Latest posts by Wanderer (see all)
- Reader Case: Should I Enter The Market? - February 15, 2019
- How Does a Pension Affect My 401(k)/RRSP Withdrawal? - February 11, 2019
- Reader Case: Bay Area Conundrum - February 1, 2019
Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.
First of all, I just wanted to say how grateful we both are for the outpouring of support and well-wishing we got from the last article. Our readers mean so much to us and its nice to know that the we mean so much to them. That being said, we don’t actually know if anything is wrong yet, so no need to freak out just yet. When we know more, we’ll let you know as well.
And on that note, on to the Investment Workshop.
Here on the Investment Workshop, we talk almost exclusively about how to BUILD your portfolio, but we haven’t really touched on what to do when you actually retire and need to start withdrawing from it.
The Withdrawal Method
Managing a portfolio is kinda like sex. It’s important to pull out at the exact right time. Pull out too late and your future gets boned. Pull out too soon and you just make a huge mess all over everything.
Ahem. OK, that analogy kinda went off the rails. MY POINT IS, it’s important to manage your portfolio withdrawals in retirement carefully.
First, though a quick recap of the 4% rule. The 4% rule states that:
A retiree invested in low-cost Index ETFs can withdraw 4% of their initial portfolio balance, adjusting for inflation each year and not run out of money over a 30-year retirement period with 95% certainty.
This is a general rule-of-thumb the Early Retirement community uses to figure out when it’s relatively safe to pull the trigger and give the ol’ 9-to-5 the finger and ride off into the sunset.
But what is this actually like in practice? And how is investing in retirement different than investing when you’re still working?
When you’re building your portfolio from scratch, your portfolio yield, meaning the percentage of your total portfolio value that’s paid out as dividends or interest every year, isn’t really all that important. Sure, yield is all fun and good, because who doesn’t like free money? But when your investment time-frame is 15-20 years, the majority of your gains will come from capital gains, not dividends.
This is because any temporary losses that happen due to bad market conditions don’t really hurt you all that much. Your day-to-day expenses are taken care of by your day job (or emergency fund, if things go south), so you can ride through the storm without being forced to panic-sell. You just hold on for the ride, DCA into the storm and come out smiling on the other end. That’s how we made it through the Great Financial Crisis of 2008 without losing any money.
But when you’re retired? The game changes.
The most dangerous period of any retirement is the first 5 years. Why? Because if a market downturn happens right as you retire, you will be forced to sell assets to fund your retirement at the worst possible time. Then later, when the market inevitably recovers, you’ll have less assets than when you started with and won’t be able to participate fully in the recovery. Which just sets you up for a worse crash later, etc.
But what can you do? The 4% rule requires you to raise money each year by harvesting capital gains. And if you don’t have any capital gains to harvest? Too bad, you’re in trouble.
This is where yield comes in.
Yields, in the form of dividends or interest, are paid to you without having to sell anything. So if you had a $1 Million portfolio yielding 2.5%, even if the market crashed and took the portfolio down 10% to $900,000, you still get paid $25,000, or 2.5%. And that’s 2.5% of the ORIGINAL amount, not the new, lower value. This is because yield gets locked in when you buy, and generally isn’t affected by the day-to-day gyrations of the stock market.
So when you retire, you want to have as much of your annual living expenses covered by your portfolio yield as possible. This way, you’re not vulnerable to a sudden market crash that blows up your retirement plan.
But how do you do this? Well, generally there are 3 ways to do this:
- Lower your living expenses. This is the most straightforward way of ensuring your retirement plan goes smoothly. If you had a$1 Million portfolio and an annual spend of $40k, that’s great. That’s 4%, and you will have a 95% chance of success of making it 30 years without running out of money. But if you used global arbitrage like we did to lower your expenses to just 3%? Your chance of success jumps to 100%.
- Shift your asset allocation towards fixed income. When you’re young and building your portfolio, you generally want a high equity allocation. This is because you care less about volatility and more about long-term capital appreciation. But in retirement? You want safety, stability, and above all else, income. Thus, shifting your allocation more towards fixed income as you approach retirement can do this.
