How does the bucket approach work?

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Q. I’m planning for retirement and I’ve heard about the bucket approach to allocating my savings. How exactly does that work?

A. The bucket approach is one way to separate your money for different time frames.

The idea is that you can set up a bucket for short-term, medium-term and long-term time frames, and that will make it easier for you to decide on the correct asset allocation for each.

It will also give you some breathing room so you won’t have to sell investments at a loss when you need the money, said Jerry Lynch, a certified financial planner with JFL Total Wealth Management in Boonton.

He said Bucket One would be your short-term bucket.

“It focuses on the cash flow that you need for the next three to five years,” he said. “Generally it will include cash, CDs, money market accounts and other short duration conservative investments designed to make sure we have cash to pay expenses over the next three to five years.”

He gave this example: Let’s say you have expenses of $50,000 a year, and Social Security benefits of $35,000 a year. He’s recommend putting $75,000 — enough to cover $15,000 a year — in this bucket. That means you’ll have the money you need for your expenses for five years no matter what the stock market does.

Bucket Two is designed for five to ten years in the future, and he recommends you invest this rather conservatively, with maybe 40 percent of the bucket in stocks.

” This is designed for conservative growth without too much downside,” he said. “If you have a few good years, we take some money from the account and refill Bucket One to protect the cash flow.”

In a word? Rebalance.

Bucket Three is designed for more than 10 years into the future, and he’d recommend a 60 percent stock allocation.

“This is a longer term bucket that is going to be much more volatile and over time should produce greater returns,” he said. “If we have a few years of higher returns, we take part and use it to refill Bucket Two.”

Lynch said the bucket approach protects your cash flow, which is the most important issue for a retiree.

“In 2008, most retirees were like deer in the headlights with the exception of people with pensions, annuities and Social Security benefits,” he said.

He said if your portfolio is down 30 percent and you haven’t structured your portfolio with buckets, you’ll be forced to sell at a loss.

The strategy will also help you make more rational decisions with your money, Lynch said.

“If your cash flow is protected, you do not have to make rash decisions,” he said. “I think it is a great way to allow your money to go through business cycles, allowing your money to get reasonable returns, while protecting your cash flow.”

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NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.