Why a bucket strategy might be destroying your retirement

The Bucket Strategy (TL;DR)

The bucket strategy for retirement investing divides portfolios into time-based segments (cash, medium-term bonds, long-term growth assets) in an attempt to avoid selling during market downturns. 

However, this approach is fundamentally flawed as it involves market timing decisions about when to replenish buckets, prevents taking advantage of buying opportunities during market declines, and causes portfolio risk allocation to drift over time. 

As retirees spend down their portfolios, defensive allocations increase inappropriately when growth assets should maintain higher weightings.

A superior risk-based allocation approach maintains consistent asset allocation through regular rebalancing, delivering better long-term retirement income outcomes.

The Bucket Strategy (why you should avoid it)

The bucket strategy is an investment approach for retirement where the investor splits their portfolio into either two or three buckets and invests each in a different way.

It is sold as a way to reap the rewards of higher returns, without jeopardising your ability to meet shorter-term expenses. Tantalisingly, it claims to allow you to avoid selling growth-oriented investments to cover expenses in what could be unfavourable market conditions.

What’s not to like?

It looks like a way to have the best of both worlds – the returns of risky assets, without the downside that you might have to sell during a downturn to pay your bills.

However, reality is much different.

Implementing a bucket strategy

A three-bucket approach would have a cash bucket containing immediate needs – perhaps two to three years spending; a medium-term bucket invested in bonds, gold, or other conservative assets for the next 3 to 5 years spending and the balance allocated to growth assets (shares, real estate, and infrastructure) for longer term spending and to provide for any planned bequests for your heirs or favourite charity.

This means that with a portfolio of $1,000,000 and planned annual spending of $50,000 you would allocate $150,000 (3 years) to bucket #1, $250,000 (5 years) to bucket #2, and $600,000 to bucket #3. Overall, this delivers a 60% growth/40% defensive portfolio which is a typical retirement portfolio.

By varying the time periods in each bucket, you can create a portfolio that (initially) aligns with any risk profile.

Spending is then funded from the cash bucket in the first instance. The cash bucket is then topped up by transfers from the other two buckets. But if there is a market decline that reduces the value the assets in the growth bucket, the top up is deferred until the market recovers. As a result, you are not selling assets when the market is down.

Over time, as the total value of your portfolio declines due to spending, the proportion of your portfolio allocated to buckets one and two will increase. This is because bucket #3 is simply what is left over after providing for the coming five years’ spending.

The bucket strategy is in effect a time-based allocation.

The better alternative

The alternative is a risk-based allocation where your asset allocation is chosen based on your risk profile. Withdrawals also come from the cash account under this method. But then the portfolio is periodically rebalanced back to the target asset allocation.

For a 60/40 risk profile, the starting portfolio would be identical to the three-bucket strategy described above – that is 15% cash, 25% gold, bonds, and other defensive assets and 60% growth assets (shares, real estate, and infrastructure).

The key difference is that after the withdrawal from the cash account to pay for current spending, the portfolio is rebalanced. This is usually done at fixed intervals – quarterly or annually rather than after each withdrawal to avoid excessive trading costs.

If growth assets have returned more than cash or bonds (as they would do in most years), the portfolio will be over allocated to this category and so will be sold down to add to the cash and defensive categories and bring the risk in the portfolio back to target. In a down market, the value of the growth assets will decline, meaning the portion allocated to cash and defensive will be higher than target, so some of the cash will be used to buy more growth assets. In a year (2022 for example) where both bond and share markets declined, cash will be used to buy both asset classes and again return the portfolio to its chosen risk setting.

This means that the risk profile of the portfolio remains constant over time.

This strategy is in effect a risk-based allocation.

Why the bucket strategy is sub optimal

Its market timing in disguise

Retirees using the bucket strategy must choose when to replenish the cash or medium-term buckets as they get depleted through spending. The sales pitch is that investors can avoid doing so during market declines. However, the investor must make a call as to when to do this. How is the investor to know when the market has bottomed? It could fall materially after the initial fall and part recovery (a so-called dead cat bounce). This is market timing and the evidence shows that investors cannot consistently make these calls correctly.

If you doubt this – ask yourself when you would have replenished your cash bucket during the GFC. 

In price terms the ASX200 (as represented by the SPDR AS200 ETF) took until 2020 (just prior to the COVID decline) to recover its peak achieved in November 2007. Many would have capitulated after 16 months of decline (when their 2-year cash bucket was almost fully depleted) and sold close to the low in early 2009.

You don’t take advantage of market declines to buy assets cheaply

In the bucket strategy there is no scope for funds to move up the risk curve – it is always from high risk to lower risk to replenish the short- and medium-term buckets. In contrast, the risk-based approach will buy lower priced higher risk assets during market declines. This means the risk-based investor would have been buying the ASX200 at lower prices in 2008 and 2009 while the bucket investor would have been sitting on the sidelines wondering when to sell equities to replenish their cash bucket.

Your portfolio risk (asset allocation) will vary from time to time

Asset allocation – that is the spread of your investments between cash, bonds, gold, shares, real estate, and infrastructure is responsible for 90% of the risk and return in a portfolio. The risk-based approach ensures that this remains constant in line with your risk profile. This is how you maximise long term returns for any level of risk you can tolerate.

In the bucket approach, the risk will fall when growth assets decline (when low valuations make growth assets less risky) and increase when growth assets boom (and valuations make growth assets riskier). This is the opposite of what portfolio construction best practice would suggest.

Your portfolio risk will decline over time

Over your retirement as you spend down your portfolio, a year’s spending will represent a growing proportion of your portfolio. By the time you have spent half of your nest egg, perhaps 15 years into retirement, your 3-year cash bucket now represents 30% of your portfolio instead of the more reasonable 15% at commencement. Your overall portfolio would then be 80% defensive and incapable of delivering long term inflation linked income at the same level of certainty.

This at a time when your age pension entitlement is likely to represent a higher portion of your income and net assets. The growing importance of your age pension entitlement should enable you to raise the level of risk in your portfolio.

Implications for your retirement

These are not technical niceties, they have a material impact on the sustainable level of income that you can generate from your portfolio. By adopting a (time based) bucket strategy, you will almost certainly have a lower retirement income, leave a smaller bequest or be forced to start retirement with a higher balance.