Retiring with a bucketing strategy

The time-bucket strategy is a way of managing income during retirement. This is done by dividing the retirement portfolio by time horizons of, for instance, one year, three years and seven years.

Each time-horizon bucket contains different asset allocations, and is constructed with different risk profiles in mind. 

What is the bucket approach to retirement?

For short-term expenses, a retiree will draw down from the first bucket, which should therefore consist of highly liquid assets such as cash, fixed-term deposits, and money market funds. 

Money that is not needed in the near future will then be parked in the longer-term buckets. These will comprise a variety of investment options, ranging from those that are conservative or low-risk — such as fixed-income funds and bonds — to the more aggressive or high-risk holdings, such as equities.

Each bucket’s asset allocation is unique to the individual, depending on considerations including risk tolerance, goals, and the size of the retirement fund. 

Why is the time-bucket strategy useful?

The idea of this approach is to balance the need for a stable income stream with capital growth, and to ensure the longevity of the retirement portfolio.

There are many possible variations to the number of buckets and their time horizons.

Here’s an example of one variation to illustrate how the strategy works.

1. Cash bucket: For use within three years, this bucket contains up to three years’ worth of savings to cover short-term expenses. All are held in either cash or short-term deposits.
2. Defensive bucket: For use in the next three to seven years, the money in this bucket is invested in defensive assets such as bonds.
3. Equity bucket: For use after seven years and beyond, this is invested in assets, particularly stocks, that are expected to grow over the longer term.

After the retiree spends cash from Bucket 1, the assets in Bucket 2 will be sold down in order to replenish Bucket 1. Meanwhile, an equivalent amount of assets from Bucket 3 will be sold down to refill Bucket 2.

While the transfers from buckets are taking place, the stock-heavy Bucket 3 is diminishing in assets, and will eventually become empty or fully drawn down as time passes. The next to be depleted entirely will be the defensive portfolio in Bucket 2.

Eventually, all that is left will be the cash in Bucket 1. That will be closer to the individual’s end of life expectancy.

Another benefit of the time-bucket strategy is that the different asset allocations can be shifted according to changing needs or preferences, if the investor wishes to do so. For instance, cash in the portfolio or from selling bonds can be used to buy stocks. Stocks can also be sold to replenish the cash and buy more bonds. The presence of the cash buffer offers peace of mind during volatile times and allows you to enjoy your retirement.

What are the pitfalls of the bucketing approach in 2022?

The current turbulent economic and market conditions in 2022 so far have posed challenges for most investment and retirement strategies, including the time-bucket concept.

Given the recent market corrections, the medium to long-term components of the bucket system are seeing price declines, although the silver lining is that Bucket 1 is still available for retirees' cash flow needs.

However, if stocks and bonds continue to fall and the long-term components of the retirement portfolio shrink further, retirees may eventually find it difficult to refill their cash reserves in Bucket 1. 

On top of that, with rising inflation, short-term expenses are likely to increase and require greater withdrawals from the cash cushion, while the purchasing power of the money is eroded.

One way to mitigate this is to ensure each bucket’s allocations are well-diversified, such as by holding bonds of varying tenors and grades, or by buying equities that are of higher quality and lower volatility.

In a downturn, retirees may also wish to spend the organically generated income — from bonds in Bucket 2 and dividend-paying shares in Bucket 3, for example — rather than reinvesting them.

Such lean times have led to some individuals making adjustments such as lowering their standard of living, delaying retirement, or taking on more risks in their portfolios.

The aggressive interest rate hikes of late may offer some comfort. As central banks raise rates to tame inflation, that means some bond and cash yields are going up as well.

Previously, ultra-low interest rates in the past two decades had caused the shorter-term buckets to earn minimal income. Loose monetary policy at the height of the Covid-19 pandemic had also pushed rates even lower.

At the end of the day, the time-bucket strategy is a way to diversify and manage a retirement portfolio. Different time buckets carry different levels of risks. 

No matter what you decide to do to combat inflation and low rates during your retirement, it is important to at least have a target asset mix with an overall risk profile that you are comfortable with.

Learn more about how to build passive income here, or get started with Endowus Income Portfolios.

Next on the Endowus Fin.Lit Academy

Read the next article in the curriculum: Prepare for retirement amid higher inflation with the 4% rule

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