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David Graham, MD is back to talk about buffer assets. The FI Physician recently addressed the effect of asset location on making your money last.
He has clearly done a lot of thinking and modeling on how to avoid running out of money in retirement. The easiest way is to have an extremely low withdrawal rate, but that could mean working additional years and shortening your retirement or making frugal choices you don’t want to (or necessarily need to) make.
Today, Dr. Graham looks at a number of ways one can use “buffer assets” to mitigate the risk of a particularly bad stretch of returns near your retirement date, such as those we had to kick off this century.
Stick around to the end; you will likely be surprised to see what might work best!
Buffer Assets, Bucket Plans, and Sequence of Return Risk
How effectively do various buffer assets protect portfolios against sequence of return risk?
Buffer assets stand between cash and equities. During the distribution phase of retirement, buffer assets prevent selling equities at a loss to pay expenses. This is especially important just prior to and during retirement.
“Reverse dollar cost averaging” (or Dollar Cost Ravaging) can have devastating and permanent effects on portfolio value. Sequence of return risk (SORR) describes this long-term effect of negative initial stock market returns on the portfolio.
What is a Buffer Asset?
Like many terms in retirement planning, “buffer asset” doesn’t have a clear definition. Wade Pfau coined the term by borrowing from the insurance industry. Dr. Pfau states he started using it after seeing cash value life insurance described as a “volatility buffer.” He specifically refers to buffer assets as those assets outside of your investment portfolio where returns are not correlated with the stock market. He cites cash value life insurance and reverse home mortgages as examples.
Other assets have the same intent, however: to immunize your portfolio against SORR and prevent reverse dollar cost averaging.
In this blog, I define buffer assets as any strategy, investment or asset that stands between cash and equities. Buffer assets provide you with the luxury to sell equities when you chose, rather than being forced to sell for living expenses. Buffer assets’ specific purpose is to avoid SORR; they are bucket 2 assets.
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The Bucket Plan
Actually, 1-3 years of cash reserve is not infrequently called a buffer. In the simplest of “bucket plans,” bucket one is cash or treasury bills and bucket two is everything else. This plan has a bad rap, and rightfully so, as cash is for spending and not an effective buffer to reduce SORR. This is a cash reserve plan rather than a bucket plan.
Other bucket approach strategies are mere time-segmentation of the portfolio’s asset allocations into different mental buckets. There is a bucket for the next 5 years, then 5-10 years, and then more than 10 years. Stock allocation increases as the time until the money is needed increases. This simplistic bucket approach, while attempting to prevent poor behavior during market downturns, is just fancy mental accounting of a systematic withdrawal strategy (such as safe withdrawal rate). This is a “now, soon, and later” plan rather than a bucket plan.
A more complete bucket plan has 4 buckets. Bucket 1 is 1-2 years of cash for spending. Buffer assets fill bucket 2. The third bucket contains stocks and bonds in an appropriate ratio to maintain overall asset allocation. Bucket 4 provides lifetime guaranteed income (a “floor” for fixed/essential expenses) from social security, pensions, and annuities. This plan has “time segmentation” (buckets 1-3) in addition to “goal segmentation,” which is the flooring of fixed income needs from bucket 4.
Time segmentation, however, is commonly misconceived. The intent is not to spend sequentially in order from bucket 1 to 2 to 3, rather you refill bucket 1 from 2 OR 3 depending on market conditions. If socks prices are soaring, you sell some bucket 3 to refill bucket 1. If there is a bear market, you convert buffer assets into cash and avoid reverse dollar cost averaging. SORR is greatest 5 years before and 10 years after retirement, so the eventual goal is to spend down bucket 2 when the risk has passed.
Goal segmentation is important to consider as well. No one wants to run out of money in retirement, and the future is plagued by market, inflation, and longevity risk. Understanding future fixed/essential expenses (vs discretionary expenses and legacy goals) and matching these expenses with secure, inflation adjusted income is important for piece of mind.
