Let’s say you’ve been diligently saving half of your income for the last 15 or 20 years, and you finally accumulated enough to call yourself free. If you’re convinced of the merits of the 3% rule, then that means you have saved up 33x your yearly spending.
For example, if you plan on spending around $60,000 per year (which is close to the average yearly household spending in the United States), then that means you’ve accumulated a $2 million nest egg.
Now that you’ve earned your freedom, you go out and celebrate with an epic vacation to Bora Bora. However, over the next several years, the stock market enters a deep bear market, perhaps like the ones in 2000 and 2007. You watch as your investments plummet by nearly 50%, and your portfolio is now only worth $1 million.
Sequence of Returns Risk
This scenario illustrates the so-called “Sequence of Returns” risk in retirement. If the market loses value significantly in early retirement, and you continue to withdraw from a depleted portfolio (before it returns to it’s original value before the bear market), then your portfolio could be irreparably damaged and never recover. Goodbye freedom!
Mitigating Sequence of Returns Risk
Thankfully, some very smart people have already considered this possibility and have devised some ways to mitigate sequence of returns risk. I’ll outline some of these ideas below.
1. Diversify Your Investments
If your portfolio is comprised of 100% stocks, and the S&P 500 (a measure of total stock market performance) loses half of it’s value (as it did in the 2007 bear market), then your portfolio will lose 50% of it’s value.
However, if you have, say, 60% stocks and 40% bonds, then your portfolio will drop somewhere around 30%, because bonds are much less volatile than the stock market. A 30% drop in portfolio value, while still quite damaging, is not quite as catastrophic as a 50% drop.
You could diversify further by owning real estate in addition to stocks and bonds. It is possible that the value of your real estate property could drop as much as the stock market, but not likely. Regardless, the point is that if you diversify your investments, you lessen the potential impact of a abrupt decline in any one sector of your portfolio.
2. Use a 3% Withdrawal Rate
Big ERN over at Early Retirement Now has performed a thorough, rigorous analysis of safe withdrawal rates using historical data. Basically, he computed the absolute safe withdrawal rate where your portfolio would last at least 60 years, regardless of when you retired.
So, for example, if you retired on the day before the great depression (arguably the worst possible time in history to retire), you still would have done just fine. These safe withdrawal rates are shown in the table below, under the column Min (fail-safe). The other columns show the safe withdrawal rates if you’re willing to accept 1%, 5%, 10%, or 25% failure rates.
You can see from the table that as long as your portfolio contains between 60% and 85% stocks (equities), there has been no retirement date in history where a 3% withdrawal rate would not have been successful. The best fixed percentage of stocks seems to by 75% (green outline).
3. Maintain a cash cushion
Another helpful strategy may be to maintain several years worth of spending in cash to avoid withdrawing from a depleted portfolio in a bear market. However, if you look at the value of the S&P 500 over the last 60 years or so, you can see that it often takes nearly 10 years for the market to return to it’s pre-bear-market values. Ten years in cash reserves would be a very large amount of idle cash. Due to the effects of inflation, cash actually loses value over time, so this might not be the best option.
4. Cut spending during a market downturn
If you see the value of your portfolio declining rapidly during a market downturn, this would NOT be the time to take a month-long trip to Europe. Rather, this is the time to cut spending dramatically, ideally in proportion to the decline in your portfolio.
For example, if your portfolio declines by 20% in a single year, then it might be reasonable to cut your yearly spending by 20% (thus still maintaining a 3% draw on the portfolio).
This would only work if you have some spending cushion in your budget. If your fixed expenses are exactly $60,000 per year, and your $2 million portfolio declines to $1.6 million, then it will be challenging to cut back to spending level of $48,000. Therefore, it might be reasonable to build in a spending cushion to your planned spending in retirement.
Note however, that Big ERN’s analysis showed that even if you don’t cut spending during a market downturn, the 3% rule has a 100% chance of success – at least according to historical data. I recommend you tread carefully and consider some decrease in spending during a market downturn, even if you decide not to decrease your spending by the exact percentage of the market downturn.
5. Maintain a side gig or part-time work
Many who have decided to retire early don’t completely check out on a beach for the rest of their lives. They do something enjoyable and low stress that brings in perhaps $20,000 to $30,000 per year. This might be blogging, writing a book, working at REI, or consulting on issues related to their primary career. Even a small amount of income during retirement can significantly reduce the sequence of returns risk.
For example, suppose you have a side gig that makes $30,000 per year. Your planned spending is $60,000 per year, and you have a $2 million portfolio. Even if the portfolio drops to $1 million and takes 10 years to recover, you will still only need to withdraw $30,000 per year, thus maintaining a very safe 3% withdrawal rate.
6. Hope for a pension or Social Security
One advantage of a pension or Social Security payments is that they are essentially guaranteed income, not susceptible to sequence of returns risk. If you are fortunate enough to have a pension or Social Security income, your retirement income will be less variable and risky than if you are drawing all your income from your portfolio.
Conclusion
A particularly brutal market downturn in early retirement can devastate your portfolio and threaten your freedom. However, there are certainly ways to mitigate the risk. I recommend that you target a 3% withdrawal rate, maintain reasonable but not excessive equity exposure (60-80%), consider a several year cash cushion, pursue a low-stress side gig in retirement, and cut spending in a market downturn. If you can do those things, you will have a very high likelihood of maintaining your freedom in retirement.
Great points.
Most of us are in accumulation mode and not concerned about what happens later. Talk to those on a fixed income though and you will hear about the very real risks of sequence of return, market decline etc. People forget about the option of cutting expenses during a bear market but that is very normal behavior and should be part of this.
The SWR could be debated forever. I have been pushing the 33X for quite awhile. I do wonder where this is heading though. I’m old enough to remember when 7% was thought ok. Then 6%. Sometimes I still hear 4% or 5% but more often 3.5%, 3%, or 2.5% now. I wonder where this trend is heading?
I agree that at some point it becomes ridiculous proposing lower and lower safe withdrawal rates. Theoretically, even a 1% withdrawal rate wouldn’t be safe if the entire financial system collapsed. I still think that 3% is a reasonable initial target, and you can adjust up if things are going well, or down if doomsday scenarios manifest.