Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How to Cut Sequence Risk With a 3-Bucket Strategy
Transcript
- Lucas: So you've saved one point two million dollars, you quit your job at 50, and then the market drops 37 percent in Year One of retirement. That's the nightmare scenario sequence of returns risk and it's the single biggest threat to early retirees who think they've done the math. Luna: And the standard advice is to just ride it out, but that's easy to say when you don't need to pull cash from a shrinking portfolio every month. Lucas: Exactly. Which is why a growing number of financial independence folks are building what's called a three-bucket portfolio. The idea is simple: you split your nest egg into three time-based pools — cash, bonds, and stocks — and you spend from them in a strict order. It's not a new idea. Charles Farrell wrote about it in 2012. But it's been getting a second look because the sequence risk problem isn't going anywhere. Luna: So walk me through the buckets. Where does the cash go? Lucas: Bucket One is immediate cash — enough to cover one to two years of living expenses. We're talking high-yield savings, money market, maybe a short-term CD ladder. This money isn't invested for growth, it's there so you never have to sell stocks or bonds when the market is down. You refill it during good years by selling from Bucket Three. Luna: And Bucket Two? Lucas: Bucket Two is your intermediate safety net — three to five years of expenses in high-quality short- to intermediate-term bonds. Think short-term bond ETFs or a ladder of individual Treasuries. This bucket generates a little yield, maybe three to four percent now, and its job is to refill Bucket One when cash runs low. You draw from it in years when the stock market is down, so you give Bucket Three time to recover. Luna: And Bucket Three is the growth engine — stocks. Lucas: Right. Bucket Three is everything else — 70 to 80 percent of the portfolio, invested in a diversified mix of global equities. Index funds, maybe some REITs if you want real estate exposure. This bucket stays untouched for as long as possible. You only sell from it when the other two buckets are full and the market is up. Over a thirty-year retirement, that's the part that actually grows the portfolio. Luna: I've seen some people argue for a four-bucket system that adds an annuity bucket, but I like the simplicity of three. It's something you can manage yourself without a financial advisor. Lucas: Absolutely. And the key is the refill discipline. Let's say you have a $1.2 million portfolio. You decide on a 4 percent withdrawal rate, so 48 thousand a year. You put 48 thousand — one year's expenses — into a high-yield savings account. That's Bucket One. Then you put three years of expenses — 144 thousand — into a short-term bond ladder. That's Bucket Two. The remaining $1,008,000 goes into a total stock market index fund. Bucket Three. Luna: So you spend from cash first. When that runs out, you refill from bonds. And you only touch stocks after a good year. Lucas: Exactly. Now imagine Year One of retirement is 2022 — stocks down 18 percent, bonds down 13 percent. A traditional retiree who rebalances annually would have to sell stocks at a loss to fund spending. The bucket retiree just spends cash. They don't sell anything. That alone protects them from locking in losses. Luna: And psychologically, I bet it makes a huge difference. You're not checking your 401k every day and panicking. Lucas: That's actually one of the biggest advantages. The bucket strategy is as much behavioral as it is mathematical. When you know you have two years of expenses in cash, you can genuinely ignore the market noise. You don't make emotional decisions. Luna: So how do you decide the exact sizes? One year of cash, three years of bonds — is that a rule of thumb? Lucas: It's a starting point. Some retirees prefer two years of cash and five years of bonds if they're more conservative. The key variable is your comfort with refilling Bucket One. If you're comfortable selling bonds every year, you can keep Bucket One small. If you hate touching bonds, keep more cash. There's no one-size-fits-all. Luna: And when do you sell from Bucket Three to refill the other buckets? Lucas: You do it opportunistically. Let's say the S&P 500 is up 20 percent in a given year. You take your annual withdrawal from Bucket Three — 48 thousand — and use it to top up Bucket One and Bucket Two back to their target levels. That way you're selling when stocks are high. If the market is flat or down, you skip the refill and keep spending from Bucket Two. Luna: So you're effectively timing the market on your withdrawals, but in a