Can I use a single bucket to manage inflation-indexed income?

A reader asks in response to – I am 30 and wish to retire by 50; how should I plan my investments? – “Can I use a single bucket to manage inflation-indexed income?”. The article details the retirement bucket strategy adopted by the freefincal robo advisor tool. We reproduce an extract below for a discussion.

The retirement corpus is assumed to be invested in five buckets.

• An emergency bucket to handle unexpected expenses.
• The income bucket provides guaranteed income for the first 15 years of retirement. During this time, investments are made in the following three buckets.
• Corpus is from a low-risk bucket that provides retirement income from year 16 to year 26. To provide this income, the low-risk bucket will have an asset allocation of 30% equity and 70% debt during the investment period (years 1 to 15 of retirement).
• Corpus from a medium-risk bucket will provide retirement income from years 27 to 34. To provide this income, this bucket shall have an asset allocation of 50% equity and 50% debt during the investment period (year 1 to year 26)
• Corpus from a high-risk bucket will provide retirement income from years 35 to 42. To provide this income, this bucket shall have an asset allocation of 70% equity and 30% debt during the investment period (year 1 to year 34)

That is, the retirement corpus will be divided into four parts (excluding the emergency bucket)

• 5% in an emergency bucket
• 47% in an income bucket will guarantee risk-free inflation-protected income for the first 15 years. The rest of the parts will be invested in three buckets: low-risk (26%), medium-risk (12%) and high-risk (9%) in the asset allocations indicated above. During this investment period, the buckets will be actively managed to reduce risk: rebalancing and profit booking from one bucket to another. To understand how this works, try The Retirement Bucket Strategy Simulator.
• After 15 years, the low-risk bucket will be turned into 100% debt and provide income for about 11 years. After that, the other buckets will also be progressively used.

The reader is asking, “Is all this gymnastics necessary? Why not use a single bucket with equity and fixed income?” The answer is subjective and depends on who you ask. Some would argue the above is an over-kill, and three buckets are enough, and so on.

Since we were asked the question, we can only offer our reasoning behind this structure used in the freefincal robo advisor tool. It all boils down to peace of mind and necessity.

The emergency bucket lets the retiree know that unexpected expenses can be handled. But how do we replenish this? Whenever the equity or bond markets are kind, we can top up the emergency bucket whether or not we have withdrawn from it.

A poor run of equity returns in the first decade of returns can severely deplete a retirement corpus. So, the income bucket is the most crucial element. It guarantees inflation-index income (income that increases at the assumed inflation rate) for the first 15 years of retirement. This ensures adequate protection from the sequence of returns risk.

With these two in place, the remaining corpus is distributed among low-risk, medium-risk and high-risk buckets. The retire can adjust risk levels according to the available corpus and risk appetite. Investors and advisors who use our robo tool assume 100% equity in the high-risk bucket or assume it is to be invested in an aggressive hybrid or balanced advantage fund, depending on the circumstances.

Is this a form of mental accounting? Not quite. The buckets do not have the same risk level. That is, the money is invested differently in each bucket. The income bucket could have a liquid or money market fund, while the low/medium/high risk bucket is a mix of equity and long term bond funds (corporate bond, conservative hybrid, gilts, etc). See: List of investments suitable for building a retirement bucket strategy

A retiree can safely take on varying levels of risk once the emergency and income buckets are in place.

In addition, the robo tools also have options for income flooring and annuity laddering. These provide additional layers of security. See:

• Use this annuity ladder calculator to plan for retirement with multiple pension streams
• Creating the “ideal” retirement plan with income flooring!

Assuming a single bucket with some expected return from equity and fixed income is a non-representative over-simplification. Without bucketing, it would be difficult to plan risk diversification efficiently.

It is not impossible, but it is hard for most retirees to pull it off. Even advisors prefer the above bucket strategy because it gives their clients peace of mind. They can stomach a capital market-linked post-retirement plan much better only because of these buckets. Therefore, we do not recommend using a single bucket for retirement planning.