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We’ve written extensively about the 4% rule, and we’ve also written about how to guard against an unluckily timed market crash screwing over your portfolio right as you retire. And to recap, the way to guard against this (called Sequence of Returns Risk by finance wonks) is to do the following:
- Swing your portfolio towards fixed income assets to establish a “Yield Shield”
- Build up a 3 year cash cushion outside the portfolio
- Identify ways to cut your expenses to below the Yield Shield if a market crash happens.
- Travelling to low cost countries is our preferred method. “If shit hits the fan, we’re going to Thailand”
And all that’s great, in theory. Many other famous bloggers have backup plans too, but rather annoyingly (for us, not them) their blog starts making money and the backup plans become a moot point. Who needs to care about withdrawing from their portfolio when they can just live off their blog income?
So as a result, it seems that despite the fact everybody has backup plans, nobody seems to have had their backup plans tested in any meaningful way, right? How annoying. Damned FI bloggers and their success!
Well, as it turns out, someone did have their backup plans tested. Who, you may ask?
The Oil Crash
Gather round, children. It’s story time.
The year was 2015. Obama was president, health care was totally a thing that people could count on, and half the people in showbiz hadn’t been accused of sexual assault. It was a simpler time. And up in the frozen Northern reaches of Toronto, 2 annoying millennials had stumbled into Financial Independence the year before and had just completed their last day of work. Freedom from work! Freedom to travel! So in June 2015, we got on a plane and embarked on our year-long victory-lap trip around the world.
And then the oil crash happened.
Now to those who may not be following the day-to-day gyrations of WTI (West Texas Intermediate) crude oil, it wasn’t that long ago that a barrel of the black stuff was over $100 USD. But around mid-2014, the Saudis, annoyed at fracking in the US and the emerging Canadian oil sands as competitors to their near-monopoly on oil production, decided to really open the taps and flood the market. Their aim was to drive the price of oil as low as possible, and boy did it work.
It was, as we Westerners would call it, a truly baller move.
Because in Saudi Arabia, all one has to do is poke a stick in the ground and oil will come out . Other countries had to work for it, drilling and fracking and shit like that. I don’t know the details. I’m a computer engineer, not a chemical engineer. But anyway the end result is that the cost to produce a barrel of oil in Saudi Arabia is a LOT cheaper than producing a barrel of oil in Alaska, Texas, or Alberta. So by flooding the market with oil and driving the price of oil down, the hope was that it would drive non-Saudi oil producing companies out of business.
And MAN did it work. From WTI crude’s peak price of $107 USD, it fell all the way down to $29 USD in Jan 2016.
This fucked up our portfolio, to put it mildly. Because a significant part of it is based on the Canadian index, and our stock market is so heavily resource-based, we had the experience of retiring, and then seeing our portfolio go into a goddamned free-fall.
The 4% rule more formally stated is this: If one were to withdraw 4% of your starting portfolio and adjust for inflation each year, you would have a 95% chance of the portfolio surviving for 30 years.
A 95% success rate means a 5% chance of failure. And that 5% chance of failure is caused by a market crash at the beginning of your retirement.
And in that moment, we thought we were part of the 5%.
So What Did We Do?
We only started this blog in May 2016. So when the crash happened and our first year of retirement drew to a close, we were staring at a negative return on our portfolio. And in case you were wondering, no, we didn’t rely on our blog to earn any additional money. There was no blog income because we hadn’t started it yet.
So shit got real. But in that moment we realized how to measure whether our retirement was still on track or not.
And that method is this:
Every Year After Your Retire, Pretend You’re Retiring All Over Again
What does this mean? When you’re saving your way to retirement, you’re chasing that 4% number for your portfolio target. You spend $40k, and according to the 4% rule you need $1M, so that’s how much you need to save. And when you hit that number, you retire. Woohoo! But remember what the 4% rule actually means. If you withdraw 4% (inflation adjusted) of your starting portfolio, you have a 95% chance of lasting 30 years.
So after a year has passed, your portfolio may have gone up. Or (in our case), it may have gone down. What to do know, am I still on track?
Well, if you think about it, your chances of success are exactly the same as someone who has saved and invested up to your new current portfolio balance, is thinking of retiring, and plugging numbers into FIRECalc. Would that person still retire? Or would they choose to stay working?
