The bucket strategy for investing and drawing down on retirement savings has a lot of fans but there are plenty of detractors too.

Before we get into the objections, we will first discuss the bucket strategy itself.

What is the bucket strategy?

It is a strategy that typically involves three buckets. Each bucket is basically an asset class where you hold your money for a certain amount of time.

Bucket one is typically held in cash or cash like assets and can be for a period from 0 years all the way up to 5 years. The goal is to not lose money.

Bucket two is typically held in bonds for periods of around 3-9 years. The goal is to at least match inflation.

Bucket three is typically held in shares for periods of 10 years plus. The goal is to grow your savings significantly more than inflation.

The point is to have your money allocated in a way that reflects your time horizon (when you need the money). Money needed in the short term is very safe, medium term just a little risk and longer term more risk. The ups and downs of riskier assets don’t matter too much in bucket three as you have plenty of time for prices to recover.

How the bucket strategy works (an example)

Emma and Dave have $400,000 in savings and can also save $1,000 a month moving forward. They are still working and their income covers all their expenses, however they do have some significant short to medium term needs for their money that requires consideration.

They would like $50,000 in an emergency fund, $40,000 for new windows on their house in 2 years and $20,000 for a big trip in 5 years.

Since bucket one is a 0-3 year timeframe and the emergency fund and windows are within that timeframe, then Emma and Dave would reserve $90,000 for bucket one ($50,000 + $40,000). Using the bucket strategy this $90,000 will be kept in cash or cash like products. The emergency fund would need to be easily accessible like an online savings account. The window savings could probably be in a notice saver or term deposit if they know when they are likely to be using that money. Alternatively, if they have a mortgage and a bank that offers offset or revolving credit options, then that would likely be a great option too.

Their final financial goal (travel) is for 5 years time so fits within bucket two timeframe of 3-9 years. Instead of taking $20,000 from their current savings and investing it, I would likely recommend taking the savings for this goal from their monthly savings. This gives the larger amount of $20,000 more time to grow in bucket three. So $20,000 needed in 5 years requires saving around $330 a month. After two years (three years of the goal remaining), Emma and Dave would transfer the money saved so far (around $8,000) to bucket one, and then continue to save $330 a month for another three years, but now in bucket one. Bucket two money typically goes towards government bonds.

Any money not used in buckets one and two can be used in bucket three. This leaves a $310,000 lump sum ($400,000 minus $90,000) and $670 a month ($1,000 minus $330). This money would typically go towards your chosen share funds or your chosen growth assets.  

As income, spending, goals and investment returns change over time, it pays to review your situation once or twice a year and adjust your numbers accordingly. Effectively a rebalance.

Benefits of the bucket strategy

•    It’s really useful in deciding an appropriate asset allocation for your needs. In the example above, $90,000 was in cash and $310,000 in shares. That would mean an initial desired asset allocation of 22.5% in cash and 77.5% in shares.
•    It is comfortable knowing that your short to medium term needs will be met without worrying about market returns. This is because your money is in safer assets. It provides confidence.
•    There is no need to sell shares or growth oriented investments in a down market. Therefore not cashing in a loss. Arguably though, this can be achieved by a regular total return approach that doesn’t use a bucket strategy.

Downsides of the bucket strategy

•    It can be a little time consuming to implement. Not too bad, but maybe a few hours a year.
•    It requires regular review and changes as your situation changes.
•    Some deem it unnecessary. The argument is just to invest 77.5% in shares and 22.5% in bonds (using the example above) and not use buckets. Just rebalance periodically so that you continue to sell the overweight portion (shares or bonds) and buy the underweight portion (shares or bonds). Otherwise known as a total return approach.
•    I find bucket two timeframe is too long a timeframe (3-9 years) to put on government bonds.
•    I also find bucket two not aggressive enough for its timeframe (especially in years 6-9).

Looking at these lists it can seem like the negatives outweigh the positives. Especially when two of the positives are not really positives! The not selling down assets that are down in value can be overcome by just investing without a bucket strategy and regular rebalancing. The rebalance taking money out of assets most susceptible to sequence of returns risk. Also, once you have determined your asset allocation, then there is nothing stopping you from not using the bucket strategy. That only leaves the benefit of feeling comfortable.  

However, I think that benefit can’t be understated. We are not robots and we like our security. Especially around money. Knowing that whatever happens we have that cash cushion is quite something.

For a lot of clients that are risk averse, having this cash cushion actually allows them to invest the rest of their money more aggressively than they would otherwise. So the cash allocation can’t be looked at in isolation as a drag on our returns. For many, it is the cash that allows a lot of people to be more confident to be more aggressive with the rest of their investments.

In saying that, the traditional three bucket approach is not aggressive enough in my opinion. In particular bucket two of 4-9 years in government bonds. Some do address this by only going out to 7 years, but then arguably bucket 3 of 100% shares then becomes too aggressive for an 8 year period.

I use the bucket system for all my clients (accumulation and decumulation) and I have made the following tweaks that I think address a few of the negatives of the strategy.

