The Bucket Strategy & Managing Finances in Retirement
Christine Benz, a journalist for Morningstar, has popularized this approach which was created by Harold Evensky
Evensky interview with Benz here https://www.morningstar.com/articles/330323/the-bucket-approach-for-retirement-income
The gist is not to invest any money that you need over the short-term (say two to five years) in higher risk and higher long-term returning but more volatile equities
This is instead put into cash or short-term bonds
That way if you need that money it is quickly available and you can draw on it immediately without crystallizing a loss
How many buckets should you have?
Two is plenty, some suggest more
Periodically review your cash requirements
Rebalancing, selling assets or buying assets, a family emergency… many things could trigger the requirement for a review
How much in the “safe” bucket?
Start by sketching out spending needs on an annual basis
Subtract from that amount any certain, nonportfolio sources of income such as rental income from buy-to-let property, state benefits or pension payments
The amount left over is the starting point for Bucket 1: That’s the amount of annual income Bucket 1 will need to supply
More conservative investors will want to multiply that figure by two to determine their cash holdings
Investors concerned about the opportunity cost of so much cash might consider building a two-part liquidity pool one year of living expenses in true cash and one or more year of living expenses in a slightly higher-yielding alternative holding, such as a short-term bond fund
A retiree might also consider including an emergency fund within Bucket 1 to defray unanticipated expenses such as car repairs, additional healthcare costs, and so on
In the UK you might want to put the “safe” bucket (or part of it) into your ISA as this won’t affect your income tax
The order of drawdown usually achieves the best return if you sell the low-risk assets first (see the explainer on Drawdown Strategies for more)
Topping up the “safe” bucket with sales of the “risky” bucket
If you have no transaction charges (true of many accounts nowadays) then there is no penalty selling small amounts as required
If you have high trading costs have you thought about moving platform?
If there’s no alternative cheaper platform then the tradeoff is
How much does it cost to sell?
What’s the opportunity cost of being in cash?
Say you have £500,000 in your risky bucket and you need to withdraw an additional £10,000 per year to top up your pension income
If your cost of selling & transferring to your “safe” bucket is £10 per trade then how long would it take for the compounded opportunity cost to equal this amount?
Investment amount being transferred (from the risky bucket) is I
Rate of excess return (above cash) is r
Cost of selling & transferring cash to “safe” bucket is c
Time to break even opportunity cost and transaction cost is t
For example if I=£10000 (amount being transferred in this chunk), r=0.06 (6% excess return of equity over cash), c=£10 (cost of selling some equity & transferring to the “safe” bucket) then t = 0.017 years or about 6 days
Another way of seeing this is if you had invested £10,000 at a rate of 6% for 6 days the return would be £10 which exactly equals the transaction cost
If you leave the money in cash longer than six days the opportunity cost which you lose will be greater than the sale and transfer cost
In this case it would make no sense to sell a year’s worth of cash in one go as the opportunity cost would be huge in comparison to the transfer fee (£600 in opportunity cost over one year or 10000×0.06, £10 per transfer)
The more general question of managing your income so your money doesn’t run out is one you can answer only by modelling return on your investments and making an assumption about your personal rate of inflation
You can do this in a spreadsheet
You (or a financial advisor) can also use software like Retire Easy, CashCalc or Voyant
I have made a previous video about Voyant which is available here Creating A Financial Plan With Voyant