If you're approaching or have just reached retirement and are deciding what to do with your savings, one of the most practical frameworks available is the three-bucket strategy, which we'll adapt for annuities here.
This guide is for people deploying a lump sum in retirement — not those still in the accumulation phase.
The goal is to show you how to divide your savings into three distinct parts, each with a clear purpose so that your essential expenses are covered for life and your remaining assets can still grow.
The Three-Bucket Strategy: Original and Annuity Versions
The modern three-bucket strategy is often traced to financial planner Harold Evensky, who described a two-bucket retirement approach in the 1980s — a cash reserve for near-term spending alongside a single investment portfolio for everything else.
The three-bucket form most people know today, which adds a dedicated intermediate bucket, was later developed and popularised by Christine Benz at Morningstar. It has since become one of the most widely used retirement income frameworks, dividing assets into three time-based pots:
- cash for immediate needs
- bonds for medium-term income
- stocks for long-term growth
The central idea is that by keeping near-term spending in cash, you never have to sell your investments at a bad time to pay your bills.
The version described in this guide adapts that framework by replacing the bond bucket with an annuity. This is not a minor tweak — it changes the character of the middle bucket significantly because:
- bonds generate income and can be liquidated
- annuities convert capital into a guaranteed income stream for life
The trade-off is that with annuities, you lose access to that capital permanently, but gain something bonds cannot offer: the certainty that income will continue regardless of how long you live or what markets do.
For many retirees managing essential expenses, that certainty is worth more.
What Do the Three Buckets Look Like?
Each bucket has a single, clearly defined job. The three work together as a system: the annuities in Bucket 2 automatically refill the cash in Bucket 1 each month, while Bucket 3 grows undisturbed in the background.
The result is a retirement income structure where essential expenses are handled without requiring ongoing investment decisions — leaving you free to focus on managing Bucket 3 for growth.
Let's see the three buckets one by one:
Bucket 1 – Safety: Cash for Immediate Needs
The first bucket holds liquid cash to cover your day-to-day living expenses and any emergencies.
In the original three-bucket framework, most practitioners recommend keeping one to two years of essential spending here, in safe, accessible accounts. The priority is accessibility, not return.
This bucket serves two purposes. First, it means you're never forced to touch your investments at a bad moment to pay a bill. Second, it provides a buffer for genuine emergencies: a medical expense, an urgent home repair, or any unexpected cost that falls outside your normal budget.
Crucially, this bucket must be funded before you commit any capital to an annuity. Annuities are illiquid — once you purchase an immediate annuity, that principal is gone. If you don't have adequate cash reserves first, you may find yourself in difficulties if something unexpected arises.
Bucket 2 – Guaranteed Income: Your Annuities
The second bucket is your long-term guaranteed income source. You allocate a portion of your savings (20–60%) here to purchase annuities.
An annuity converts that money into a guaranteed monthly income — for life — that automatically replenishes Bucket 1 each month. It is sized to cover your essential non-discretionary expenses month to month: housing costs, food, utilities, healthcare premiums, insurance, and property taxes — the costs that must be paid regardless of what happens in markets or in your life.
In practice, most people build this bucket gradually rather than in a single purchase. Starting with a smaller annuity at retirement and adding further purchases over time — a strategy known as laddering — spreads your risk across different interest rate environments, allows you to diversify across insurers, and keeps your options open as your needs evolve. Our dedicated guide to the annuity ladder strategy covers this in detail.
However you build it, the mechanic is the same: each annuity pays a guaranteed monthly amount that flows directly into your Bucket 1 cash account, automatically topping it up to replace what you've spent on essential costs. Rather than deciding when to sell investments to pay your bills, the income simply arrives. You never have to make a judgment call about whether now is a good time to liquidate assets to cover your electricity bill.
This is what distinguishes annuities from bonds in this bucket. Bonds can approximate this function — a bond ladder in particular can provide fairly predictable income — but they lack the two things annuities uniquely offer: longevity protection and mortality credits. A bond portfolio runs out; an annuity does not.
This bucket typically represents 20–60% of total retirement assets, depending on how much guaranteed income you already have from Social Security, a pension, or rental income.