Bucket 4 provides this floor, which is funded at some point in the future (say when you turn 70 and take social security, or when you consider an immediate annuity at age 80), so bucket 3 only has to last for a known number of years, rather than until some unspecified time in the future when you die. This distinction is subtle yet important: bucket 3 only has to last until you fund bucket 4 and have all future expenses covered during the “no-go” years of retirement. Let’s call this the 4-bucket plan with goal segmentation.
An Aside for FIRE
Folks who retire early have additional considerations. Physician on Fire started a drawdown plan in early retirement chain which discusses strategies planning for 50 years or more in distribution.
Flexibility is key to FIRE. Those who are responsible enough to FIRE won’t stand idly by as their portfolio is decimated. Buffer assets are for traditional retirees but also require special considerations for FIRE.
Back to Buffer Assets
I define buffer assets as a bucket 2 asset. Assets are not just what you own, they are also advantages or resources that you have. Strategy plays a large role in SORR immunization, so any description of buffering is incomplete without consideration of additional planning options.
A classification system for buffer assets is lacking, but I propose the following classification scheme:
Buffer Assets:
- Cash Reserve Strategies: As mentioned above, cash is for spending and not an effective buffer asset by itself.
- Volatility Dampeners: Frequently mentioned “ladders” of CDs, bonds, or multi-year guarantee annuities (MYGAs). One may actually consider laddering a combination of 2 or 3 of these assets depending on interest rates.
- Planned Allocation Strategies: Rising equity glide paths or bond tents are important considerations.
- Income and Expense Modification: Income need is driven by expenses in retirement. One can use human capital (i.e. working part time) or modify spending (spend conservatively or have guiderails for spending).
- Uncorrelated Non-portfolio Assets: Cash value life insurance and reverse mortgages fit the bill given low correlation to market returns.
- Additional Assets: Businesses, hobby collections or rental properties can be sold to hedge against a down market.
- Goal Segmentation: Fixed guaranteed income “floor” provided by social security, pensions, annuities or TIPS ladder.
- Other Strategies: Social security claiming strategy, income from immediate annuities or longevity insurance from deferred annuities.
- Income portfolio: Preferred stock, dividend stocks, utility stocks, REITs, convertible bonds and MLPs deserve mention, but won’t be considered further due to high correlations with the market and other issues.
Let’s look at the effect some of these buffer assets have on a fictional portfolio during an especially bad sequence of return–the years 2000-2010.
Case Presentation
Consider a fictional couple who just retired at 64. They have $4.5M in assets which includes a $1M house, $500,000 in cash value life insurance, and $500,000 of LLC shares paying 5% a year.
Figure 1 (Portfolio)
Figure 1 shows the asset allocation of the $2.5M portfolio. They have a $1M taxable account with a large cash reserve, and US and International stocks and bonds. In their $1M rollover IRA, they are 60/40 US stocks/bonds. Their $500,000 Roth IRA is more aggressively invested. (Spreadsheet from PoF)
Figure 2 (Asset allocation compared to target allocation)
Above in figure 2, we see the combined asset allocation of the portfolio on the left which is similar to a model Moderate portfolio of 60/40 seen on the right. They are overweighed in US equities and cash.
Social security will provide $3000 a month at age 65. They plan on spending $150,000 a year, a 6% withdrawal rate from their investments or a 3.3% withdrawal rate from combined assets. Assume inflation is 2.5% except for health care which is 5%, and health care will cost an additional $10,000 a year.
| Year | Stock | Bond | Cash |
| 1 | -9.1 | 11.6 | 3.5 |
| 2 | -11.9 | 8.4 | 1.6 |
| 3 | -22.1 | 10.3 | 1 |
| 4 | 28.7 | 4.1 | 1.4 |
| 5 | 10.9 | 4.3 | 3.2 |
| 6 | 4.9 | 2.4 | 4.8 |
| 7 | 15.8 | 4.3 | 4.5 |
| 8 | 5.5 | 7 | 1.4 |
| 9 | -37 | 5.2 | 0.15 |
| 10 | 26.5 | 5.9 | 0.14 |
| 11+ | 6 | 3 | 2 |
Figure 3 (Assumed sequence of returns for this scenario)
Figure 3 shows the sequence of returns from 2000-2010 against which we will stress various scenarios. Note from year 11 until the end of plan, return on stocks is 6%, bonds 3% and cash 2%. These may be low returns on average, but are nonetheless interesting to look at as an added stress.
