What happens if the market crashes immediately after you retire? A major downturn during the first few years of retirement can be especially damaging because you still need money to cover your living expenses.
If you are forced to sell investments while the market is down, you are not only locking in losses. You are also reducing the amount of money left in your portfolio to benefit from a future recovery. This is known as sequence of returns risk.
Sequence of returns risk is most dangerous near the beginning of retirement, when your portfolio balance is typically at its highest and preserving your ability to recover matters most. A retirement plan based only on average market returns can overlook this problem because nobody experiences an average sequence of returns. You retire into one specific series of market years, and your plan must be able to withstand the difficult ones as well as the favorable ones.
So, how can you protect your retirement if the market falls significantly during the year you retire?
The solution is not simply choosing better investments. It is creating a retirement withdrawal strategy designed to help prevent you from becoming a forced seller at the bottom of the market. One way to do that is with the three-bucket retirement strategy.
The three-bucket system matches your money with when you expect to spend it. Money you will need soon is kept separate from the investments intended for long-term growth.
Bucket one covers your safe years, generally the first five to seven years of retirement expenses. These funds are held in conservative, stable assets. The purpose of this bucket is not aggressive growth. It is to provide dependable access to the money you may need during the early years of retirement.
Early retirees may need a deeper bucket one than traditional retirees because the years before Social Security and Medicare can require larger withdrawals from their investment portfolio.
Bucket two covers the middle years, usually years eight through fifteen. It is invested for moderate growth and can be used to refill bucket one over time, while still allowing enough time to ride out market volatility.
Bucket three is your long-term money, covering year sixteen and beyond. This portion is invested for growth because it has the most time to recover and continue growing after a market downturn.
The behavior that makes the three-bucket system work is straightforward. During a downturn, you spend from bucket one and leave the growth buckets alone. Bucket one is refilled from the growth buckets only after markets have recovered.
The goal is to sell growth assets when they are up rather than when they are down. This retirement income structure helps remove the forced-sale decision before a market crash occurs.
Building and personalizing a three-bucket retirement plan requires careful attention to two areas: sizing each bucket according to your actual spending and stress-testing the entire plan against the conditions that can disrupt retirement.
Those conditions may include an early market crash, higher-than-expected inflation, rising healthcare costs, living longer than planned and unexpected large expenses. A retirement plan that only works during favorable market conditions is not a complete plan.
Every retirement situation is different, so the size and investment approach for each bucket should reflect your spending needs, retirement timeline, income sources, risk tolerance and overall financial plan.
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