Can a bucket strategy carry you through retirement?

Few financial tasks warrant more attention and consideration than turning your retirement portfolio into a lifelong income. Nobel laureate William F. Sharpe once described it as the “nastiest, hardest problem in finance” for good reason.

Unless you’ve got sufficient income from guaranteed sources like the state pension, annuities or defined benefit (DB) pensions, you’ll need to invest your defined contribution (DC) pot wisely and withdraw prudently to maintain your lifestyle throughout retirement.

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The chief attractions of income drawdown, as it’s known, are that you retain flexibility over how the pot is accessed and unspent savings can pass to loved ones (although there might be some tax to pay). On the flip side, it does require you to manage and monitor several risks. Unknown future variables such as stock market performance, inflation, and interest rates must all be safely navigated over a period that could span several decades.

One way to scale this heady challenge is to use a bucket strategy. The idea is that you chunk your portfolio, which may also include other tax wrappers like individual savings accounts (ISA), into different parts - usually three but you could use more or fewer. 

For buckets needed for shorter-term spend, risk is dialled down, offering security and certainty. For distant expenditure, as you have time to ride out market ups and downs, you can afford a more aggressive approach.

Before we explore how a bucket strategy might work in practice, it’s helpful to flag a key threat to the durability of your retirement pot that the tactic seeks to mitigate.

Why the assets you sell to provide income matter

Sequencing of returns can have a punishing effect on your savings if not kept in check, and it’s a risk that’s most acute during your early retirement years.

Also known as sequencing risk, it refers to how the timing of portfolio withdrawals can have a marked impact on the overall rate of return. For instance, during a market slump, you’ll need to encash more share units to generate the same level of income, leaving fewer units in the pot to benefit once stock prices rebound. This can potentially reduce the lifespan of your equity holdings, a risk that’s greater when you first start to draw from your pot as it could have 25 years or more left to run.

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This is where segmenting your retirement portfolio into several buckets can help. The long and short is that if you have an adequate pot of less volatile assets to cover near-term expenditure, you can leave the share portion of your portfolio untouched amid rocky market conditions, protecting it from being ravaged too soon.

What could these buckets look like?

There’s no set rule to devising a bucket strategy; it can be aligned with your personal income goals and attitude to risk. The typical structure is to split into three parts, although you could adopt more or perhaps fewer. 

Equally, it could solely comprise a self-invested personal pension (SIPP), or include several products like ISAs, general investing accounts (GIA), and investment bonds - essentially any assets you plan to use to meet retirement outgoings.

Bucket one: security and certainty (cover two to three years’ spending)

Due to the short-term need for these funds and low capacity for loss, it should be stashed in cash or cash-like assets (like money market funds). While returns may be low and the holdings are vulnerable to inflation, you gain the comfort that the nominal value is shielded from the throes of the market. You may wish to add a bit on top of merely multiplying your annual expected spend by three to allow for cost-of-living increases.

A starting point here is to flesh out how much income you’ll need every year to meet expenses above guaranteed income sources and work out how many years you’d like to cater for.

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Adopters of bucket strategies normally seek to cover around three years’ outgoings, but the choice is up to you. You may also want to include some extra cash to fund any big-ticket purchases you plan to make soon.

Bucket two: income generation (cover spending from years four to seven)

Because you have a bit more time on your side, you can afford to invest in things that offer better potential to beat inflation, without being too adventurous. The aim is to combine growth with income, which might include certain equity income funds and fixed-interest assets, such as gilts and certain corporate bonds. Multi-asset funds, that invest in a mixture of shares and bonds, are a further option. If you’re conservative by nature, you may wish to expand covering spending from year seven to perhaps year 10.

One tactic is to feed income payments into bucket one to replenish any amounts drawn to meet immediate spend, keeping the holdings topped up.

You could, of course, distribute income from bucket two to your bank account and use it to pay for today’s expenses. The drawback here is that investment yields can rise or fall, leading to inconsistent distributions, which could pose a problem if you’ve nailed down your expected outgoings and require a steady and defined income stream to meet them.

Bucket three: growth (years eight onwards)

With seven years’ expenditure catered for within buckets one or two, you can take a longer-term view with any remaining holdings.

As such, you’ll want to jack up the risk level, investing in assets that offer high potential for growth, which for most will mainly comprise equities. Here you have the comfort that should markets experience a rough patch, shouldn’t need to sell down any shares, protecting yourself from sequencing risk.

If you want to add a bit of extra spice and can stomach the volatility, you could allocate some of this bucket to racier areas like emerging markets or smaller companies. Depending on your investing style and preferences, you might include some single-company stocks.

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The key with this pot is to give it the best chance to grow over time. This helps to prop up returns from the more defensive buckets, enabling your overall portfolio, and subsequently income, to keep pace with the rising cost of living.

Despite the long-term view, this bucket does require some maintenance to keep asset allocations balanced across the trio, perhaps creaming off gains and adding to other pots. If weightings are left to drift, you could find your equity holdings on the heavy side, with a dwindling pot of cautious assets to support you should stock prices tank.

Drawbacks of bucket strategies

Adopting a bucket strategy, if managed diligently, certainly has the potential to carry your portfolio through retirement, supporting your short, medium and long-term income needs. But it’s far from bulletproof – there are some things to be mindful of.

One drawback is that it leans towards a reasonably high proportion of lower-growth assets which can act as a drag on overall investment performance, offering less protection against inflation.

As noted above, you have the carte blanche to divvy up the buckets as you see fit, so there are ways to limit inflation risk, but be aware this could create other risks in the process – namely greater exposure to sequencing of returns.

A further consideration is the maintenance involved. You need to be engaged with your savings and monitor the performance of various asset classes to know when and how to rebalance the buckets. Timing and strategic is crucial. You’ll want to avoid selling assets from bucket three to refill others when stock prices are low.

This understandably might not chime with investors who prefer a more hands-off approach to portfolio management – or are comfortable with, and can tolerate, more risk. An alternative is to keep things simple with just two buckets, comprising a cash pot and another with your chosen weighting to equities and bonds, taking a total return approach.

Expenditure could then be funded by withdrawing a specified percentage; a widely used strategy being the Bengen Rule, which suggests if you draw 4% of your total portfolio every year, uprated annually by inflation, the money should last at least 30 years.

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Importantly, while Bengen recently revised the figure up to 4.7%, we should note that any fixed withdrawal strategy doesn’t guarantee results, nor does is promise suitability. Choosing between buckets and the 4% rule isn’t binary. It’s possible to combine the two, as one targets optimum asset allocations, while the other focuses on the optimal withdrawal rate.

A final note on tax…

It’s the not just the order you withdraw asset classes that matters, but also the sequence you deplete products, if say your retirement income is generated from a SIPP and ISA.

Sometimes it might make more sense, from a tax perspective, to draw from one before the other, depending on whether you aim to reduce your income tax bill or mitigate inheritance tax (IHT) for your offspring.

This is a further example of why ongoing maintenance of your retirement portfolio is vital. Not only could your goals shift over time, but tax rules have a habit of changing, not least the IHT reforms to pensions arriving in April 2027.

Decisions here can be complicated and will largely be determined by your personal circumstances. If you’re unsure how to go about this, regulated financial advice can help you choose wisely.