Recently, I wrote about sequencing risks and the danger of a large market fall landing early in retirement, just as you begin drawing an income. Several of you came back asking the obvious follow-up question. If that’s the risk, what actually do you do about it?
This is the answer we most often reach for.
Where it came from
The approach was devised in the 1980s by the American financial strategist Harold Evensky, who is fairly regarded as the father of the bucket strategy. I had the pleasure of meeting Harold at the United States Financial Planning Association conference in Orlando in 2004, where he set out his work in detail to attendees.
It is worth remembering the world he was writing for. In 1981 the average interest rate on a 12-month term deposit was around 13% per annum, and prices for everything were markedly cheaper than they are today. That was high enough for many retirees to enjoy a comfortable lifestyle without ever needing to risk their capital or draw it down. As recently as 1989, some superannuation funds here were offering capital guaranteed options paying around 17%.
That world is gone. With interest rates far lower, investors approaching retirement are understandably nervous about how much they need to have accumulated, recognising that some of that capital will need to be drawn down alongside the income it earns.
Risk in plain view
In Australia, many retirees remain fixated on income-centric models. That fixation pushes them towards riskier securities: the banks, and whichever stock happens to be the market darling of the moment. Fundamentally they are running a high-risk strategy without recognising it as one. We call this ‘risk in plain view’.
The bucketing strategy offers an alternative, grounded in a simple but potent principle: Money needed for imminent expenses should stay in cash. Money set aside for the more distant future can be diversified across longer-term investments.
That immediate cash reservoir is what gives you the cushion to ride out volatility everywhere else in the portfolio.
The Three Buckets
The strategy works for both superannuation and non-superannuation portfolios. Investment monies are structured into three pools of capital.
- Bucket One — short term, one to three years. Cash and term deposits, holding two to three years of income needs. This is what pays your pension payments, your fees and any ad-hoc withdrawals. It is the bucket you actually live on.
- Bucket Two — medium term, three to five years. A diversified pool of cash, government bonds, credit securities, Australian and global shares and property securities. Generally 50–60% growth assets, with the emphasis on income first and capital growth second. It holds the majority of portfolio capital, and its job is to fund Bucket One’s future years.
- Bucket Three — long term, five to ten years. Growth assets only, typically 90–100% growth. This is the bucket responsible for out-earning inflation over the long haul. It is also the bucket you leave alone.
Why it works
The key to bucketing is being able to target income from the short-term bucket while leaving the medium and long-term buckets untouched in times of market stress.
Consider the alternative. A retiree drawing a fixed dollar pension from a portfolio invested entirely in volatile securities experiences the exact opposite of the dollar-cost averaging that worked in their favour during the accumulation years. They are selling as prices fall. At lower prices they must sell more units simply to meet the same pension obligation. Once those units are gone, a smaller portfolio carries a heavier burden to recover.
This is the position many people find themselves in with unitised solutions delivered through a single balanced managed fund. When everything sits in one pool, there is no way to choose what you sell.
Large losses early in the retirement journey must be avoided, or the risk at least mitigated. A major loss in the first years of retirement can be irrecoverable.
The annual rebalance
Once a year, the buckets are rebalanced, with the objective of starting the new year with Bucket One restored to its two to three year target.
The first step is to look at the returns in Buckets Two and Three. There are three possible outcomes, and each has a rule:
- Both positive — draw from both to top up Bucket One.
- One positive, one negative — draw only from the positive bucket. The negative one is left alone.
- Both negative — leave both untouched and spend from Bucket One.
That third scenario is precisely why Bucket One is set up with two to three years of income in the first place. It buys the time to let markets recover before you have to sell anything.
If Bucket One has still not been restored to its target, equal amounts are drawn from Buckets Two and Three regardless of their returns.
What it asks of you
None of this is passive. Setting the strategy up and maintaining it demands attention and discipline.
Deciding how much sits in each bucket, and the asset mix within each, requires careful thought. The rebalancing rules have to be set in advance, and then actually followed, including in the years when following them feels uncomfortable.
There is also a trap on the conservative side. Hold too much in Buckets One and Two relative to Bucket Three, and the growth bucket won’t out-earn the withdrawals once inflation is accounted for. The result is income that quietly declines in real terms as you age. Being too cautious has a cost, even if it is a slower one.
Where to from here
Markets have run up to historic levels in recent years, cycles appear to be turning over faster, and volatility has been both increased and sustained. Against that backdrop, we believe this mitigates risk and provides genuine peace of mind, while also holding a reserve of capital ready to take advantage of opportunities when they appear.
We have detailed subject matter reading available on this strategy for anyone who wants to go deeper. Please feel free to reach out to us at enquiries@futuregen.solutions.
If you are approaching retirement, or already drawing an income from your superannuation or investment portfolios, I would encourage you to speak with us and have your position appraised.