This article continues our series on retirement drawdown strategies, the risks involved, and how to manage them. Previous articles in this series include:
This piece will explore the retirement strategy of bucketing. This is one of the most popular strategies amongst retirees and the financial advisers guiding them.
The bucket strategy is not a strict withdrawal method but rather a way of structuring a portfolio to manage volatility and provide peace of mind. It can be used alongside other drawdown approaches, such as the 4% rule, and aims to reduce the pressure to sell investments at a loss during market downturns. While it does not enhance returns, it plays a key role in addressing the behavioural challenges of retirement investing.
This article will review how the strategy works and the benefits and drawbacks to be aware of.
The Bucket Strategy
The bucket strategy was first developed by financial adviser Harold Evensky in 1985 as an alternative to the systematic drawdown approach. Under systematic drawdown, retirees withdraw a set percentage from all investments in their portfolio, regardless of market conditions. This approach remains common today, particularly in industry super funds, where investments are often held in a single diversified option, such as a balanced fund.
Evensky’s approach introduced a more structured way to manage retirement income. Instead of withdrawing proportionally across all assets, he divided the portfolio into two buckets:
- A cash bucket holding five years’ worth of income to cover short-term spending needs. This is where the retiree’s income is drawn from.
- An investments bucket containing the remaining funds in assets like shares and bonds for long-term returns.
Over time, this strategy evolved into a three-bucket system, which is now the most widely used structure. One for cash, another for shorter term and lower risk investments like bonds and the third for higher risk investments like equities and property.
Bucket 1: Cash
The cash bucket is typically recommended to hold between two and five years’ worth of retirement income. If a retiree needs $100,000 per year from their portfolio, this bucket might contain between $200,000 and $500,000.
The key function of Bucket 1 is to fund ongoing withdrawals without exposing funds to market risk. In a bucket strategy, all withdrawals are made from here, ensuring retirees always have liquid cash available.
It makes sense to maximise the income generated by this portfolio. Generally, this means utilising high interest savings accounts or even incorporating a laddering term deposit strategy. Laddering refers to purchasing multiple term deposits each with a different maturity date that aligns with when withdrawals need to be made from the portfolio. A retiree might structure it as follows:
- Six months of expenses held in pure cash.
- Another six months in a term deposit maturing in six months.
- The remaining balance in a one-year term deposit, rolling over as needed.
Regardless of the exact approach, the primary goal of Bucket 1 is to provide immediate liquidity without needing to sell investments.
Bucket 2: Bonds
The second bucket typically holds five to ten years’ worth of required income. Using the same example of a $100,000 withdrawal, this would mean $500,000 to $1,000,000 allocated to bonds.
The purpose of the bonds bucket is to hold a large portion of the portfolio’s assets in low-risk investments, whilst providing a higher return than cash. The income from these investments is used to replenish Bucket 1, replacing the withdrawals made for living expenses.
Investments in Bucket 2 generally include:
- Government bonds: The safest option, offering predictable returns over the long-term.
- High-quality corporate bonds: Carry slightly more risk but provide better income potential.
The purpose of this bucket is to reduce overall portfolio volatility while producing steady income to top up the cash bucket.
Bucket 3: Shares and Property
The final bucket holds the highest-risk investments, including shares, property funds, and other growth assets. The allocation to this bucket depends on the total portfolio size relative to withdrawal needs.
For example:
- If the portfolio is $1,000,000 and required withdrawals are $100,000 per year, Bucket 3 may be relatively small, with only $300,000 allocated after funding the other two buckets.
- If the portfolio is instead $2,000,000, there is more capacity for risk, and $1,300,000 may be allocated to growth assets.
The investments in this bucket can vary significantly. Some retirees may prefer a simple approach using broad index funds, while others might hold direct shares or actively managed funds. Regardless of the exact mix, these investments have a higher expected return and require a longer holding period to ride out market volatility.
Since most returns from this bucket come from capital growth, it may require periodic selling to replenish the other buckets. The goal is to sell when markets are performing well, avoiding forced sales during downturns.
This bucket is designed for long-term investment (7+ years), with the expectation that its higher returns will help sustain the portfolio over time. By keeping withdrawals separate from this bucket, retirees avoid selling at a loss when markets decline.
