A possible plan for early retirement: A close look at the 3-bucket strategy

The central goal of the bucket strategy is to generate cash flow at a rate that beats inflation and ensures that your corpus lasts longer than you do. (Photo by Maitree Rimthong via Pexels)

Financial Independence, Retire Early (or FIRE) is a growing movement. The community is active in the US and is now finding traction in India, with millennials earning and saving more than previous generations. The core concept of FIRE is that instead of working till 60 or 65 years, the official retirement age in most companies, you save and invest in such a way that you build enough funds that you can live off instead of relying on a salary.

In the FIRE community, discussions predominantly revolve around the meticulous art of fund accumulation, with scant attention devoted to the intricacies of withdrawal strategies, which, in truth, hold the allure of mathematical intrigue.

- How exactly can you fund the retirement phase?

- Where will the money come from every month?

- How are you withdrawing from your assets?

To be honest, these are uncomfortable and hard questions, even for traditional retirees. In India, the typical answer to this question has been rental income.

A theoretical but rarely implemented answer from stock market participants has been dividend income. There is also interest income from secure products like fixed deposits and senior citizen savings schemes.

A lucky few have some form of pension income. A combination of some or all of these is essentially the retirement plan for a majority of Indians, especially those who want to remain independent and not rely on their children.

While these ideas might suit traditional retirees, they don’t quite work for people who plan to retire in their 40s or 50s. The two main reasons for this are:

Firstly, the retirement horizon for FIRE enthusiasts vastly exceeds that of traditional retirees. A 40-year-old retiring in 2025 could anticipate a retirement span of roughly 50 years, a stark contrast to a traditional retiree who concluded their career at 60, with an expected retirement period of 20 years. The vast difference in the amount of time to be spent in retirement ensures that one needs a different strategy.

Secondly, for conventional retirees, post-retirement expenses often exhibit a declining trend. By this stage, financial goals such as a child's education are already fulfilled and lifestyle expenditure typically decreases. Conversely, early retirees face a different landscape, characterized by ongoing financial objectives and relatively stable or rising expenses, underscoring the imperative for astute cash flow and liquidity management.

The strategy of depending mostly on rental income does not work for early retirees. Rental yields in India are typically about 3 percent. This would mean an income of Rs 50,000 a month, or Rs 6 lakh a year, from a property worth Rs 2 crore in a big city.

Renting comes with many risks, the biggest one being occupancy. It is not necessary that your flat will always provide inflation-adjusted rent. It might remain vacant for a few months. Also, it is hard to liquidate real estate if you need a larger amount of money for other expenses.

The strategy of depending on dividends also has problems. Dividend yield, both in percentage and in absolute terms, varies widely over the years. You cannot depend on it for steady cash flows.

Also, to generate dividend income, you will have to invest in dividend-yielding stocks. Picking the right set of stocks that provide both dividend and growth over the long term is hard. It might have been a decent idea a decade ago but the changes in tax laws over the years have made it an unattractive option.

So, what can an early retiree do?

While there are many options – and individual cases should ideally involve consultation with a financial planner – I personally find the three-bucket strategy both practical and efficient.

Is it the ultimate solution? I'm inclined to think not. Is it sufficiently robust? For me, it is.

Now, let's delve into the intricacies of this strategy.

The central goal of the bucket strategy is to generate cash flow at a rate that beats inflation and ensures that your corpus lasts longer than you do. This is done by dividing financial assets into three broad categories:

1. Short-term/cash/liquidity bucket

2. Medium-term/safety bucket

3. Long-term/wealth creation Bucket

Liquidity bucket

What is the goal?

To provide for daily expenses. To take care of possible emergencies. For major expenses in the short-term (2-3 years).

What sort of assets does it contain?

Cash, money in savings accounts, short-term FDs, debt funds (liquid/ultra short term/short term), short-term bonds.

What amount of financial assets are needed in this bucket?

It is recommended to keep 2 to 4 years of expenses in this bucket.

What sort of returns should be targeted from this bucket?

The focus here is on liquidity. There is no need to bother too much about returns.

Safety Bucket

What is the goal?

To generate some cash flow so that your liquidity bucket can last longer. In case of a long bear market, it will help to avoid selling assets that are in the long-term bucket.

What sort of assets does it contain?

Long-term bonds, debt funds (long term/GILT), REITs, balanced funds, dividend stocks.

What amount of financial assets are needed in this bucket?

It is recommended to keep 4 to 6 years of expenses in this bucket.

What sort of returns should be targeted from this bucket?

The returns from this bucket should match inflation. Suppose you retire in 2025 and your annual expenses are Rs 10 lakh. You add Rs 50 lakh in this bucket. The assets in this bucket should grow at such a rate that they will be able to last you any five-year period in your retirement. It might be 2030-35 or 2045-50.

Wealth Creation Bucket

What is the goal?

To create wealth over the long term so that you don’t run out of money in later years. Also, to ensure that you pass something to the next generation.

What sort of assets does this bucket contain?

The bulk should be in equity (via mutual funds or direct), real estate, and gold. There should also be a debt/cash component that can be used to make use of any opportunity that arises.

What amount of financial assets are needed in this bucket?

The more the merrier. Most experts suggest 20 to 30 times of your annual expenses for early retirees.

What sort of returns should be targeted from this bucket?

It should beat inflation by a decent margin. The goal would be to beat inflation by 4 percent over the long term. However, be prepared for a 2 percent margin as well.

How to refill and rebalance the buckets

Once the buckets are created, we need to frame rules on how and when to rebalance the buckets. You take money out from the cash bucket as and when you spend. Most people refill the cash bucket every six months by selling something from the wealth creation bucket.

The assumption here is that the markets are doing well. In case the markets are not doing well or there is a bear market, you do not refill the cash bucket. Now, bear markets can last long. In most cases, a bear market lasts for a few months but it could very well extend to a decade.

The bucket strategy protects you in such scenarios. You can first spend from your cash bucket and then from your safety bucket before you are forced to sell your equity. The key idea that makes the bucket strategy successful is that you always sell equity, in small quantities, in bull markets when equity is doing well. In bear markets, you are not forced to sell equity because you have enough cash and bonds in the short-term and medium-term buckets.

Criticism of bucket strategy

Some research papers show the bucket strategy has not proven to be the most optimal way to fund retirement. While it might give us the idea that it handles the sequence of returns risk very well, there is no fundamental research to back this claim.

A simple yearly rebalance of a 60-40 portfolio or an 80-20 portfolio would roughly end up doing the same. Jack Bogle, founder of Vanguard, has often said that it might be a good idea to never rebalance the portfolio.

However, I personally find the bucket strategy comforting because it gives me a method that I can use and implement to have a comfortable retirement. At the end of the day, you have to do what you have faith in for the long term.

We will all be dead in the long term but we would not want to run out of money before that. I believe the bucket strategy would protect me from that scenario.

I would like to add here that I am not a qualified financial expert. I am a member of the FIRE community who is trying to share what he has learnt so that others don’t make the same mistakes that I did.

Remember, in the pursuit of a comfortable retirement, faith in your chosen strategy is the compass that guides us towards financial freedom, shielding us from the fear of running out of resources before our journey's end.