The Three Pots Rule – how to use it to help reach your financial goals

As a Financial Adviser, it’s my job to help clients outline their most important goals and build a strategy to reach them.

When I ask a client what they want to achieve, a common response is:

‘I want to save for the future so I can have a comfortable retirement, but I also want to save for a house and enjoy my life now.’

Some people have clear and obvious goals. But for others, it’s not always so black and white, and knowing which goal to prioritise can be tricky. Here’s how the three pots rule could help.

This article isn’t personal advice. If you’d like specific recommendations on how to save for your goals, please get in touch with a Financial Adviser.

The three pots rule

A good place to start is to outline your short, medium and long-term goals. Once you’ve done that, you can then allocate a portion of your existing savings and income to all three 'pots'.

Maybe you want to go on a big holiday in a year's time? But you also want to purchase a house in 5 years and live comfortably in retirement.

This means you’ve got short, medium and long-term goals.

Once you know what these goals are, you can use the three pots rule to make a plan.

Pot 1: short-term goals

Examples of short term goals include; holidays, a new car, home improvements, a wedding or school fees.

For any short-term goals like these (less than five years), it’s normally a good idea to stick to cash products – these tend to be lower risk. This also means your short-term plans shouldn’t be impacted by any stock market ups and downs.

It’s also a good idea to have an emergency fund. An emergency fund is there to cover unexpected costs like a broken boiler or car repairs. Three to six months’ worth of expenses is usually a good place to start, but you might want more depending on your circumstances. If nearing or in retirement it’s usually best to have closer to 1-3 years’ worth of expenses.

For any cash that you won’t need for your emergency fund, it could be worth locking it away in a fixed rate cash product. You’ll usually be able to get a better rate. But the trade-off is that you can’t usually access your money until they end.

Active Savings could help. In one online account you can choose easy access and fixed term savings products from a range of banks and building societies. Remember that inflation can reduce the spending power of money. Easy access products pay a variable rate and fixed term products pay a fixed rate.

The Active Savings service is provided by Hargreaves Lansdown Savings Limited (company number 8355960). Hargreaves Lansdown Savings Limited is authorised by the Financial Conduct Authority under the Electronic Money Regulations 2011 with firm reference 901007 for the issuing of electronic money.

Pot 2: medium-term goals

For any medium-term goals (five to fifteen years) you could think about using a Stocks and Shares ISA. Using your ISA allowance you’ll be able to choose from a wide range of investments, including shares, investment trusts and funds. Plus, you won’t have to pay income or capital gains tax on any profits you make.

Tax rules can change and their benefits depend on your personal circumstances. Unlike cash, investments fall and rise in value, so you could get back less than you invest.

Medium-term goals still have quite a short time horizon. So it’s important to choose investments that match how much risk you want to take.

A big piece of the puzzle is diversification. Having a mix of different investments in a well-diversified portfolio is normally the best approach to investing. Investments like shares, bonds and property perform differently in different market conditions. As do different regions and sectors. So having a mix could mean you always have something working well.

If you’re unsure how to diversify your portfolio, we can help either with our ready made ISAs or by asking an investment adviser.

Pot 3: long-term goals

You might feel like retirement is a long way away. But that doesn’t mean you should forget about it.

It’s understandable why there are lots of us who would rather see more money in our pockets each month. But the earlier you pay as much as you can afford into your pension (taking into consideration your other pots), the better.

Starting early means you’ll be able to make the most of compounding – this involves putting small amounts away regularly over a long period of time. While this might not make you a millionaire overnight, over longer periods of time these small savings could grow into impressive results.

More on compounding

For your longer-term goals, you could think about using a pension to boost the amount you're saving through tax relief. No matter how much tax you pay, the government will add 20% in tax relief to your pension. So if you put £8,000 in your pension, the government will add an extra £2,000, bringing the total amount to £10,000.

The amount you get in tax relief could be even higher if you’re a higher or additional rate tax payer. Tax bands and allowances are different if you’re a Scottish tax payer.

If you’re a UK resident under the age of 75, you can get tax relief. To get tax relief on your personal contributions, you can only top up as much as you earn each tax year, or £3,600, whichever is greater. Remember, money can’t usually be taken out of a pension until at least age 55 (57 from 2028). Pension and tax rules can always change.

Remember, other limits can also apply, like on how much you can put into your pension or if the total value of it exceeds a certain amount. Find out more about these limits.

Don’t forget to check in on your goals

The three pots rule is a good guideline, but everyone’s circumstances and goals will be different.

It’s important to remember that things can also change. So don’t forget to check in on your goals to make sure you’re still on track.

If you find you’re not happy with how things stand, you could always ask for more help.