Diagram
Rebalancing the Buckets
Over time, the cash bucket will naturally deplete as regular withdrawals are made. While income from the other buckets may help replenish it, this is unlikely to be sufficient on its own. To maintain the strategy, rebalancing is required.
One of the key benefits of the bucket strategy is its flexibility in rebalancing. Rather than selling assets indiscriminately, retirees can adjust based on market conditions:
- During strong equity markets, shares can be trimmed to top up the cash and bond buckets.
- During market downturns, the cash bucket can be purely topped up by the bond bucket, leaving the equities alone to recover.
This approach is supported by the historical inverse relationship between shares and bonds: when one performs well, the other often underperforms. While not always guaranteed, this dynamic can help smooth returns over time.
In theory, a well-structured bucket strategy should remain self-sustaining throughout retirement, provided withdrawals are kept at a reasonable level. The long-term outperformance of equities can help refill the cash bucket and, if needed, restore the bond bucket if it was drawn upon in periods of market volatility.
Benefits & Drawbacks
The bucket strategy is primarily a behavioural approach, not a method for maximising investment returns. It also does not eliminate sequencing risk, as portfolio longevity is still dictated by overall returns.
Drawbacks
A study conducted in 2018 found that the bucket strategy is not the most optimal method for managing retirement drawdowns compared to a static strategy. A static strategy involves holding a diversified portfolio aligned with a set risk profile, where withdrawals are taken proportionally across all assets.
The bucket strategy tends to lag behind a static strategy for two main reasons:
- Lower overall exposure to higher-returning assets: More money is typically held in cash and bonds, which reduces long-term growth potential.
- Less effective rebalancing: Riskier assets are not consistently purchased when they are depressed, missing out on the sharp recoveries.
A static strategy involves regular rebalancing. In strong markets, excess returns from equities are reallocated to bonds and cash. During downturns, safer assets are sold to top up equities, ensuring riskier assets are replenished at lower prices. This improves overall performance once those assets recover – essentially just buying low and selling high.
Since bucketing often fails to follow this strict rebalancing discipline, it may not capture the same benefits. However, if an investor carefully rebalances, strategically selling bonds to buy shares during market downturns, they may recover much of the performance gap.
Another drawback is that bucketing requires ongoing management. Unlike a static strategy, which can be rebalanced automatically when asset allocations drift beyond set thresholds, a bucket strategy requires active decision-making. This can be difficult to do consistently.
Benefits
Despite these drawbacks, the true advantage of bucketing lies in its behavioural benefits. While this might seem trivial, it should not be dismissed.
During a market downturn, it’s easy to point to research showing that a static strategy is mathematically superior. But living through market crashes in retirement is a different story, one that isn’t purely logical.
The bucket strategy proves its worth in periods of high market volatility, primarily due to loss aversion: the psychological tendency to feel the pain of losses more intensely than the satisfaction of equivalent gains.
- In a static strategy, withdrawals are taken proportionally, meaning riskier assets may need to be sold even during downturns.
- In a bucket strategy, retirees can avoid selling depressed assets because they have a dedicated reserve of low-risk funds.
This creates a powerful psychological buffer. Knowing they have 7+ years’ worth of withdrawals covered in cash and bonds allows retirees to feel more comfortable, reducing the risk of panic selling at the worst possible time.
While theoretically suboptimal, the bucket strategy may actually lead to higher realised returns for some retirees. If the added sense of security prevents them from making emotionally driven decisions, such as selling equities in a downturn, the strategy could ultimately improve long-term outcomes.
No matter the strategy, the primary determinant of retirement success is the balance between the income required and the size of the portfolio. This is the challenge that drawdown strategies, such as the 4% rule, are designed to address. The bucket strategy is simply a way of setting up a portfolio for retirement.
Summary
The bucketing strategy primarily manages behavioural risk, but this comes at the cost of long-term returns. Whilst the difference in returns is unlikely to be significant, especially with disciplined rebalancing, it remains a non-optimal portfolio approach from a pure return perspective.
That said, the highest-returning portfolio isn’t necessarily the best if it doesn’t provide enough comfort for someone to enjoy their retirement. If an investor feels more secure knowing they have several years’ worth of income in lower-risk assets, then bucketing may be a suitable trade-off.
Ultimately, finance isn’t just about logic and data, behaviour matters. Even the most mathematically optimal portfolio can be undermined by irrational decisions during market stress.
