Unconventional wisdom: How to survive the worst year to retire
Retirees who stopped working in 1968 faced a brutal combination of bear markets, soaring inflation and poor returns. I tested the 4% rule, the income method and the bucket approach to see which strategies stood up to the challenge.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: How to survive the worst year to retire
When reality looks too ugly, fantasize.
- Jimmy Buffett
As you may have noticed I am not retired. Surprisingly I am still compensated for writing this column and suffering through various other corporate indignities.
My retirement experience is confined to helping my mother navigate the financial aspects of retirement and digging through data and research.
I’ve greatly benefited by hearing from retired readers about their experiences.
One reader pointed out that in my last retirement column I may have exhibited some bias towards the income method and bucket approach over the traditional 4% rule.
This is a fair interpretation. In my previous column I relied on monte carlo simulations to poke holes in the 4% rule while singing the praises of a more conceptually based case for the income method and bucket approach.
This is my attempt at putting more rigor into my arguments.
The terrible, horrible, no good, very bad time to retire
1968 was not a great year for the world. The Tet offensive ended the illusion that progress was being made in Vietnam.
Martin Luther King and Robert Kennedy were assassinated. The Prague Spring was crushed by the Soviets.
Perhaps most consequently, Peter Townsend of the Who vowed to never return to Australia after being labeled a ‘scruffy long-haired junky’ by the Aussie Press.
1968 also happened to be the worst year to retire according to the financial planner who came up with the 4% rule – Bill Bengen.
When Bill Bengen set out to find a safe withdrawal rate in the early 1990s he was trying to overcome the sequence and magnitude of challenges faced by people who retired in 1968.
Those challenges included bear markets starting in 1968 and 1973 followed by a tepid recovery until the early 1980s. Meanwhile inflation soared with prices tripling between 1968 and 1983. It was a perfect storm.
This is the period I want to test the income method and bucket approach against. I’ve mapped out scenarios through 2010 for someone who retired in 1968.
Why 2010? It felt disingenous to stop before the global financial crisis and a 43-year retirement covers most plausable scenarios.
Challenges with retirement modeling
Bengen used a monte carlo simulation to come up with the 4% rule. This is a method that tests a range of possible outcomes using a random combination of data points. In Bengen’s case the data points were historical returns and inflation data.
There is no nuance in a monte carlo simulation because you can’t model outcomes based on choices made by individuals.
The bucket approach requires human intervention to decide when to replace asset sales with cash withdrawals in a declining market. It requires a decision on when to revert to asset sales.
Running a monte carlo simulation on an income-based withdrawal strategy is also unhelpful as spending levels adjust based on income. While a retiree won’t run out of money there will be periods when living standards drop as income goes down.
That is why I want to use a specific period – the worst time to retire - to test the other methods and compare the outcomes to the 4% rule.
The baseline is the 4% rule and I’ve seen different data on when a 1968 retiree would have run out of money. Most sources suggest barely getting by the 30-year mark in 1998 but I modeled it out and came up with 2002. I will use my figure of 2002.
Income method
To test the income method I assumed someone retired at the beginning of 1968 with a $1,000,000 portfolio. I understand that is a lot of money for 1968 but I just wanted a round number as the figure is irrelevant.
In the first year of retirement the withdrawal was calculated by multiplying the S&P 500 dividend yield of 3.06% in 1968 by $1,000,000. The $30,640 withdrawal was adjusted each year by the increase / decrease of total S&P 500 dividends paid.
The following chart shows the withdrawals for each year between 1968 and 2010 and compares them to the initial $40,000 withdrawal under the 4% rule which is adjusted by the actual inflation over the same period.
There are advantages and disadvantages to the income approach. The first-year withdrawal is meaningfully lower than the 4% rule. To fund the same withdrawal would require $1,111,111 or almost 11% more money.
An advantage is that over the 43 years dividends grew 667% while inflation increased 517%. On a real or inflation adjusted basis dividends delivered.
However, during the high inflation years of 1973 and 1985 the income method fell behind as dividend increases didn’t match inflation. During that 13-year period real – or inflation adjusted – income fell by a cumulative 4.97% or 0.38% annually.
Would most retirees notice this? Probably not but this is early in retirement which tends to be the time when people spend the most.
There were five years when dividends dropped on an absolute basis – 1971, 1972, 2001, 2002 and 2010. A retiree would have to adjust spending levels in these years.
Another big advantage is the growth in the retiree’s portfolio. Just spending income allows a portfolio to grow - albeit at a slower rate since dividends aren’t reinvested. By 2010 the share portfolio would have grown to $13,027,597. The 4% rule portfolio would have run out of money in 2002.
Some thoughts on the income method
In the real world the income method could be modified. A retiree could opportunistically sell assets to increase spending and keep a cash buffer to deal with fluctuations in dividends. But there are also challenges for today’s retirees.
