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After working hard for years and saving money, retirement should be a time to relax and enjoy life. This is possible with a good financial plan.
Even though you might now be sitting on a nice pot of money, it is still important to manage your finances carefully during retirement. Luckily, there are effective ways to manage your money, and one of them is the bucket strategy.
The main goal in retirement is to ensure you do not run out of money. That means having a blend of growth and income from your investments. But what happens if markets go through a difficult patch?
A key risk is drawing down on your investments when they have fallen in value as that could deplete your pot sooner than you would like. One solution is to divide your money into different parts. Using three buckets helps you see which money will cover distinct stages of your retirement. Each bucket can have investments with different goals, risks, and time frames.
The three-bucket strategy is popular because it is simple to understand. This is not investment advice and there are no guarantees. It is just a method to think about.
Bucket 1: Cash
The first bucket is for living expenses for the next two years. You might consider holding this money in cash or cash-like investments such as money market funds to shield yourself from any sudden downturn in financial markets.
It’s a similar approach to someone who might have invested over five years to buy a first home or pay for their child’s university – the last thing they want is for markets to drop just as they need to access that money so derisking ahead of the event is a natural strategy.
ISAs are ideal for bucket one as you can hold cash and money market funds in them, and you have complete freedom with withdrawals. Dealing accounts are subject to tax once you have used your personal allowances.
Bucket 2: Income
The second bucket focuses on income-generating investments. Having a steady income is important in retirement, so you should check where the money is coming from.
This might include equity income funds that invest in financially strong companies, investment-grade bonds such as those issued by government or financially stable companies, or funds that contain a mixture of high-quality bonds.
These types of investments are not low risk, so the investor needs to be prepared to hold them for a longer period, such as three to seven years. That would allow for enough time to ride out any volatility in financial markets. The cash generated from dividends and bond coupons can feed bucket one.
Bucket: 3 Growth
The third bucket is for growing your money and is for funds you will not need for at least seven years. People are now living for longer so they might find their assets are insufficient at the point of retirement. Growing investments during retirement is often a necessity to avoid running out of money. Inflation is also a crucial factor to consider – you want to maintain the purchasing power of your money if goods and services are a little bit more expensive each year.
It can be comforting to have short-term spending money set aside in a separate bucket. It reduces the temptation of selling investments in the growth bucket during a market downturn. Financial markets regularly move up and down, and patience is paramount.
Because bucket one pays the bills, and bucket two replenishes bucket one, an investor can have a much longer period with assets in bucket three. They might be happy to take slightly higher risks with investment choices and have time to ride out market ups and downs. This does not mean taking big risks, and you might not want to keep growth investments until you die, unless you plan to leave money to others.
Bucket strategy mistakes to avoid
Even though the strategy is easy to understand, it needs careful attention. This means regularly adding to bucket one without keeping too much cash that is not being used. Even though holding three to five years’ worth of cash might feel like a safety blanket, this might be an inefficient use of your money.
That said, think about any substantial changes to your spending needs in the near-term. You might need a new car or a new boiler, which means extra cash versus what you spent in the previous year.
It is also important to keep adding money to bucket two from bucket three. While you want to avoid selling investments from bucket three in a market downturn, there is still a need to periodically transfer funds into bucket two. One method might be to transfer more money when markets are rallying and less when markets are weaker.
Review the buckets every year to make sure the plan is working, you are comfortable with the risks, and your financial needs have not changed a lot.
You might argue that having a portfolio of 60% equities and 40% bonds is already structuring your retirement money into distinct pots with different risk profiles. The equities function as the growth engine while the bonds provide the income. However, separating assets into distinct buckets can be much easier for some people to understand. It is up to individuals to decide which method works for them, or even if they want to use a completely different approach.
Dan Coatsworth: Head of Markets
Dan Coatsworth is AJ Bell's Head of Markets. Dan has been with the company since December 2012 and has more than 18 years' experience in the industry, following the markets and all things investing. He...