Results of the Plan
Monte Carlo simulation of this plan demonstrates an 82% success rate using standard returns on financial planning software. Stress testing reveals concern for a market crash, inflation, and longevity. Net worth at year 90 (end of plan) is $5.8M with their portfolio worth about $3.8M.
When we stress this plan with return assumptions from figure 3 (actual returns from 2000 to 2010), however, there is a zero percent chance of success and their portfolio expires at age 84.
Now, let’s examine some different options for immunizing their portfolio against SORR.
Delay Social Security
Figure 4 (Delay in social security)
What if they delay claiming social security? The dark green demonstrates portfolio value over time if they delay to 70. The lighter green shows portfolio value if they claim immediately. Over time, we see the investment accounts expire at age 84 with either strategy.
The cross over point where income from social security is higher as a result of a delayed claiming strategy is age 79. It is interesting to note they actually do worse with a delayed claiming strategy as they have a higher distribution rate from the brokerage account prior to claiming, and this occurs during some very negative years of market returns.
Therefore, to prevent SORR during years where you delay claiming social security, buffer assets are needed to draw on during years of negative stock market returns.
A More Conservative Allocation
Figure 5 (20/80 Asset Allocation)
What if they were more conservatively allocated? Figure 5 shows the effect of a 20/80 portfolio, where they have 80% of their assets allocated to fixed income. Although they suffer from less volatility especially during the down years, and have an extra $500,000 after the poor sequence, the initial drawdown in the portfolio value is eventually eaten away by inflation and runs out at year 87.
A rising equity glidepath or a bond tent would improve this scenario. These allow programmatic increases in equity exposure without “market timing.” Unfortunately, however, I’m not able to demonstrate these changes in portfolio allocation with current planning software. This is a good reminder that a financial plan is not set in stone and requires periodical re-evaluation.
Bond/CD Ladder
Bond and CD ladders are popular for SORR planning. For a large upfront investment, you can guarantee 5 or more years of income.
Figure 6 ($75,000 a year bond ladder)
In this scenario, $500,000 is used to purchase an 8-year treasury bond ladder paying out $75,000 a year. A Bond/CD Ladder Toolkit helped model the purchase price.
As seen above, this bond ladder fails. Note that at year 9 there was a large drop in market prices, so perhaps a 10 year bond ladder may have performed better. CD ladders or use of MYGAs are not modeled, but also suffer from current low interest rates.
Given low current interest rates of about 2.4-3%, treasury bond or CD ladders are not all that exciting. Historically, when interest rates were closer to 6%, a similar bond ladder costs about 20% less.
What about Selling a Business?
Figure 7 (Sale of the business)
They do have assets outside of their portfolio. Figure 6 shows income sources for retirement. As seen above, when they are 65 years old, they sell the LLC and receive $500,000 in income (though they lose the 5% returns for the rest of the plan). In this scenario, they still run out of money at age 84. A poorly timed infusion of cash is not beneficial during these harsh sequence of returns. The income peak at age 90 is the life insurance policy paying out upon death.
What About Annuities?
In this scenario, the fictional couple really didn’t need income, so models of single premium immediate annuities (SPIAs) are not shown here–they didn’t help against SORR in this scenario anyway. Let’s look at differed income annuities (DIAs) and their kissing cousin QLACs, which is a qualified longevity annuity contract — a DIA in a qualified account — and see if they help.
Figure 8 (10-year $500,000 DIA)
Income sources are shown above with a DIA. Assume $500,000 from the brokerage account purchases DIA payments of 14.2% after a 10-year deferral period. Note that we have social security and income from the LLC. At 10 years the annuity starts to pay, as well, but their investment accounts run dry at age 83. The large withdrawal from the brokerage account raises the withdrawal rate from the portfolio higher than can be tolerated during SORR, leading to this poor result.
