Managing Investment Risk in Retirement

A few weeks ago I talked about the retirement savings rules: the 30x Rule, 25x Rule, and 20x Rule. These rules are based on a >90% probability of success in retirement with a higher than standard life expectancy using financial market data that goes back to the 1870s.

Although most low-fee, balanced or growth-oriented index portfolios will provide an inflation-adjusted return of about 6% annually over the long haul, we know stock markets go up and down somewhat erratically and investing is not a smooth ride.

Benjamin Graham, a stock market legend, created the allegorical character of "Mr. Market"—a bipolar depressive individual—to describe the changes in stock market price behaviour. Mr. Market is rarely even-keeled. He is often optimistic and demands higher and higher prices for his stocks, but suddenly he becomes pessimistic and offers stocks at lower prices. Thankfully we know Mr. Market is more often happy than fearful which is why stock markets tend to go up over the long haul.

Dangers of Mr. Market

Depending on your age and length of retirement, you could withdraw between 3.5% to 5% of your initial portfolio value at retirement each year and adjust that withdrawal amount up each year to account for inflation. While we believe the stock market will return an average of 6% per year adjusting for inflation, we can't withdraw 6% per year.

The 20x to 30x Rules make up for Sequencing Risk—knowledge that withdrawing money from your investment portfolio during large market drawdowns can cause severe, long-term damage to your portfolio. In fact, all failed retirement scenarios in history are caused by starting retirement just before a large market crash or just before a rapid inflationary period.

For example, let's say you are retiring in your 60s with a $1,000,000 portfolio and follow the 20x Rule. You withdraw $50,000 to fund your first year of retirement bringing your portfolio down to $950,000. The next year we get a market crash and your portfolio drops 40% to $570,000. Inflation went up 3%, so you withdraw $51,500 to fund year 2 of retirement. That's 9% of your investments and the value of your portfolio now sits at $518,500. Your portfolio climbs 6% to reach $549,610 and inflation went up 3% again. The year 3 withdrawal is $53,045 ( 9.7% of your investments) which drops your remaining portfolio down to $496,565. We could continue this example on and on but you can see that you are quickly in a precarious situation.

Although it's unlikely for the market to return only 6% in the years shortly following a massive 40% crash, this type of return sequence is exactly what happened in the 1930s. I think any retiree who is living off the proceeds of their portfolio would be sweating if they found themselves in this situation.

Increasing Retirement Success

There are a few ways to significantly increase your odds of success when retiring on your investment portfolio for a very long period (30+ years). The first way is to simply follow the 30x Rule. We know the 30x Rule worked 100% of the time since 1870; barring complete catastrophe worse than the Great Depression, two World Wars, the inflationary 70s, and the Financial Crisis, we will be good when we withdraw 3.33% of our portfolio in the first year and increase with inflation from there.

If we want to increase to the 25x Rule in long retirements, we need to maintain a high allocation to stocks and guard with some shorter term government bonds and gold. In a standard passive portfolio, withdrawing primarily from stocks during good market years and primarily from bonds and gold during bad market years we can mitigate Sequencing Risk.

Stock market downturns typically last less than two years. In the year following the market bottom, it's common for stocks to increase 30% or more. If you can make your bonds and gold stretch up to 2 years, you will be able to increase your odds of success into the 95% range.

Another way to improve success is to create a bottom target and top target for spending in retirement. An appropriate top target might be 4% of your initial portfolio adjusted for inflation (25x Rule) and bottom target at 3.33% of your initial portfolio adjusted for inflation (30x Rule). During good market years you spend at your top target and during bad market years you spend at your bottom target. Reducing withdrawals 15% or so by cancelling vacations, cutting back on entertainment, halting monetary charitable gifts, and the tax savings of withdrawing less for a year or two are often tolerable changes to make. Using this strategy we can increase our odds of success to about 100% in a long-term retirement.

Take Away

There are many strategies you can use to ensure financial success in retirement. Success depends on spending flexibility, knowing that withdrawals over 5% of your initial portfolio is reckless at any age, and understanding withdrawal rates over 4% are dangerous in early retirement. After that, disciplined portfolio strategy can carry you through even the worst downturns.

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