The Two-Bucket Approach for Retirement Income

At today’s yields, individual bonds can help advisors fund and lock in retirement income for clients for the next five years.

By Scott Stratton

2022 has been a horrific year for retirees and for the 60/40 portfolio. Through September 30, global stocks (ACWI) were down 25.72% and the U.S. bond market (AGG) was down 14.38%. That puts the 60/40 portfolio down 21%, likely its worst nine-month drawdown ever.

In the previous two bear markets diversification helped, with bonds holding their value when stocks dropped. Not so for ‘22. Both stocks and bonds are down a painful amount.

For retirees taking distributions from their portfolio, 2022 is driving home the reality of sequence-of-returns risk. Are their withdrawals sustainable after a 21% hit? Can they keep the same level of income in 2023? Withdrawals from a 60/40 portfolio look OK when we look at the long-term average returns, but 2022 is a big problem. Are there better ways to establish ongoing retirement income from a diversified portfolio?

With interest rates rising to attractive levels, we are buying individual bonds laddered from one to five years in a five-year fixed-income bucket for retirees. We are going to discuss the benefits of the two-bucket approach for helping your retired clients meet their income needs and feel more confident that they can survive current and future bear markets.

Five-year bucket strategy

By buying individual bonds, we match a client’s liabilities or spending needs for the next five years in their five-year bucket. If they need $30,000 a year in withdrawals, we want $30,000 maturing in each of the next five years, for a total of $150,000.

If their RMDs are $70,000 a year, we will target that amount to mature each year and create a total of $350,000 in their five-year bucket. The rest of the portfolio is invested for growth and we call that the long-term bucket.

The benefit to the client is that we have already funded and locked in their income for the next five years. They feel more confident that we will be able to meet their retirement spending needs regardless of what the stock market (or bond market) does today. There are several advantages compared to the more common approach of maintaining a static asset allocation (such as 60/40) and reverse dollar cost averaging by selling assets each year to meet income requirements.

With shorter-duration bonds, investors understand that if their bond is priced at 95 today, the pain of rising interest rates is only temporary. We will hold that bond to maturity and get back to 100. This is more transparent than in bond funds, where the investor may only see the pain of falling bond prices and is not guaranteed to get back to par in a fund.

With the potential for further interest rate hikes from the Federal Reserve, I think clients feel more defensive owning individual bonds than a bond fund. If we bought a bond with a 3% yield to maturity, that will be their return to maturity, even if that return is uneven on an annual basis. Owning a bond fund when you know interest rates will rise feels like a guaranteed loser, at least in the short term.

Even more importantly, having a five-year bucket of bonds means that retirees don’t have to touch their stocks this year. They don’t have to sell in a down market and we can potentially wait out the bear market. Historically, bear markets are three years or less. By not having to sell when stocks are down, we can help mitigate our sequence of returns risk.

Isn’t this just a 75/25 portfolio?

Yes, at any given point in time, the split between the five-year bucket and the long-term bucket may be 75/25, 80/20 or 60/40. The key difference is that we are no longer rebalancing to maintain a static allocation. Rather, we replenish the five-year bucket and buy at the top of the ladder, when the stock market is up. If the stock market is down, we don’t replenish bonds for that year, and we leave the stocks to hopefully rebound the next year.

We also drop dividends and interest into the five-year bucket before reinvesting into stocks. From year to year, the portfolio does not stay fixed at 75/25 or any other number. The asset allocation will vary depending on the returns of the stock market and when we can replenish the five-year bucket. We always take income from the five-year bucket, whereas a static 60/40 portfolio will take each withdrawal 60% from stocks and 40% from bonds.

If your long-term bucket is 100% stocks, and you have a 4% withdrawal rate, your five-year bucket of bonds would be about 20%. And you’d have an 80/20 portfolio for someone entering retirement. This may be more aggressive than some investors would prefer, so it is possible that your long-term bucket may also have alternatives, TIPS, commodities, real estate, preferred stocks, or other diversifying assets. But the key is that we are neither targeting a static asset allocation nor rebalancing on a calendar basis.

In some cases, a client may prefer to increase from five years to seven or 10 years. This will provide an additional cushion to wait out a bear market, while still retaining an overall allocation of at least 60% in stocks.

Is rebalancing overrated?

This brings up the rarely discussed problem with rebalancing. Rebalancing is not guaranteed to improve returns. If you never rebalance a 60/40 portfolio, you will have a higher return over most 30-year periods. After all, the expected return from stocks is higher than bonds. Letting stocks run is likely going to be better than constantly trimming them. And rebalancing frequently (i.e., early) in a bear market actually increases losses, as you buy more of stocks while they continue to plummet.

The more frequently you rebalance, the worse your return when a market is trending in one direction, up or down. And yet, robo-advisors have made rebalancing a key benefit, as if rebalancing quarterly or even monthly is better than rebalancing less frequently such as annually. It’s not true.

Wade Pfau looked at rebalancing a 60/40 portfolio from 1979 to 2018 and found that the more frequently the portfolio was rebalanced, the worse the returns. With quarterly rebalancing, an investment of $10,000 grew to $343,600. With rebalancing every two years, it grew to $385,300. And it grew the most, to $451,300, by never rebalancing:

“The real reason to rebalance is to maintain a target level of risk for a client’s portfolio. This works OK for portfolios in accumulation, and I do rebalance those clients. But for retirees with portfolios in distribution, we have to worry about sequence-of-returns risk.”

