The bucket strategy is a simple way to conceptualize your saving and investing goals while keeping you focused and organized on your journey toward financial freedom.
Visualize 3 buckets representing your “Emergency Fund”, “Discretionary Fund”, and “Retirement Fund”.
The Emergency Fund Bucket is arguably the most important of the three. Without it you will have difficulty filling the other 2 buckets. Financial crises always seem to pop up at the most inconvenient times. If you have to raid your vacation fund or new car fund every time a crisis pops up, you may never attain your goals. And before long, you may lose the incentive to save.
If your employment is secure and your income is consistent, your emergency fund should hold 3 to 6 months of living expenses. Three months if you are single and renting, 6 months if you are married and own a home. If you or your spouse’s employment is not secure or your income varies significantly throughout the year, 6 months for singles and 12 months for couples may be more prudent.
Your Emergency Bucket contains your “liquid assets” such as checking and savings accounts, a Money Market Account, and Certificates of Deposit (CD’s). Although Money Market Accounts and CD’s aren’t paying much interest these days, it is still wise to segregate your emergency funds in separate accounts. “Out of site – Out of Mind” helps to reduce your temptation to spend frivolously.
Your Retirement Bucket is the largest bucket and the corner stone to your long term financial independence. Traditional pensions are nearly extinct. Only 30% of the workforce currently has a defined benefit pension and this figure is falling every year.
That leaves social security and your own personal savings to support you in your golden years. Social Security was never intended to provide you with a “comfortable” retirement. It was designed as a safety net and a supplement to cover basic necessities.
Your Retirement Bucket is the biggest of the 3. It will need to contain 10 – 15 times your annual income upon retirement. No, that’s not a typo! If your annual income at retirement is $50,000 per year, your retirement bucket will need to have $500,000 to $750,000. That amount doesn’t sound so crazy if you consider that you only have 40+ working years to save for 20+ retirement years.
Fortunately leverage, time, and diversification help to soften this blow. Leverage comes in the form of incentives. Investing in an IRA, 401K, or Thrift Savings Plan allows you to contribute pretax dollars to your retirement bucket. If you are in the 25% tax bracket, each $100 saved will only reduce your take home pay by $75. Many employers also offer matching contributions to 401k type plans (TSP) up to a specified limit. In which case, a $75 nominal investment might increase your retirement bucket $200.
The time factor allows you to put your money to work for you by investing. Your retirement bucket will contain investments in Government Securities, Bonds, and Stocks. These categories are not suited for short term savings due to their inherent short term volatility, but their long term performance far exceeds what a bank can pay in interest. This long term horizon mitigates the short term risk while diversification across stocks, bonds, and government securities mitigates the long term risk. The key to success is having a plan and sticking to it!
Finally, your Discretionary Bucket is for goals you wish to reach in 1-5 years. Such as a new car, a down payment for a house, a vacation, new furniture, near term College Funds, etc. This bucket may contain short term CD’s for near term goals of a year or less, but it also may contain Series I Bonds or an intermediate term Bond Index Fund for goals extending out 2-5 years.
At this point you are probably a little overwhelmed and asking yourself, where do I begin? The first step is committing to pay yourself first. Scrub your budget and commit to saving at least 10% of your income. The first 5% goes to your emergency fund. The other 5% goes toward your retirement fund.
The second step is to give yourself a raise each year. Increase your contributions toward your retirement fund 1% each year until you reach the maximum contribution limit.
When your emergency bucket is fully funded, shift that 5% contribution to your discretionary bucket. You are now firmly on the path to life long financial freedom.
You will reach “cruise altitude” when your Emergency Fund Bucket is full and you are contributing 15% to your Retirement Bucket.