Let me give you an example.
Say you’re like us. $40k living expenses, $1M portfolio. In the first year, say your portfolio goes down 5% while throwing off 3.5% yield. So now your portfolio is $950k, it’s generated cash of $35k, and your living expenses remain at $40k.
In this situation, if you were to continue doing a “normal” early retirement (as if such a thing exists), you would take the $35k cash, sell off $5k more to make up the $40k at a loss and hope for the best. This would take your portfolio down to $945k. Going forward, this would result in a withdrawal rate of 4.2%. Putting that info into FIRECalc puts your success rate at 92%.
Hmm, the success rate has gone down! That means my risk of failing has now increased. To be precise, your chance of failure has increased over the next 30 year window, from 5% to 8%.
So what should you do in this scenario? Well, it’s really up to you. You have lots of options. Here are a few:
- Increase your income via side hustles
- Reduce your spending via budgeting
- Reduce your spending via travelling
- Eat into your cash cushion
- Go back to work (as a last resort)
Let me give you an example. Say a part of your spending is $5k in travel. If you cut that out next year, your withdrawal requirements go from $40k down to $35k. $35k / $945k = 3.7%, and plugging those numbers into FIRECalc reveals a success rate of 99%! So by cutting $5k from your retirement budget, you’ve actually increased the success rate of your retirement!
What We Did
So what did we do? Well, when this scenario happened to us, we chose to eat into our cash cushion. Rather than take a withdrawal in the first year, we chose to spend down 1 of the 3 years of cash we had saved up and avoided withdrawing. Because we did that, not only were we able to avoid selling any assets during the downturn, we reinvested the dividends that had been generated, essentially buying into the trough. And as a result, when the oil prices rebounded from $29 USD to it’s current level of around $60 USD, we were able to participate in all of the upside, recovered our original portfolio, and then participated in the gains of this crazy post-Trump stock market.
Now, our portfolio has climbed in value, yet our expenses have not. Right now, our portfolio is $1.182M (as of the time of this writing), yet due to travelling our expenses have gone down. We’re looking at our spreadsheets right now and we’re projecting a total expenditure of $36K for the year. That’s including Mexico, US, Central America, South America, UK, and Central Europe! How is life this easy? It almost feels like cheating.
Actively Manage Your Withdrawal Rate
The first couple of years after retirement are the riskiest, and a small (5%) probability does exist that your retirement may fail. However, be re-retiring every year, you can measure the change in your probability of success. So the 5% of people whose retirement fails would have seen their withdrawal rate gradually creep up as their portfolio got hammered, but did nothing about it. They would have seen their success rate drop every year from 95%, to 80%, to 70%, and yet chose not to reduce their spending, work a side hustle, or move anywhere cheaper. So rather than simply be a victim of bad luck, the 5% of people who fail would have been able to see their ship starting to get pointed towards an iceberg yet ignored all the warning signs and let it happen.
Don’t be one of those people.
But on the flip side, by actively watching and managing your withdrawal rate (especially over the first few years of retirement), you can execute on your backup plans as the need arises and avoid being seriously hurt by bad timing. And over time, you’ll find the vastly more likely scenario of seeing your portfolio grow. And as your portfolio grows, your withdrawal rate naturally drops, and your success rate increases.
For us, now that we’ve successfully weathered the oil crash storm by using our cash cushion, our portfolio has grown in value to $1.182 M (excluding cash cushion and passion project earnings). At the same time, by travelling and living nomadically, our personal inflation has actually been negative, so we’re going to keep our spending target at a conservative $40k. This means that going into 2018, our withdrawal rate will be $40k / $1.182M = 3.4%, which according to FIRECalc, has a 100% success rate.
And once that happens, you’re done with your worrying about running out of money post-retirement. A 100% success rate means you have successfully secured your place as one of the people who WON’T run out of money after 30 years.
So every year, re-retire. Pretend you’re still in your job, with the amount of money you now have because of stock market fluctuations, and decide what to do. If your withdrawal rate has gone up and your success rate has gone down, start executing on your backup plans. And if your withdrawal rate has gone down and your success rate gone up, pat yourself on the back because your retirement is now safer than ever.
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