Rebalancing is more problematic for portfolios in distribution. If you keep buying stocks as they drop, you are not only magnifying losses, you then have to sell those stocks to meet income. In long bull markets, selling stocks to maintain a 60/40 portfolio cuts your winners early. And, so, for my retired clients, I prefer we invest using the five-year buckets.

A related idea that corroborates the problems with rebalancing portfolios in distribution is the rising equity glide path. It is similar to the bucket strategy in that we sell bonds first to meet income needs and do not rebalance to a fixed target allocation.

Michael Kitces presented compelling evidence for the benefits of the rising equity glide path. However, I’ve never met an advisor (or client) who believes that an 80-year-old retiree wants to be 100% in equities, which is a possible result of taking the rising equity glide path literally. Instead, Kitces notes:

“Ironically, though, perhaps the best way to handle the client psychology aspects of implementing a rising equity glide path strategy is to frame it as a bucket strategy … there’s little doubt in practice that clients mentally respond better to bucket strategies; as a way to frame and explain the strategy, it can be highly effective …”

Buckets can improve client confidence

A five-year bucket does not guarantee that your clients will not have losses, obviously, but the process can help your clients feel better about their retirement income plan. Although traditional finance views money as fungible, behavioral finance recognizes that people may favor the mental accounting bias of segregating money into buckets for different goals.

Setting aside five years of income can give your clients more confidence in being able to wait out a two-to-three-year bear market in stocks. They don’t have to sell stocks that are down 25% this year to meet income needs. And this is not a Jedi mind trick, we are actually managing the portfolio differently by not rebalancing and not taking withdrawals from stocks. So, while the “performance” of a two-bucket portfolio may be the same as a traditional portfolio in any single month or year, clients appreciate the benefits:

  • They already have bonds set aside to fund five years of their spending needs.
  • If bond prices are down, it’s only temporary. They are holding individual bonds to maturity.
  • They don’t need to sell stocks this year to meet withdrawal needs. They can wait until the market is up to replenish their five-year bucket.
  • You are creating a systematic process for trimming stocks and managing their portfolio when stocks are up.

Which bonds are best?

I like to buy A-rated corporate and municipal bonds, although recently, government agency bonds and even CDs and Treasury bonds are also very compelling. Don’t reach for yield with BBB bonds, some of those will become junk and have the potential to default.

If you want inflation protection, consider TIPS or I-Series savings bonds. TIPS are better held in an IRA to avoid phantom income as the inflation adjustment to principal is taxable annually. Don’t forget that existing TIPS can go down in principal if CPI is negative in the future. Only new issue TIPS are guaranteed to not go below your initial investment.

At the start of 2022, 5-year TIPS had a negative 1.5% real yield (your return would be 1.5% less than inflation). Today, that has swung to a positive real yield of 1.7%. And while the Fed is certainly committed to bring inflation down to 2%, a real yield of 1.7% offers a decent hedge that it might take a while to reduce inflation.

Many advisors will not want to use individual bonds because it is more work than an ETF or bond fund. It is harder to use automatic trading or rebalancing tools with individual bonds. You may need to do credit research on the bonds you buy, if you are looking at corporate or municipal bonds.

Unfortunately for those advisors, I think clients appreciate having laddered individual bonds in a five-year bucket. In years like 2022, the traditional approach — selling assets each year to meet withdrawals — is painful and creates doubt about the sustainability of their plan.

Bye-bye Tina

Five-year buckets are not a new concept. Harold Evensky may be credited with the concept going back to 1985. He detailed the approach in “Withdrawal Strategies, A Cash Flow Solution”, chapter 11 of “Retirement Income Redesigned: Master Plans for Distribution.”

While bonds are compelling today, the fact is that it has been challenging to use the bucket approach for much of the last 13 years. Since 2009, global interest rates have been near zero. During that time, you couldn’t build out a five-year ladder that produced more than a percent or two in yield.

And so it was the age of TINA, “There Is No Alternative” to risk assets like stocks. Today things have changed. We can build our five-year ladder with yields of 4% to nearly 6% today. Ask your retired clients if they’d be happy with a 4% to 6% return with low risk, and many will be thrilled. So bye-bye TINA, bonds are back.

Owning your ladder means we have locked in today’s yields to maturity. If yields continue to go up, that’s OK, clients understand we are holding to maturity. If yields are higher next year, we will replenish the top of our ladder with the purchase of new five-year bonds. I think this is preferable to owning a bond index fund, which is down 14% YTD and could be down again next year.

Clients appreciate knowing that their advisor has provided five years of income needs, and has a defined process for how and when they will shift from stocks to bonds. Many will feel more secure with this approach than rebalancing to a static allocation and selling assets when their 60/40 portfolio is down 21%.

Certainly a big part of an advisor’s job should be to improve behavioral outcomes and a two-bucket strategy may help your clients feel more confident about their retirement. You can provide both medium-term income and still have the bulk of assets invested for long-term growth. And keeping clients from selling or giving up when there is a bear market is the guidance they need most.

Scott Stratton, CFP, CFA, is the president of Good Life Wealth Management, a Registered Investment Advisor in Little Rock, Arkansas. He can be reached at

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