The Bucket Approach to Managing Retirement Income

Most retirees who have their savings in a living annuity or discretionary investment portfolio need exposure to high-growth assets such as listed shares (equities) to boost returns, which means taking on a higher degree of investment risk. This risk needs to be managed, one way or another.

In previous articles (‘What is the ‘4% rule’ for retirement income?’ and ‘Is the 4% rule useful for South African retirees?’)we looked at the ‘4% rule”, which states that, in a portfolio roughly half in bonds and half in equities, withdrawing 4% of capital in the first year and subsequently increasing that rand amount by inflation each year will see you through virtually any market conditions for at least 30 years, based on historical data.

Under this scenario, you can enjoy a stress-free retirement with a steady income. The portfolio must be rebalanced from time to time to maintain the asset allocation.

However, retirees requiring more than an initial 4% need a higher exposure to equities and thus have to manage their drawdowns and portfolios more actively if they want their savings to last the distance.

One method is to apportion your savings to different “buckets” for shorter and longer-term savings, with varying degrees of equity exposure and liquidity. (Note that this strategy should not be confused with the “two-bucket system” introduced by the National Treasury for pre-retirement savings.)

Christine Benz, director of personal finance and retirement planning at Morningstar, is an advocate of this strategy. “The bucket approach to retirement-portfolio management, pioneered by financial-planning guru Harold Evensky, is anchored on the basic premise that assets needed to fund near-term living expenses ought to remain in cash. Assets that won’t be needed for several years or more can be parked in a diversified pool of long-term holdings, with the cash buffer providing the peace of mind to ride out periodic downturns in the long-term portfolio,” Benz says.

A favoured approach is to have three buckets – for short-, medium- and long-term savings.

Short-term bucket

This is the bucket from which you draw your income. It is a virtually risk-free investment in a bank account or money-market unit trust fund with enough savings to provide income for one to two years and possibly an added amount for emergency expenses. It is topped up periodically by the medium-term bucket.

Medium-term bucket

This bucket contains about five years’ worth of income (some experts suggest more, some less) in a low- to medium-risk portfolio, with a high percentage of bonds and some exposure to less-volatile equities such as defensive stocks. The portfolio would typically resemble a low-equity multi-asset unit trust fund. This bucket is topped up by the long-term bucket when the markets are performing well, but is allowed to deplete when markets drop, providing a cushion for market volatility.

Long-term bucket

This contains the remainder of your savings and generates most of your returns. It is primarily in high-growth assets and would likely fit the profile of a high-equity multi-asset fund. It tops up the medium-term bucket in good times, but is allowed to recover after a market crash.

Pros and cons of the bucket approach

Investment experts and financial planners are divided on the merits of the bucket approach, with some arguing that the full capital amount can be more easily managed in a single diversified portfolio with similar overall asset allocation, with much the same results.

They more readily agree on the psychological advantages for the investor of separating income-producing investments from return-generating investments. Advocates of the approach say there is a real difference between the single-portfolio and bucket strategies in practice: the bucket strategy often makes retirees more comfortable in taking on risk in the long-term portfolio and less likely to panic in times of market turmoil.