disciplined way. Lucas: That's exactly what it is. Disciplined market timing. And because you're forced by the buckets to buy low and sell high — you refill cash after a good year, you avoid selling in a bad year — it naturally reduces sequence risk. One study I saw from Wade Pfau showed that a bucket strategy historically reduced the failure rate — the chance of running out of money over 30 years — by about half compared to a constant-rebalancing approach, given the same withdrawal rate. Luna: Half? That's massive. Lucas: It is. But there's a trade-off. You're keeping a chunk of the portfolio in low-yielding assets. Over a full thirty years, a bucket portfolio can underperform an all-stock portfolio by maybe half a percent a year. You're trading some long-term growth for short-term stability. For early retirees, that trade is usually worth it. Luna: I think for most people, the peace of mind alone is worth the small drag. If it stops them from panic-selling in a 2008 moment, they come out way ahead. Lucas: Exactly. And that's the thing — the math only works if you actually stick to it. A bucket strategy that you abandon after a bad year is worse than no strategy at all. Luna: Speaking of sticking with it — you know, if our money conversations have helped you think about a decision differently, it genuinely means a lot. A couple of dollars a month is what keeps these shows ad-free and independent. Buy me a coffee dot com slash fexingo — if you've gotten something out of them, that's the place. Lucas: Yeah, it's the kind of support that lets us keep digging into topics like this without commercial breaks. Appreciate anyone who's contributed. Luna: Alright, back to buckets. One thing I hear from listeners is they worry about running out of cash during a long bear market. What happens if stocks are down for three years straight? Lucas: That's the stress test. Let's take 2000 to 2003 — the dot-com crash. Stocks fell 49 percent peak to trough over about two and a half years. A bucket retiree starting in 2000 would have spent through Bucket One in the first year, then Bucket Two for the next three years. By 2003, Bucket Two would be empty, but Bucket Three would have taken a hit. At that point you'd be forced to sell stocks at depressed prices to refill cash. That's the real risk — a prolonged downturn. Luna: But in that case, if you had a 4 percent withdrawal rate, you'd still survive, just with a smaller portfolio at the end. Lucas: Right. The Trinity Study showed that a 50-50 stock-bond portfolio had a 95 percent success rate over 30 years at 4 percent. The bucket approach doesn't change the terminal portfolio value much, but it dramatically improves the experience along the way. You avoid selling at the worst possible time. Luna: And I suppose you could adjust the withdrawal rate temporarily. If stocks are down 40 percent, maybe you cut spending by 10 percent to reduce the pressure. Lucas: That's a great point. The bucket strategy works best when combined with flexible spending. If you can trim discretionary expenses in bad years, you extend the life of Bucket Two and give Bucket Three more time to recover. It's the dynamic spending approach that Michael Kitces advocates. Luna: So for someone listening who wants to set this up, what's the first practical step? Lucas: Figure out your annual expenses in retirement. That's the denominator for everything. Then decide your cash reserve — I'd start with one year in a high-yield savings account. Then three years in a short-term bond ETF like BSV or a Treasury ladder. Everything else goes into a total stock market index fund like VTI. That's it. Rebalance only by refilling when stocks are up. Luna: And update the bucket sizes as you get older. A 70-year-old might want a bigger cash buffer than a 50-year-old. Lucas: Exactly. In later retirement, you might shift to two years of cash and four years of bonds. But the core discipline stays the same — spend from cash first, refill from bonds, and only touch stocks in good years. Luna: I think the beauty of this system is that it's simple enough to explain to a spouse or partner. They don't need to understand beta or standard deviation. They just need to know: we spend from this account, and when it's low, we refill it from that account. Lucas: That's a huge advantage. If your partner can execute the plan without you, it's a better plan. Bucket strategies are incredibly spouse-friendly. Luna: So next time the market drops 20 percent, instead of panic-selling, you just look at your cash bucket and say, I've got two years. I'm fine. Lucas: Exactly. And that mindset shift — from reactive to prepared — is worth more than any optimization in withdrawal rate.