How a 3-Bucket Strategy Can Help Optimise Retirement Income

Retiring soon and wondering how to structure your investments? There are a range of strategies you can follow, from maintaining your existing approach to shifting into a new strategy. One approach investors use is known as the 3-bucket strategy. 

The 3-bucket strategy is a behavioural approach that breaks a portfolio into investments for specific time frames to help manage different aspects of retirement. It was first proposed by financial adviser and professor Harold Evensky in 1985. 

What makes it appealing to many investors is the ability to manage your own concerns about having liquidity now for your income, as well as continuing to invest for long-term growth to avoid longevity and inflation risks (i.e. the risks that you outlive your finances or that inflation chews up your income). It isn’t necessarily the right approach for everyone, but can provide a measure of comfort during volatile market periods for investors. Here’s how it works. 

The Basics: The 3-Bucket Strategy 

The 3-Bucket strategy divides your investments into three buckets focused on short, medium and long-term investing.

• Bucket 1 – also known as the Cash bucket: Investments with less than three years’ time horizons, typically cash and short-term deposits. It can contain up to five years’ worth of savings that can be used in market downturns rather than needing to sell other assets at a loss. Withdrawals would typically be made from here to avoid selling down other assets. 
  
  
• Bucket 2 – the Defensive or Bonds bucket: Investments with a three-to-seven-year time horizon and typically defensive assets like fixed income or bonds. The aim is for this to represent around five to 10 years’ worth of income. The aim is for income generated by the investments in this bucket to reach the cash bucket and manage volatility in the portfolio over time. 
  
  
• Bucket 3 – the Equity or Growth bucket: Investments expected to grow in value over the longer term (seven years+), such as equities and other alternative assets. 
  
  

Calculating how much to place in each bucket 

Morningstar suggests approaching your allocation by starting with your expected annual spending, less any income outside of your investments like the pension. That amount is what you’ll need as a minimum in bucket 1, but you may want to buffer that by multiplying it out a few years, or considering an amount for emergencies within that. 

For bucket two, you are allocating around five years’ worth of income. While the traditional version of the bucket strategy focuses on bonds, Morningstar suggests a mix of bonds alongside high-quality dividend-paying equities. 

The third bucket is the highest-risk portion of the portfolio and should be actively managed to maintain your strategy, and ensure income distributions move into the other buckets over time. 

An alternative way of calculating is proposed by Peak Financial Planning, which suggests that the first bucket include five years of cash with the remaining funds after that directed 40% to bucket 2 and 60% to bucket 3.  

Pros and Cons of the 3-Bucket Strategy 

Some of the advantages of this strategy include: 

• Access to liquidity during periods of market volatility without necessarily needing to sell down long-term growth assets. This can help with sequencing risk (where market volatility earlier in retirement can have a worse effect on your retirement and affect your investments compared to later.) 
  
  
• From a behavioural perspective, it can appear more predictable, stable and documented to give some peace of mind. This can also take some emotional decisions out of the mix in periods of market uncertainty. 
  
  
• Can appear simpler to organise and operate. 
  
  

Some of the disadvantages of this approach can include: 

• The prospect of missing out on growth because this is a largely conservative investment approach. One study by Javier Estrada in 2018 suggested static strategies rather than bucket strategies outperformed over the longer term.
  
  
• It can be difficult to accurately estimate life expenses.
  
  
• Bucketing often misses regular rebalancing which means it can vary from your strategy, and you can miss out on the advantages of dollar-cost averaging. Investors need to be actively involved in decision-making. 
  
  
  

‘New’ versions of the 3-Bucket Strategy 

Different market conditions have put the 3-Bucket Strategy under pressure – for example, the decade after the Global Financial Crisis when interest rates were at record lows and it was a struggle for investors to generate the income they needed to offset inflation. 

In light of this, some experts have adjusted  the strategy to work better for their needs.  

One option is to ‘ladder’ investments in each of the buckets to manage different points at which income is required, while managing different market risks. You can read more about income laddering here.  

Schroders suggested breaking Bucket 1, the cash bucket into two, with one bucket for immediate income needs (covering up to the next 12 months) and the second bucket for the following years – a ‘later’ bucket, also dubbed as an ‘absolute return’ bucket. In the immediate bucket, you may use cash investments and short-term deposits, while in the later bucket, you may use higher-income instruments with slightly higher risk levels and timeframes, such as investment grade corporate bonds.  

Morningstar’s Christine Benz suggests adding an additional discretionary bucket to the original three. This one would include assets that aren’t necessarily held in the other buckets and could go towards key longer-term needs, such as aged care or other goals like travel or charitable giving. The aim would be to not deplete this bucket unless for that specific purpose – but also to avoid needing to dip too much into your other buckets for this particular goal. It is individual-specific and Benz notes that it should be carved out as separate from the broader retirement spending portfolio. 

Bucketing and Retirement 

For some investors, using a bucket approach, be it the traditional form or adjusted to work for individual needs, can be a simple and effective approach to retirement investing. 

It is a conservative strategy so investors should bear in mind that it may not actually be the ideal approach for their overall needs, goals and circumstances in retirement. It also requires active ongoing management to ensure that each bucket continues to meet strategic needs. 

When it comes to retirement, planning is always key – talking to an expert can help match you with the right investment strategy, be it bucketing, a static strategy or another approach. 

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.