Final answer:
The three-year bucket approach in retirement offers protection against sequence of return risk by allocating savings across short-term, medium-term, and long-term buckets to prevent selling investments at a loss during market downturns.
Step-by-step explanation:
The three-year bucket approach in retirement planning offers a measure of protection against a) sequence of return risk. This approach involves dividing retirement savings into three portions (or "buckets"): one for short-term needs, one for medium-term needs, and one for long-term needs. The idea is to have cash or cash equivalents available in the short-term bucket to cover immediate expenses without having to sell investments at a potential loss if the market is down.
By doing so, this strategy helps mitigate the risk that the order or sequence of investment returns could negatively impact the longevity of a retiree's savings. Adverse market conditions early in retirement can significantly affect the overall portfolio balance if withdrawals are made from a diminishing pool. However, with the bucket strategy, retirees can avoid or minimize the need to withdraw from investments that have temporarily decreased in value, thus preserving their portfolio for longer.