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As more and more baby boomers hit retirement age, and with interest rates at record-low levels, the question is how retirees can generate the income they need to meet their expenses.

I’d like to focus on a popular strategy used by financial advisers: the bucket strategy.

This strategy became mainstreamed after the book Buckets of Money: The UltimateGuide to Income for Life by Ray Lucia became a best-seller. This is not a review of the book. I liked the book and have used a variation of the strategy for my clients for many years. My only issue with Lucia – and reader beware – is that he uses certain investments (annuities and non-traded REITs) that pay huge fees to advisers and are probably not in the best interest of the client.

Conventional Wisdom

Common financial-planning wisdom says that in order to generate your desired retirement income you need to withdraw 4 percent from your portfolio each year. Let’s say that at retirement you have saved $400,000. Taking into account pensions, social security, etc., you need another $16,000 to supplement your income. The common wisdom would say invest 60% of you money in stocks and 40% in bonds, and based on historical data this will generate the needed $16,000. The problem with this strategy is that what may have been true 30 years ago is irrelevant today.

Financial advisers love to trot out data and use fancy computer simulations that say based on decades of data and running over 1,000 simulations, if you follow the allocation mentioned above (60/40) you will have more than enough money to live out your life. The problem is that 30 years ago interest rates were double digits and today they are close to zero.

In addition, these models use an 11% annual return on stocks as a given. We have just been through a 10-year market period that produced a zero return. This means that retirees are drawing down their portfolios as stock prices are very low. Not exactly the time you want to be selling.

Due to today’s investing climate, the old-school conventional wisdom has become very problematic. It’s very questionable whether retirees will be able to achieve their goals by following the old strategy. This has led advisers to look for new ways to help their clients generate the income needed.

Fill Your Buckets

The bucket strategy calls for investors to divide their money into three buckets: a short-term liquid bucket, a slightly higher-yielding mid-term bucket and then a more aggressive long-term bucket. Keep in mind that there are many versions to the strategy.

When starting the strategy take a look at current market conditions and then set up the buckets. Most variations call for each bucket lasting 10 years. Based on current conditions, I would say investors will be better served to cut the first bucket down to five years and add the remaining years to the middle bucket.

Let’s go back to our example based on a $400,000 portfolio and a 65-year-old freshly retired individual. The investor would take $80,000 in the first bucket and invest it in very liquid, very safe investments like CDs, inflation-protected government bonds and highly rated corporate bonds. It would be set up so that each year $16,000 becomes free. Any money left after five years would be transferred to bucket No. 2.

The next bucket would have $240,000 to start with. It again would be invested so that $16,000 comes due every year for the next 15 years. Here a combination of highly rated corporate bonds, hi-yield bonds, international bonds, preferred stocks and government bonds would be used. The extra income generated from these investments should help preserve the value of the money versus inflation and leave over money to be invested in the third bucket.

Bucket No. 3 is the growth bucket. Here you have at least $80,000 that has been invested for 20 years before being tapped. Using a dividend-growth strategy and a mix of international stocks has the potential, over 20 years, to appreciate significantly. A 3.5% annual return will basically double the money ($160,000), and the hope is that after 20 years the market should do better than 3.5%. Even if it doesn’t happen, you will have 10 years of money to draw down. You have now made it to 95 years old.

We should all merit to live 120 years, but for financial planners, making it to 95 is considered a success. This is a very brief synopsis of the strategy, so speak with your adviser to see whether the bucket approach is right for you.

Disclaimer: Past performance is not a reliable indicator of future results. The S&P 500 index measures large-cap stocks and US stock market performance of leading companies in leading industries. An investor can not invest directly in an index.

Source: Retirement Planning With 'Buckets' Of Money