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The Third Bucket; Is 15 Years Long Enough?

I got an e-mail question in response to my last post on The Bucket Strategy. The question was in regard to the length of time a retiree should wait before dipping into the third bucket. I thought the e-mailer had a good question, given the poor equity markets returns since 2000, is 15 years an adequate time period for the equity assets in the third bucket to grow? In this post I will provide some data and my thoughts on this question.

As I stated in my last post, Raymond Lucia’s Bucket Strategy suggests that for the average person retiring at age 65, the safe investments contained in buckets #1 and #2 together should fund about the first 15 years of retirement. This 15 year period is supposed to allow enough time for your equity investments in bucket #3 to grow large enough to fund the rest of your retirement years which, could be another 10, 15, or even 20 years.

Before providing my thoughts on this e-mailer’s question, let me first provide some historical data.

Table 1

I had Table 1 handy so I have reproduced it here. Table 1 shows the percent chance that the S&P 500 index will have negative returns during any time frame indicated in the table from 1929 to 2010. For example let’s take 1 month: According to the return data collected for every month from 1929 to 2010, if you invested in the S&P 500 index in any one month during this period, you would have a 39% chance of having a negative return. If we change our time period to any 12 month period (1 year in Table 1), you would have a 28% chance of having a negative return. But if we change our investing timeframe to any 10-year period from 1929 to 2010, there is only a 6% chance of having a negative return.

The data in Table 1 tells us that, no matter when you start your investment period, the longer time you keep your money invested in equities, then the better your chance of getting a positive return. So, from Table 1, although not a large chance, it is possible to buy and hold equities for a 10-year period and still lose money. But to put this 6% probability in context, the 81 years from 1929 to 2010 contains 71 ten-year periods in which 6% had negative returns. 6% of 71 years translates to about 4 ten-year periods with negative returns. In all probability these 4 ten-year periods began in the years 1929-1930 and 2000-2001, which were the start of the biggest bear markets in the last 100 years. If you can avoid these few years when stocks are obviously overvalued, then your chance of experiencing a negative 10-year return is essentially 0%.

Nevertheless, the data in Table 1 does indicate that, if you are very unlucky, it is possible to invest in US stocks over a 10-year period and lose money. So this tells me if you have a normal retirement period of around 20 to 25 years, buckets #1 and #2 together should be longer than 10 years. And remember, as retirees, we don’t want our bucket #3 to just “not lose money” over a certain time period. Bucket #3 has to grow significantly above the rate of inflation, so when bucket #2 is exhausted, the equity assets are large enough to convert to fixed income assets which will fund the remaining years of retirement.

But Table 1 only shows data for the S&P 500 index for 10 years. Therefore it does not really answer the question: Is 15 years long enough to hold equities and receive equities’ average long term returns?

Table 2 below shows the actual returns for the S&P 500 index between 1950 and 2010 (Table 2 does not include dividends). Even though Table 2 data only covers 60 years, it confirms the data in Table 1 that there are 10-year periods in which it is possible to buy and hold US equities and still have a average annual negative return the worst of which was -5.1%. However, Table 2 also includes S&P 500 return data for 20 year holding periods. Since 1950, if an investor bought and held the S&P 500 index stocks for 20 years, even if he had picked the worst 20-year period; he would still have a positive average annual return of 2.4%.

 S&P 500 Average Annual Returns (1950 to 2010)

Source: Oppenheimer Asset Management Investment Strategy

Table 2

Neither Table 1 nor 2 has a holding period of 15 years. However, we know it is possible to have total negative returns for a 10-year holding period, and that the probably of negative returns with a 20-year holding period is probably zero. Table 2 however does not provide the probability of receiving the minimum average annual return, but we do know from Table 1 that the longer an investor holds equities, the more likely they will receive a positive return. Not only is it more likely that the equity returns will be positive, but the longer time periods also cause equity returns to move closer to their long term averages.

In summary, the data in the above tables would lead me to conclude that, for a 15 year holding period, it is highly likely that my equity investments will be positive. The average annual return would likely be close to the 7.2 % to 7.5% realized in the longer holding periods in Table 2. So in designing my third bucket, I would use the long term average annual return indicated in Table 2, assuming at least a 15-year holding period. I think any retiree using these assumptions to design their third bucket should be safe.

Of course, there is no guarantee that this approach will work out as planned. I would keep close track of the average annual returns of my equity assets in my bucket #3. If equities hit a prolonged difficult period, I would probably adjust my withdrawal amounts from buckets #1 and #2 causing them to last a little longer than the original plan. In a future post I will present some techniques on recognizing when and how to make adjustments to your income withdrawal plan.

One of the biggest considerations when setting up your buckets strategy is how long you will be retired. This is a function of your retirement age and your life expectancy.

For example, if a couple both in good health retire at 70 years old, individually the probability that either the male or female will live to age 90 is about 6% and 14% respectively. On a joint basis the probability that either of the couple will live to 90 years old is about 20%. (NOTE: I estimated these probabilities using a life expectancy calculator available on Vanguard’s site. Click here if you want to try it out.) Despite only a 20% probability of either of the couple living to 90 years old, I think this couple should plan on a 25 year retirement income withdrawal plan. This couple could set up their Bucket #1 and #2 to cover the first 15 years and their bucket #3 would only have to fund 10 years. In this scenario, the equity portion of their retirement assets contained in bucket #3 would only have to be about 30% of their total asset base when they retired at 70 years old. I don’t think this couple will have any trouble with their bucket #3 being able to fund their last ten years of retirement.

However, at the other end of the retirement timeline, a couple retiring at 55 years old, would have a joint probability of 17% of one or the other living to age 95. For me, a 17% chance is high enough that I would plan for a 40 year retirement. This means that each bucket must contain a greater amount of assets to cover the longer retirement time period, especially if this couple does not have a defined employer pension providing lifetime income.  If I were this couple, because of their longer retirement, I would try to have my safe money buckets #1 and #2 be able to provide income for 20 years. This couple would most likely have to dedicate about 40% of their retirement assets to equities for bucket #3, to assure that it will grow large enough to fund the second 20 years of this couple’s 40 year retirement period.

Also it should be remembered that some of the income provided by bucket #1 and #2 is annuity income (e.g., social security). This income will continue after the financial assets in bucket #2 have been exhausted. This means that the equity assets in bucket #3 may not have to cover in real dollars 100% of the income requirement that, perhaps, bucket #1 did when this couple first retired at age 55.

As you can see, when designing your retirement income withdrawal strategy, there are many things to consider and everyone’s situation is different. This is why I would strongly suggest that you read Raymond J. Lucia’s book, Buckets of Money: How to Retire in Comfort and Safety. If you are nearing retirement, I would seek counsel from someone who is experienced at designing retirement income withdrawal strategies.

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