Figure 9 ($130,000 QLAC)
A QLAC is more successful than a DIA as seen above in figure 8. Even though it is a smaller sum of money (QLAC maximum contribution is $130,000 currently), it is taken from the IRA rather than the brokerage account. This QLAC only utilizes 13% of the IRA, and although the income is fully taxable, there are benefits in maintaining funds in the brokerage account, which are spent down first. A QLAC still fails in this scenario but I have high expectations that QLACs will be part of a successful SORR plan among 401k Millionaires.
Get a Job
What about working in retirement to increase income? Given their high spending levels, they would have to earn $60,000 a year for 10 years in order for Monte Carlo analysis to be above 50%. They are already in high tax brackets from other income, and it is difficult to out-earn their high spending rate.
What Actually Works?
Let’s now move on to demonstrate effective ways to avoid SORR in this scenario.
Decrease Spending
Figure 10 (Decreasing spending to $120,000 a year)
Variable spending strategies are important for retirement income planning. Logically and emotionally, this is what most retirees will do during down markets, though a good bucket plan allow planned spending during the “go go” years of early retirement.
Note that the portfolio is not much larger even after the second major decrease in the stock market, but the tail end stays much higher showing that likely they could have increased spending again after the sequence of risk evaporated (usually about 10 years).
Cash Value Life Insurance
Figure 11 (50k loan a year from cash value life insurance)
You can “borrow” the cash value of a permanent life insurance product tax free. In this example, $40,000 a year is borrowed from the cash value of the policy for 10 years. Even though this is a fraction of their spending, the results are impressive, and this plan does not fail. Cash value life insurance is not a popular topic among DIY investors, but clearly it is a consideration for those worried about SORR. You can pay back the money you borrow from your life insurance or it can be deducted from the death benefit when the time comes.
The problem with borrowing from your cash value life insurance policy is, of course, it must be set up decades before it is needed. In this example, the life insurance is counted as an asset, but of course this is an asset outside of the portfolio and not correlated with stock returns, which is why Wade Pfau finds them so useful.
Reverse Mortgage
Figure 12 (Reverse mortgage of 40k a year for 10 years)
Reverse mortgages have become slightly more popular in the last few years, mostly thanks to a book by Wade Pfau. He suggests a Home Equity Conversion Mortgage (HECM) to be used early in the planning process, rather than as a last resort (as home mortgages are considered in popular culture).
These are FHA loans with mortgage insurance written into the deal. HECMs are non-recourse loans, which means as long as the property is kept up and property insurance and taxes are paid, the homeowner keeps title and cannot be evicted.
Loan-to-value amount is based upon the owner’s age (you must be at least 62) and current interest rates. The lending limit is based upon a maximum value of $726,525 and is usually 40-60%.
HECMs have a line of credit option which is of most interest. You can open the account and only use it if needed. Also of note, this line of credit grows larger with time.
In order to combat a negative sequence of return, draw on your line of credit in years when equities are down in order to avoid reverse dollar cost averaging. Money from the line of credit is tax free, which may be especially important if you are getting income from your fully taxable IRA, or if additional ordinary income would increase taxation of social security, or cause increased Medicare surcharges.
So, Which Buffer Assets Would You Choose?
In summary, only three strategies perform well against a repeat of the market foibles from 20 years ago.
Spending less money, or even a variable spending plan, is an important consideration. The 4-bucket system, however, is set up so that you don’t have to reduce spending during go-go years even if you get stuck with a bad sequence of returns.
Bucket 2 buffer assets fill the cash account during the bad years, and bucket 4 ensures a floor lifetime of income. Bucket 2 assets are spent down as needed over the first decade or two of retirement simulating a rising equity glidepath while providing inflation protection.
Other effective assets to consider are reverse mortgages and cash value life insurance. Obviously, cash value life insurance must be set up decades in advance (and has other downsides), but is a consideration for high-income individuals who already have large tax-deferred retirement accounts.
While reverse mortgages can be set up anytime, the amount you are able to borrow from actually increases with time if you set up your mortgage early (though of course after age 62). The key to these assets: they are not correlated with stock market returns, and equally important, the “income” is tax free.
Final Thoughts
I would hate to be accused of fear mongering. The decade from 2000-2010 was not typical, though not infrequently used by insurance salesmen masquerading as financial advisors to pitch equity indexed annuities or life insurance that “have no downside” and are “guaranteed not to lose value.”
