People often assume that what they can afford in retirement should be based on the total assets they’ve accumulated. In some cases, this leads them to structure their portfolios to provide growth rather than income. Many financial advisors use a bucket strategy as part of a comprehensive financial plan. The bucket strategy allocates funds into separate portfolios based on when the money is needed. These buckets then fund everything from short-term emergencies to far-off goals like retirement.
How to Structure the Bucket Strategy
Think of your goals in terms of their time frame. This is when the money needs to be available to finance the goal. Some goals need to be addressed very quickly. Others may not happen for decades. A bucket strategy is the framework to match the time frame of your savings and investments with the time frame of your goals.
There’s a short-term portfolio to fund immediate needs. A mid-term portfolio finances goals a few years (or more) out. And a long-term portfolio is designed to address goals envisioned several years (or decades) away. The shortest time frame portfolio is the most conservative. Longer time frame portfolios may include riskier assets.
Separating the Individual Buckets
Some advisors dissuade people from shortening the time frames of the three buckets. Widening them, however, might be okay. For example, a short-term bucket could be used to finance goals up to five years away, a mid-term bucket could carry you out to 15 years, and a long-term for over 15.
The strategy works the same regardless of the size of each bucket. The strategy is, after all, intended to conform to the needs of your unique situation. But as a rule of thumb, the shorter the time frame, the more conservative investments in the bucket should be. The opposite holds true for the long time frame bucket.
Some investors may maintain a conservative posture in their long time frame bucket because of their risk tolerance or other factors. This exception to the rule may work if you increase the size of the long-term bucket (i.e., put more money into it). This is because more conservative investments (like bonds) typically provide lower returns than riskier investments (like stocks).
The Short-Term Bucket
The short-term bucket is the one you will draw on for daily living expenses. This is the only bucket from which you should actually receive money.
You should invest it very conservatively, in cash or equivalents. The important thing for the assets in the short-term bucket is that they not fluctuate in value. Your living expenses are mostly fixed. So, the investments in this bucket cannot vary in value.
Bear in mind that over time, your fixed living expenses will get more expensive, typically every year. So, your other buckets will have to account for annual spending increases to offset inflation and keep your purchasing power constant.
If you are retired, consider setting an automatic periodic distribution (e.g., monthly) from your short-term bucket into a checking account. You can use this income to cover living expenses and luxuries like travel and entertainment. If you’re still working, then this bucket will be your emergency fund to help pay your regular living expenses if something happens to your income.
The Mid-term Bucket
The mid-term bucket holds investments you will use to finance goals and expenses three to six years out. These investments can be riskier than those in the short-term bucket…but not a great deal riskier.
Some fluctuation in value is acceptable in this bucket, but don’t forget: this money is used to fill your short-term bucket annually. So, you’ll want to avoid excessive fluctuation. It can hold some risky assets – in an attempt to achieve better returns than cash – but the overall mix should still be pretty conservative.
The Long-term Bucket
Your long-term investment bucket can be invested as conservatively or aggressively as your objectives and risk tolerance dictate. The long-term returns this bucket generates will be determined by its mix of assets. So, you should look to an experienced financial advisor for guidance.
This is important because the returns this bucket generates must be sufficient for your assets to last throughout your whole retirement. The most common mistake people make with this bucket isn’t being too aggressive. It’s being too conservative.
Retirement can last 30 years or longer. That’s a long time for investment returns to compound. It is also a long time for inflation to erode purchasing power. Costs could triple or quadruple in that time frame, even if inflation remained modest by historical standards. This is why an asset mix poised for growth is reasonable for this bucket.
But this can change over time. For example, a growth-oriented portfolio may be necessary to get a 40-year-old to retirement. By the time that 40-year-old retires, the portfolio may have to finance living expenses and fund goals for another 30 or more years. But in the ensuing years, the mix can be modified to generate more income and less growth.
Your short-term bucket gets replenished by the two longer-term buckets. So, they need to be manually adjusted to keep the program on track. Some people replenish annually. Others as necessary. They take funds from the long-term bucket to replenish the mid-term, and from the mid-term bucket they replenish the short-term.
To a certain extent, the amount needed to replenish the buckets will be determined by each one’s investment returns. How you spend money over time will have a greater impact. So, focus on what you can control.
Then, replenish each bucket so that it can meet the obligations dictated by your consumption goals over time. For example, the three-year bucket always has three years’ worth of assets.
The Bucket Strategy and Financial Planning
The bucket strategy is very straightforward. You simply match the timing of your investments to the timing of your consumption goals. This is much the same as comprehensive financial planning, which is intended to guide you along the most efficient path to accomplish specific financial objectives.
Planning is a process and there is no better time to start than right now. Victory Capital’s Retirement Planner Calculator can help you with this process. And our Member Service Representatives are available to help you get started.