- Pivot towards higher-yielding assets. Shifting your asset allocation trades off volatility for income, and most of the time that’s exactly what you want to do. But in our low-interest world, investors searching for yield (like us) have to look at higher-yielding fixed income assets. Assets like Corporate Bonds, Preferred Shares, REITs, and High-Yield bonds. These assets, however, are far more volatile then their boring safe Bond Index cousins, so you end up losing the volatility-dampening effect that the fixed-income side of your portfolio gives you. But in exchange, they DO pay higher yields. At the time of thie writing, our Preferred Shares Index (CPD) is paying 4.6%, while our REIT index (XRE) is paying 5.2%.
The Cash Cushion
Creating a cash cushion in your portfolio is the 2nd line of defense in your withdrawal strategy. This is your buffer if you happen to hit that stock market crash at the beginning of your retirement. And the strategy behind making this work is actually pretty simple.
Basically, keep 5 years of living expenses as cash in your portfolio.
Simple right? And why 5 years? Well basically, most stock market crashes recover in 1-2 years, but the worst ones can take up to 5 years to recover. The worst stock market crash ever in recorded history (1929) took about 4 1/2 years to recover its value after inflation and dividends were taken into account. So a safety net of 5 years is sufficient to survive any stock market crash up to and including the worst one that’s ever happened.
But wait, you might be saying, that sucks! If my living expenses were $40k, then I’d have to keep $200k just lying around in cash?
Because in order to calculate your cash cushion, you have to take into account your portfolio yield. Remember, this is money that’s going to be coming in whether you sell anything or not. So to calculate the size of your cash cushion, you use the following formula.
Cash Cushion = (Living Expenses – Yield) x 5
So if you, for example, had living expenses of $40k, and your portfolio was yielding 2%, or $20k, then you only need to keep a cash cushion of ($40k – $20k) x 5 = $100k, or half of what you were expecting.
Plus, you can see how as your portfolio yield increases, you would need to keep less and less in cash. At a yield of 2.5%, you would need ($40k – $25k) x 5 = $75k. At 3%, ($40k – $30k) x 5 = $50k. At 3.5%, ($40k – $35k) = $25k. And of course, at a yield of 4%, you would need ($40k – $40) x 5 = $0.
So now to put it all together, in a structure I call “The Three Buckets.”
You have 3 buckets, positioned one above the other.
The bottom bucket contains money you need to fund your current year’s retirement expenses.
The middle bucket contains money that can fund 5 years of retirement.
And the top bucket contains the rest of your portfolio.
As the year goes on, you spend down the bottom bucket to fund your living expenses. In January, it’s full, and by December, it’s empty.
The middle bucket contains enough money to fund 5 years of retirement, structured as the Cash Cushion we just talked about. At the beginning of every year, that bucket tips over a bit and refills the bottom bucket with enough money to fund the rest of the year.
And that top bucket? That’s the rest of your portfolio. Sometimes it’s growing with the markets, and sometimes its shrinking as markets crash. But regardless of what markets do, it drip drip drips its yield into the middle bucket keeping it from going empty too quickly.
So here’s how this works.
The bottom bucket we use to fund our living expenses. And the middle bucket gets sized just right using the simple formula we described above so that it can cover 5 years of living expenses in down markets without being TOO big that it takes up too much of the portfolio. And finally, the top bucket drips down its dividends continuously, and when the markets rise (as they usually do), it sells off some of its assets to replenish the middle bucket. When markets fall, it does nothing but continues to drip its dividends.
And that is how you implement a safe withdrawal strategy.
And We’re Done
Now, feel free to disagree and add your own flair to this. Think you don’t need such a large cash cushion? Go ahead and reduce it! You don’t like Preferred Shares and would rather stick to safe government bonds? Be our guest. Just understand how each financial decision you make changes the size of each bucket, and as long as you’re confident it will work for you, then go for it. Everyone’s retirement journey is different.
So what did we end up doing ourselves? We started off with a living cost of $40k and a 2% yield, which meant we had to keep a cash cushion of ($40k – $20k) x 5 = $100k. However, after our first year of retirement we discovered the power of global arbitrage (i.e. staying in cheaper places like SE Asia) to bring our living costs down to around $30k. We then pivoted towards higher-yielding fixed income assets to bring our total portfolio yield to around 3.5%. This allowed us to reduce our cash cushion to $0. And as a result, we now make money as we travel.
So let’s hear from you guys! What will your withdrawal strategy look like?
Update: After much wailing and gnashing of teeth the TD Ameritrade link below now works again. Praise Jeebus
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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.