I used US data because it is more robust than Australian data. I can’t find sources that provide everything I need to model out a similar scenario locally.
In some ways the US market in 1968 with a decent dividend yield was more like the Australian market than it is today. The local market has a generous dividend yield – especially with franking credits – but dividend growth in Australia has fallen behind inflation over the last decade.
An investor today in the US has a different problem. Dividend growth has been robust but with a 1% S&P 500 yield an investor would need a retirement nest egg roughly 4 times larger just to match the 4% rule spending.
Is a similar outcome to the hypothetical 1968 retiree possible now? It is. But it requires a more thoughtfully constructed portfolio which significantly increases execution risk.
The bucket approach
This is a more challenging scenario to model. I’ve started with a $200,000 allocation to cash and $800,000 to the S&P 500. The share allocation grew by the S&P 500 return, and the cash allocation grew by the US Treasury Bill return.
The whole purpose of the bucket approach is to get a retiree through the exact environment faced by someone who stopped working in 1968 – an early bear market and high levels of inflation.
This approach relies on judgement calls by the retiree. A decision needs to be made when to stop selling shares and dip into the cash bucket for living expenses. Conversely, the bucket approach requires a decision of when to go back to selling shares to fund withdrawals.
This is an easier call to make using historical data as outcomes are known. In this case the bear market started in the early 1970s and I started dipping into the cash in 1973 for four years before starting to sell shares again in 1977.
The following chart shows the results with years the withdrawals came from the cash bucket highlighted.
The next major bear market started with the dotcom bust in 2000 and again, I dipped into the cash bucket. But at this point there was not enough cash to last the entire downturn and in 2001 shares were sold to fund the withdrawals. This worked out as the portfolio had grown large enough to weather the continuing sell-off.
There was not enough cash to fund total withdrawals during the global financial crisis in 2008. But 40 years into retirement the share portfolio was high enough to withstand the bear market. At the end of 2010 the retiree was left with $19,928 in shares and $224,484 in cash.
Under this scenario the bucket approach kept the retiree solvent far beyond the 4% rule which ran out of money in 2002. The bucket approach – with historical hindsight - has overcome sequencing and longevity risk.
Can the bucket approach support higher spending?
I’ve adjusted the initial withdrawal to model out a scenario where the same approach runs out of money in 2002 and matches the 35-year time frame supported by the 4% rule. A retiree could withdrawal $42,750 or 4.275% in 1968 while running out of money in 2002. That equates to a 6.875% increase in living standards.
The following chart shows the outcome.
Some thoughts on the bucket approach
It is fair to critique the scenario I’ve outlined. As previously stated, it required me to make judgement calls with the benefit of hindsight. What I’ve created is not a model or rule. An economic model must contain a set of rules and assumptions, which is what Bill Bengen set out to do with his work on finding a sustainable withdrawal rate.
It is fair to claim that I’ve massaged the approach – both the size of the cash bucket and when to start using the cash bucket – to make this work. This is an excercise in possibility and not repeatability.
My counterargument is life is not a model. The best any of us can hope for in an uncertain future is to seek an understanding of the range of possible future outcomes and the risks to the outcome we desire.
Once you’ve accepted life is uncertain, you try and set yourself up for success by laying a strong foundation. After that all you can do is hope for the future wisdom to address the inevitable challenges that will arise.
Final thoughts
I will admit that I have a bias against the 4% rule. I find the income and bucket approach more intellectually appealing.
My bias is also influenced by the fact that I used the bucket approach for my mother’s retirement – with 5 years of cash which equates to the $200,000 cash bucket I used in this exercise.
This approach worked out well for her and I plan to use the same approach when I hang up the keyboard and retire.
Too many personal finance and investing decisions are framed as having a right or wrong answer. What is right for you may not be right for me – and that is ok.
Preaching a doctrinal approach to finance does a disservice to everyone trying to create a better life. Come up with a retirement approach that works for you.
I want to hear about the approach you are – or plan to use – in retirement. Email me at mark.lamonica1@morningstar.com
I have an upcoming series of webinars on ETFs coming up. Sign-up for the first one here.
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What I’ve been eating
Some might say it is lucky I arrived in Hobart at the start of Tasmanian truffle season. But luck is what happens when preparation meets opportunity. I am always prepared to eat truffles and took advantage of the opportunity.
Ogee is the latest venture from restaurateur Matt Breen. This was my first time at Ogee but I’ve been to his previous restaurants Templo and Sonny. The man knows what he is doing. Pictured is the agnolotti del plin. This is a dish from Piedmont and plin means pinch in the local dialect. The pasta was filled with beef and pork, sealed with a pinch, and covered in shaved truffles from Pipers Brook in northern Tassie.
