There's a term in French cooking called "mise en place." As any chef will tell you, mise en place is the practice of measuring and organizing your ingredients before you begin preparing a dish. What your chef friend may not know is that there's a similar approach to money management, and it's called bucketing.
For retirees, bucketing is an alternative to the more common systematic withdrawal. The systematic withdrawal approach is exactly what it sounds like: You follow one investment strategy and take regular distributions from your portfolio to cover your living expenses. Many financial planners and independent investors follow this method because it's easy and straightforward.
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Bucketing, on the other hand, involves dividing up your assets into segments based on when you'll need them. Each segment then follows a different investment strategy. Your short-term bucket, for example, would be cash and money market funds -- highly liquid assets that are resistant to value loss. You'd also have intermediate-term and long-term buckets that would be invested more aggressively. You could even have a "never" bucket for assets you'd like to bequeath to your heirs.
Advantages of bucketing
The main reason to pursue a bucketing strategy is to reduce the stress associated with market downturns. Say your near-term bucket is large enough to support you for four years. If the market crashes, you're less likely to panic and feel the compulsion to sell -- because your near-term funds are still intact. You'll see the effects of the crash in your other buckets, but your cash balance will be unaffected. That cushion makes it emotionally easier to ride out the storm.
Under the systematic withdrawal approach, you're liquidating investments every month. There will be times when you sell assets during a downturn and lock in losses. A bucket strategy gives you more flexibility to manage the timing of those liquidations, because you don't need monthly withdrawals from your invested assets.
Disadvantages of bucketing
Bucketing is a more complicated approach, because you have to design and maintain an asset allocation strategy for multiple buckets. That assumes you know how to differentiate between the risk you'll accept in the intermediate term versus the long term. You also take on the job of rebalancing those portfolios periodically. In reality, unless you're working with a savvy financial advisor or you have specialized investment knowledge, the complexity of bucketing often outweighs the advantages.
The other problem with bucketing is that it can lead to lower overall returns. A large cash balance may feel safer, but it doesn't produce the same returns as, say, index funds.
Bucketing to meet financial goals
Though full-blown bucketing isn't for everyone, you can adopt the spirit of this approach to move closer to your financial goals -- whether you're working or retired. And you may naturally be doing this already. For example, if you have a cash emergency fund, that's a bucket of sorts. You keep it in a savings account so it doesn't lose value and it's available whenever you might need it. Another bucket you already have is your retirement account or 401(k). You have these assets invested for the long haul in low-cost mutual funds for higher returns.
You can easily take your bucketing one step further by addressing more granular short- and medium-term goals. Any goal you'd like to realize within the next five years is a nice starting point, because you'd keep that money in cash -- so there's no need for an allocation strategy or rebalancing schedule. You might set up short-term buckets for vacations, holiday gifts, smaller home improvement projects, and even your larger annual bills. Medium-term goals might include saving for a wedding, a home down payment, or a new car. For each goal, you'd budget a monthly deposit based on how quickly you need to grow the balance and how much you can afford to save.
This strategy adds predictability to your finances. Assuming you commit to the monthly deposits, you'll know exactly how long it will take to reach each goal. Saving year-round for your goals also keeps you from dipping into your emergency fund for things that aren't truly emergencies.
There are a few different ways you can keep track of your buckets. You could use one bank account plus a spreadsheet that tracks the funds earmarked for each goal. Or you could open multiple high-yield savings accounts, and use one for each goal -- assuming your bank won't charge you extra fees for those accounts. Lastly, you could find a bank that offers online features to let you define buckets, set target balances, and make automatic contributions. Then, sit back and watch your balances grow.
Remove friction from your finances
Treat your money like ingredients in a recipe. Start with a plan, then measure, organize, and implement. Doing so adds predictability and removes friction from your finances. You'll also make better decisions and have more realistic expectations as a result.
