choose a payout for life, a fixed payment over a certain number of years, or even a survivorship benefit for your heirs. This flexibility allows you to address any income shortfall you might face in retirement. For example, if you decide you need $3,500 per month to maintain your lifestyle but are only going to receive $1,000 a month from your government pension, you could use a portion of your pension balance to purchase an annuity that guarantees the remaining $2,500.
- Investment security: With a guaranteed income in place, you can afford to adopt a more aggressive investment strategy with the remaining balance in your retirement accounts. For instance, after purchasing the annuity, you could allocate the remaining funds into a growth portfolio, potentially increasing your overall returns without the stress of market fluctuations impacting your essential income.
- Protection against longevity risk: Research into longevity pooling suggests that many retirees face the risk of outliving their savings. An annuity helps lessen this risk by providing a steady income stream that can last throughout your lifetime, regardless of how long you live.
- Strategic financial planning: An annuity can be part of a more comprehensive, well-rounded retirement plan that addresses both income stability and growth potential. In many instances, such an approach can yield better results than traditional stock-and-bond portfolios, especially in a rapidly changing financial landscape.
Annuities do have a few potential pitfalls:
- Liquidity concerns: A significant downside to annuities is that they can tie up a portion of your savings, making it less accessible in emergencies. Once you commit your funds to an annuity, retrieving them may be challenging if unexpected expenses arise. Some kinds of annuities address this liquidity issue by allowing you to withdraw up to 10% of your account balance, penalty-free.
- Fees and complexity: Some annuities often come with various fees that could impact your account’s performance. Be sure your advisor explains any such fees and helps you your annuity’s terms and conditions before purchasing. Consulting with a qualified advisor will help ensure you’re making informed decisions.
- Inflation risk: Some annuities offer inflation-adjusted payouts, but many do not. If your fixed payments don’t keep pace with inflation, you could face decreased purchasing power over time.
- Market perception: Annuities sometimes carry a stigma as being overly complex or expensive. Some individuals may shy away from them due to misconceptions. However, incorporating annuities into a broader financial strategy can enhance overall returns and stability.
Summing it up:
Supplementing a current retirement portfolio “bucket” with an annuity can give you additional security and peace of mind.
By ensuring you have at least one reliable income stream, an annuity lets you invest your assets more confidently, and perhaps grow your portfolio more significantly. An annuity can help cover essential living expenses or provide emergency funds so you don’t have to dip into your growth assets before you are ready.
If you’re considering adding an annuity, always seek advice from a financial advisor who is trained to help you navigate the spend-down phase of retirement and find the best solutions for your retirement needs.
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