Why Your Retirement Needs Plans B & C


The Fat Tailed and Happy blog looked at sequence of return risk including a good bit of number crunching. Sequence of return risk is usually framed as the risk that the equity market, and by extension an investment portfolio, has a run of poor returns at the very beginning of an investor's retirement which can create a big hole to dig out from, possibly a hole that can never be dug out from.

Fat Tailed lays out a scenario where an investor retired in 2000 with a $1 million now having a little under $400,000 despite being disciplined in limiting withdrawals to 4% per year. In that same period, he observes that US equities had an average annual return of 5.7%. It may seem counter intuitive that you could take out less than the market's average annual return and be down so much. That is sequence of return risk, a couple of unluckily placed years in this person's sequence have made things much harder, especially if this person is still taking out 4%, is 80 years old and very healthy.

It is important to understand the 4% rule in order to mitigate the sequence of return risk. Advisor William Bengen determined that 4% was the optimal retirement withdrawal rate in terms of maximizing the payout with the least likelihood of outliving your money. If there is a flaw to it, he did the work back in the 90's so part of the math includes bond yields that no longer exist. When you fully understand the 4% rule, you can then be more informed of the risks if you decide to take more than 4%; the odds of sustainability success are well north of 80% with a 5% withdrawal rate.

So then sequence of return risk becomes a huge risk factor for the 4% rule. Another one is life circumstances. Things come up in life that cost money, I've had several clients over the years who've had big unexpected expenses come up causing them to significantly exceed taking 4%. In past blog posts we've looked at examples when all of these factors come together at once--this will happen to a few baby boomers when the next bear market comes. Imagine having hit your number, let's say $900,000, and you intend to take out $36,000. Let's say in September of that first year the market starts to roll over into a bear, dropping just 6% in year one and you took your $36,000. Assuming a 60% allocation to equities, your account might be down to $831,000. Now the second year is when the bear market hit is hardest, dropping 30% and you stuck to your $36,000 withdrawal. That might now have you at $678,000. At this point, you're a long way from $900,000. Layer on top of that something unexpected comes up (insert your own relevant example) in that second year that costs $50,000 and your $900,000 is down by almost 1/3 in just two years. If nothing else, this is going to be stressful.

There are quite a few ways to potentially mitigate an adverse sequence of returns. The first one is take less than 4%. Can you make 3% work? What about 2%? The less you take then the less vulnerable you are to an adverse sequence. Another way is a slight tweak to the 4% rule. Specifically, the 4% rule means taking 4% in year one and then increasing by the rate of inflation. This has always struck me as odd. "I see CPI was 1.8% for the year so instead of $40,000 I will take $40,720." I've never heard of someone doing this. My tweak is "whatever you got, 4%." If you start with $700,000 then no more than $28,000. If a year later you have $800,000 then no more than $32,000. This requires a lot of flexibility as available income will go down every so often.

Bear markets tend to last 18-30 months. Another mitigation technique would be to keep a lot in cash so that you wouldn't need to sell anything during a protracted downturn. If you kept two years of anticipated withdrawals in cash then obviously that tranche would not be exposed to the decline. Of course the opportunity cost could be painful if the market defies your expectation/concern.

There are investment products that can help too. I've mentioned these before but the Innovator ETF and Pacer Trend Pilot ETFs take different routes to avoiding the full brunt of large declines. You wouldn't be immune from large declines but hopefully your retirement isn't too fragile to endure down a little. I have used one of the Pacer funds for quite a while.

I've previously laid out my thoughts on what my wife and I hope to do. Our plan changed when we bought the cabin next door back in 2017 to rent it out on Airbnb. We bought it with a 15 year mortgage so it will be paid off when I am 66. It had been generating about $1500/mo pretty reliably which when combined with our projected Social Security benefits would be enough for us to live on without needing regular portfolio income. This then would leave the portfolio for emergencies, travel, upgrades to our vehicles once they hopefully get to 20 years (or more?) and psychic value. There is obviously a discretionary tilt to what I hope the portfolio would be used for. To be clear, the context is not (what is hopefully) a lot of money that never gets spent, it is about not being singularly dependent on that money. My preference continues to be that I never retire but at some age it becomes difficult/impossible for an advisor to get new clients.

I've mentioned before that our Airbnb will be featured on CNBC's new show, Cash Pad on September 3rd. Even before the show aired our bookings have gone up dramatically. If the increase persists (fingers crossed on that one) then it further bolsters our Plan A. Plan B might be selling the rental, Plan C might be selling the house we live in and moving into the rental.

I would encourage having a backup plan or two at least partially sketched out in case things don't go as hoped for. A reasonably thought out back up plan is a way to increase your optionality or put differently, reduce fragility. The idea of not freaking out over something negatively unexpected is a big one for me, we've had a couple of things over the years and have been lucky enough to avoid panic thanks to a little bit of forethought. Where retirement planning is concerned, this seems like an important concept.