Bucket 3 – Growth: Investments for the Long Term
The third bucket holds the remainder of your savings in a diversified portfolio of stocks, bonds, and other investments.
Its primary purpose is long-term growth to keep pace with inflation and provide a financial buffer if you live longer than expected. It may also fund discretionary spending (such as travel, hobbies, gifts, or entertainment) over time, through occasional withdrawals as needed.
This bucket can take more investment risk than it otherwise could, precisely because Bucket 2 exists. For example, if markets fall 30% and your portfolio drops with them, you are not forced to sell at a loss to pay your rent or your grocery bills. The annuity keeps covering those. You can simply leave Bucket 3 alone and wait for a recovery. This significant reduction of what's called sequence-of-returns risk (the danger of a bad market early in retirement permanently damaging your plan) is one of the most underappreciated benefits of the three-bucket approach.
How much goes here depends on your risk tolerance, legacy goals, and how much you've committed to Buckets 1 and 2.
How Much Should Go Into the Annuities?
There is no universal answer, but the following two-step framework helps narrow it down:
1. Start with Your Income Gap
The most practical starting point is to calculate your essential monthly expenses and subtract any guaranteed income you already receive.
Example:
- Essential expenses: $4,000/month
- Pension / Social Security: $2,200/month
- Income gap: $1,800/month (= $4,000/month - $2,200/month)
You then purchase enough annuities to close that gap.
At current rates, generating $1,800/month requires roughly $200,000–$265,000 for a straightforward life-only contract, or considerably more if you add features such as a period-certain guarantee or inflation protection.
2. Adjust for Your Situation
Beyond the gap calculation, your allocation should reflect a few personal factors:
A conservative allocation (40–60% to annuities) makes sense if you have very low risk tolerance, no other significant guaranteed income, a strong family history of longevity, or concerns about managing investments later in life due to potential cognitive decline.
A moderate allocation (20–40% to annuities) is what most retirement advisors suggest for typical retirees. It covers essential expenses while leaving meaningful assets invested for growth and accessible for flexibility.
A minimal allocation (10–20% to annuities) suits those who already have substantial guaranteed income from a pension or Social Security payments, have high risk tolerance, or want to maximize what they leave to heirs.
A Sample Portfolio in Practice
Here is how this might look for someone retiring at 65 with $500,000 in savings:
At retirement:
- $50,000 → Bucket 1 (cash reserves, approximately 1–2 years of essential expenses)
- $100,000 → Bucket 2 (first annuity purchase, generating roughly $575–$760/month at current rates — the exact amount varies by insurer, age, gender, and payout option)
- $350,000 → Bucket 3 (diversified index funds and bonds)
Combined with pension or Social Security, the initial annuity covers a portion of essential costs, with Bucket 3 covering the rest and potentially funding discretionary spending.
At age 70:
Use some of Bucket 3's growth to add a second annuity purchase — perhaps $75,000–$100,000 — bringing the total guaranteed income closer to fully covering essential expenses, while also locking in better payout rates available to a 70-year-old. This staged approach is explored in detail in our guide to the annuity ladder strategy.
Keeping the Strategy on Track
Once set up, the three-bucket strategy requires relatively light maintenance. Each year, check that your cash reserves in Bucket 1 remain adequate, review the financial strength ratings of your annuity provider, and reassess whether Bucket 3's investment allocation still matches your risk tolerance and time horizon.
Revisit the overall strategy if your circumstances change significantly: a spouse's death, a major health development, an inheritance, or a change in housing situation can all shift how much guaranteed income you need and how much flexibility you want.
Wrapping Up
The three-bucket strategy works because it matches the right financial tool to each type of retirement spending.
Cash handles immediate needs and surprises. Annuities, with their guaranteed, automatic monthly payments, cover essential expenses for life, removing the anxiety of market dependence from the costs you simply cannot defer. Investments handle discretionary spending and growth, which can take appropriate risk precisely because the essentials are already secured.
The key decision is how much to annuitize, which comes down to your income gap, risk tolerance, other guaranteed income sources, and legacy goals. Most people land somewhere in the moderate range: enough guaranteed income to cover essentials comfortably, with the rest left invested and accessible.
Use our annuity calculator to model how different annuity amounts would affect your income in retirement.