What is the bucket strategy?
Bucket strategy was introduced in 1985 by financial planning expert, Harold Evensky. Under this approach, the retirement portfolio is divided into three accounts, which are referred to as buckets. Retirement assets are allocated to each bucket in a predetermined proportion. The risk and returns associated with each bucket are different. While one bucket is responsible for maintaining income stability, other buckets offer growth in investment. This strategy is an amalgamation of security, control, and growth of investment for retirement. The bucket approach is adopted to ensure that -the inflation rate is taken into account at regular intervals. In addition to this, growth in investment is used to fund the lifestyle of the investor upon retirement.
Investment in various buckets
The allocation of funds to various buckets or accounts is done in a manner to ensure a constant supply of income. It also provides the option to make a bulk withdrawal for travel, renovations, etc. In addition to this, a bucket strategy must lead to prevention against investment risk.
While there are several ways in which a bucket concept can be executed, retirement assets are typically divided into three buckets to meet monetary requirements at different stages of life.
This is the short-term bucket. Funds allocated for this bucket are deposited either into a savings bank account or money market mutual funds. This is the liquid component of a bucket strategy. It aims to fund the investor’s day-to-day expenditures for livelihood over the next 2–3 years and weather market instability. Furthermore, the cash bucket is established to fund the monetary requirements that are not covered by other sources of income, like pension or retirement accounts. This segment is not responsible for investment growth, but to prevent disposal of long-term investments to fund short-term expenditures. This bucket must be replenished with earnings from the other two buckets. At any given time, the cash in this account should also be equivalent to the expenditure of the next three years.
2. Fixed-income assets
This is the medium-term bucket. Funds allocated for this bucket are invested in bonds and bond mutual funds like treasury bonds, corporate investment-grade bonds, etc. This component is meant to offer income and stability to the retirement portfolio of the investor. The interest earnings from this bucket are higher than the first bucket. The interest rate can vary between 3% and 5%. Investment in riskier bonds can also earn higher interest.
This is the long-term bucket. Funds allocated for this bucket are invested in the stock market and equities. This component involves maximum risk and, therefore, entails maximum growth anticipations. Conventionally, the stock market has displayed a boost apart from rare circumstances of fall. For example, the S&P 500 stock market index witnessed a surge of nearly 30% in 2019. This, however, was a rare scenario of appreciation. Usually, after accounting for inflation, stocks have an average growth rate of about 7% in the long run. Investors can also witness fluctuations in short-term and medium-term returns from this investment. The primary aim of this segment of the bucket strategy is to prevent the exhaustion of retirement savings. The returns are earned through interest, dividends, and price appreciation. These returns are subsequently used to replenish the cash bucket to ensure income stability.
Once the bucket strategy is executed, annual adjustments are made in every bucket manually. Only the cash bucket is used for withdrawals and is replenished through the fixed-income bucket. A medium-term bucket, in turn, is refilled by the stocks bucket. In this manner, a bucket strategy ensures that through retirement, an investor has a stable inflow of income to meet living expenditure. In addition to this, there are enough investments to ensure that this income stability is maintained through constant returns from these assets.
Suitability of a bucket strategy
A bucket strategy involves the holistic organization of retirement savings. The aim is to handle market volatilities and ensuring that short- to long-term financial objectives are met.
Several reasons make a bucket strategy suitable for attaining pre-retirement and retirement financial stability.
1. Risk aversion
A bucket approach can work as a shield against sequence risk and longevity risk. Sequence risk indicates the risk of lower or even negative returns due to the withdrawal of assets during the initial phase of retirement. This risk gets averted due to investment in fixed-income assets, ensuring constant return. In addition to this, withdrawals are made only from the cash bucket, while the other two buckets are utilized only for replenishing the cash bucket. Longevity risk refers to the risk of running out of savings during the lifetime. With the cash bucket being replenished by the other two, this risk of savings getting exhausted is also avoided.
2. Better financial predictability and clarity
Bucket strategy reduces ambiguity associated with the overall structure of retirement income. The investor has a clear picture of the returns being generated by each bucket for different phases of life. This enhances the predictability and eliminates panic, thereby strengthening confidence in the retirement plan. With a fixed income bucket, there is the certainty of assured inflow of income throughout the life of the investor. This further alleviates the apprehension for market performance.
3. Growth of retirement accounts
The cash bucket ensures that expenses for the first few years of retirement are covered. Thus, the investor is not required to make withdrawals from retirement accounts like a 401(k), traditional individual retirement account, or taxable brokerage account. The funds in these accounts, therefore, continue to grow.
Amid all the above benefits, there are certain concerns associated with the bucket strategy.
- Complexity of setting up
The establishment of the retirement bucket strategy involves certain complexities. There can be a difference in opinions on the number of buckets to be established and the basis of which the buckets should be made. Also, it can be difficult to decide the appropriate investment category for each bucket.
- Management of buckets
It can be a challenge to maintain this strategy. The investments in each bucket have to be periodically modified to ensure the right amount of funds in each bucket. A system must be put in place on the timely replenishment of the accounts. This process can be time-consuming. In addition to this, one must be prepared for investments to go uphill or downhill against the expectations.
- Not for conventional retirees
This approach is not suitable for retirees with low-risk tolerance. The cash bucket grows at a minimal rate. Therefore, investments in other buckets have to be made in riskier instruments. This is necessary for timely and adequate replenishment of the cash bucket.
To sum it up
Every investor needs to establish a strategy to ensure financial security at every phase of life. A bucket strategy can be instrumental in providing this stability. However, establishing and maintaining a bucket strategy can also be a difficult and time-consuming task.