My recommended bucket strategy

I use four buckets for our own situation and also my clients.

My bucket one is typically the same as the traditional bucket strategy (three years cash) and my bucket four is the same as the traditional bucket strategies bucket three (90-100% shares).

Where it changes though is the middle buckets. To address the fact that bucket two 3-9 year period is a long time and not aggressive enough, I tend to make the following changes:

•    Bucket two (years 4-6): 65% government bonds and 35% shares
•    Bucket three (years 7-9): 30% corporate bonds and 70% shares

This is much more aggressive than 100% government bonds for years 4-9. So why such a big difference?

I like my clients to be well diversified not gambling all their savings on particular shares or niche markets. Most of my clients recommended shares will predominantly be in a diversified international index fund. Of which the U.S makes up a large portion.

There have been 24 S & P 500 (U.S) bear markets in the last 100 years. The average fall from top to bottom lasting almost a year. The longest bear markets lasting almost 3 years. The shortest just a month and a half.

After the market bottom, it has taken an average of just over 2 years for you to recover your losses. Half of all the bear markets break even in less than a year following the market bottom.

The average peak to recovery in total lasting 3 years. The worst 16 years (after the great depression) and the quickest 4 months. The third worst bear market from peak to recovery was 5.5 years.

This gives a pretty good indicator of how long downturns can last and how long it may take to recover your losses.

An average of 3 years is not long at all, and it is these numbers that made me want to be a bit more aggressive with my bucket allocations, than is associated with the traditional bucket strategy.

And these recovery timeframes assume 100% shares too. If your allocation was less towards shares, the time to recovery even shorter as bonds and cash help absorb some of the losses from shares.

This is why I have included shares in the 3-9 year timeframe.

As for the percentages, I have a much lower allocation towards shares for bucket two (4-6 years) than for bucket three (7-9 years). This is due to the fact that 50% of all bear markets take longer than 3 years from peak to recovery. The 65% allocation towards bonds in bucket two helps protect against those worst case instances.  

The 70% allocation towards shares in bucket three reflects the fact there are a small amount of instances where peak to recovery can take longer than 7 years.

You will also notice a change in bond recommendations from bucket two to bucket three. Bucket two is government bonds and bucket three is corporate bonds. Corporate bonds are riskier but also offer higher potential growth. That’s why they are suited for 7 years plus.

Finally, one other difference between my version and more traditional bucket strategies are that buckets two and three have a mix of shares and bonds in each of the buckets. This provides extra flexibility for when you do need to sell down the buckets you look at past returns and current asset allocations and decide whether to withdraw from shares or bonds. This way you don’t have to lock in unnecessary losses. If you do experience losses in both shares and bonds, the timeframes used for the buckets allow you to delay selling until markets have hopefully recovered.

I find this modified bucket strategy removes the downside of not being invested aggressively enough in that 4-9 year timeframe. The trade off for the extra potential portfolio growth and having shares and bonds in the same buckets is that four buckets makes it a little trickier to manage than three.  

One final note on the bucket strategy for those that have mortgages. I don’t see much sense for holding bonds when you have a mortgage. Bonds are predominantly in buckets two and three, which is a 4-9 year timeframe. If you have needs for money in that timeframe it is obviously for a financial goal so you don’t want to be paying down the mortgage with that money. You need that money to be available to spend, not on the house. What you can do though, is put the money against the house. There is a difference between that and paying down the mortgage. Think of products like offset or revolving credit mortgages. You get to keep that money for your goals whilst enjoying the benefit of saving interest on your mortgage. The interest rate often better, and less risky, than what you would get from bonds.

To add a little more complexity for those with mortgages, is that the percentage allocation within each bucket (two and three) will change as mortgage interest rates change. Lower interest rates mean closer to the original recommendations, whereas higher interest rates mean a much higher allocation towards defensive and less towards shares. I tend to follow percentages similar to this:

 
Final thoughts

The bucket strategy can be a little tricky and time consuming at first. But once you have done a couple of rebalances and reviews it isn’t that difficult.

I love the fact that it can give people peace of mind knowing their short term money is very safe and their longer term money is working hard for them, albeit with more risk.

The bucket strategy does have its detractors but I use it as both an asset accumulation and decumulation tool.

I am not a fan of the traditional version. The timeframes are too long and the asset allocation is too conservative. Hence the need to have a modified version.

I can’t think of a better way to decide on an appropriate allocation. Sure, you could ditch the bucket strategy once you have used it to decide on an appropriate asset allocation, but then I think you lose the flexibility of knowing where to invest if you have new goals and how much to withdraw from where when you need the money.

At the end of the day it is all part of the same money. Either in bonds, shares, or cash. But the compartmentalization is worth the extra complexity if it means a clearer vision on why you are doing things and the peace of mind the time segmentation brings, not to mention the confidence to invest in shares when you may not have otherwise.

If you need an investment plan or recommendations , then get in touch today.

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here