The bucket approach and what it does

The bucket approach divides retirement assets by when they will be needed. It is widely recommended and its actual benefit is frequently misdescribed.

The structure

Assets are divided into segments by time horizon.

A near-term bucket holding one to three years of spending in cash and short-term instruments.

A medium-term bucket holding perhaps three to ten years of spending in bonds and conservative assets.

A long-term bucket holding the remainder in equities, intended to be untouched for a decade or more.

Spending comes from the first bucket, which is periodically refilled from the second, which is periodically refilled from the third.

The claimed benefit

The usual explanation is that it protects against having to sell equities during a downturn, thereby addressing sequence risk.

That explanation is partly right and does not survive close analysis on its own terms.

A bucket portfolio with a given overall allocation behaves the same as a single portfolio with the same allocation and periodic rebalancing. Money is fungible, and labelling it does not change returns.

Studies comparing bucket approaches to equivalent rebalanced portfolios generally find little difference in outcomes attributable to the structure itself.

The actual benefit

Which is behavioural, and is worth taking seriously rather than dismissing.

The most common way retirement plans fail is not mathematical. It is that people sell equities during a decline, crystallise losses, and fail to reinvest.

Knowing that several years of spending sit in cash makes that behaviour much less likely. The retiree can look at a falling equity balance and observe that it does not affect next year's grocery money.

If the framework prevents one panic sale over thirty years, it has more than paid for the modest drag from holding extra cash.

That is a legitimate justification and it should be stated honestly rather than dressed up as a mathematical advantage.

The costs

Cash drag. Holding several years of spending in low-yielding instruments reduces expected returns.

The size of this cost depends on prevailing rates. In periods of very low rates it is meaningful; when short-term rates are reasonable it is modest.

Complexity. Three buckets with refill rules is more to manage than one portfolio with an allocation target.

Ambiguity about refilling. The rules for when and how to move money between buckets are frequently unspecified, which is where the approach becomes vague in practice.

Making it work

If adopting it, the refill rules need to be defined in advance.

One common approach is to refill the cash bucket annually from whichever other bucket has performed best, which functions as a rebalancing discipline.

Another is to refill only after positive years and to run the cash bucket down during declines, which is closer to the original rationale.

Whichever is chosen, writing it down before it is needed is what prevents improvisation during a stressful period, which is the entire point of the framework.

The relationship to allocation

Worth being clear about.

The bucket structure implies an overall allocation, and that allocation is what actually determines the risk and return profile.

Someone with three years of cash, seven years of bonds and the rest in equities has a portfolio allocation determined by how many total years of spending the portfolio represents.

For a large portfolio relative to spending, this produces a high equity allocation. For a small one, a very conservative allocation.

That is worth checking, because it may not be the allocation you would have chosen directly.

The simpler alternative

For anyone who finds the structure cumbersome.

A single portfolio with a target allocation, rebalanced annually, with one to two years of spending held in cash.

This achieves most of the behavioural benefit with much less administration, and it makes the actual allocation explicit rather than implied.

Where it suits people best

A note on who benefits most.

The framework tends to help people who find portfolio declines genuinely distressing, and who have previously sold during one.

It tends to add unnecessary complexity for people who are comfortable with an allocation and rebalancing rule and who did not sell during previous declines.

Which suggests choosing on the basis of your own history rather than on the theoretical merits.

Past behaviour during a decline is the most reliable available predictor of future behaviour during one, and it should inform the structure more than any modelling does.

General information only, not financial advice. Past performance does not predict future results — consult a qualified adviser about your own situation.