Corrections and bear markets are common and expected. The lost decade of the 21st century, however, saw two “100-year events.” Maybe we won’t see such downside risk again in our lives. Maybe.
Thus, it does take planning to make sure you don’t crash and burn due to SORR in early retirement. That actually is the point of retirement planning. No single buffer asset is perfect for everyone. Likely a combination of investments, products, and strategies will be needed in order to spend freely during your early retirement all the while planning to live a long and comfortable life.
David Graham, MD is an Infectious Diseases Physician and Registered Investment Advisor in the state of Montana. He blogs at FiPhysician.com
[PoF: The results surprised me, initially. I did not expect two products you don’t hear much good about, cash value life insurance and reverse mortgages, to protect against a poor sequence of returns.
However, it makes perfect sense when you think about it. Both a home and a life insurance policy represent a stockpile of money that’s set aside for a different purpose (living in and for next of kin, respectively).
When you take either of those stashes of money and repurpose them to instead pay for your retirement lifestyle, you’ve got more money available to spend. Yes, there will be less for heirs, but accessing the value in them during your lifetime can help guarantee you don’t run out of money.
I think there may be better, less costly ways to make that money accessible. In the case of cash value life insurance, not buying any in the first place (and using term life insurance when it’s needed) will give you a larger bankroll to play with from the beginning.
Rather than a reverse mortgage, you could sell outright and move to a smaller home that is purchased with a down payment or you could choose to rent. Such a move would require more disruption, but it might be the best choice, and it avoids the high fees that gives reverse mortgages a bad name in the first place.
I shared these thoughts with the good doctor, and he wanted to point out that a big reason these two strategies work is the tax-free nature of the “income,” which is really just a return of your principal.
Thanks again to Dr. Graham for the insightful post and giving me a lot to think about!]
Do you have “buffer assets” to fill a bucket in your retirement plan? How do you think a poor sequence of returns is best counteracted?
23 thoughts on “Buffer Assets, Bucket Plans, and Sequence of Return Risk”
I have updated the definition and categorization of buffer assets for those who have interest: https://www.fiphysician.com/buffer-assets-definition-and-use-to-prevent-sequence-of-return-risk/
I find it disappointing to see an otherwise serious article citing Wade Pfau’s whole life insurance “study” that was industry-sponsored.
The whole TIPS, cash, buckets etc strategy is just a different view point. The end result is the same when you add up the entire asset allocation. “Refilling from bucket two instead of bucket three” is just another name for rebalancing the portfolio.
But it shouldn’t come as a surprise that buying insurance against an unlikely event that actually takes place comes out well.
At any rate, I wasn’t surprised to see my own plan (start in a reasonable place and be flexible) come out ahead in this little study.
Jim, thanks for the comment. I find “otherwise serious article” high praise from the patron saint of physician financial blogging.
I will defend Wade Pfau, however, in this case (though I agree his writing not infrequently smacks of industry support).
In the article I reference above, he clearly points out that table two is industry sponsored. Table two talks about annuities and life insurance to meat a legacy goal. You have criticized this on your message board at WCI ( https://www.whitecoatinvestor.com/forums/topic/whole-life-help-with-the-math/ )
It is table three where he discusses cash value as volatility buffer. He does not disclose a conflict of interest for table three.
As you point out in your above criticism, Dr. Pfau specifically mentions “I take special care in the whitepaper to explain my methods and assumptions as clearly as possible, so that readers can potentially challenge my conclusions.”
I think he is at least trying to acknowledge that there is a bias due to sponsorship. We have all seen physicians pitching drugs do far worse…
There are a ton of reasons not to have a permanent life insurance policy. If you already have one, however, I still conclude borrowing the cash value during years of negative returns is a good way to mitigate SORR.
Why borrow against the perm insurance vs just withdrawing basis dollars?
Cool stuff.
I do worry about SORR, especially now – after a decade long bull.
Just when I think I know a lot I read a post from David and a comment from Gasem and my brain starts to hurt.
Wealthydoc — what? this piece is straight forward compared to what you let me put on your site last week!
I agree scary times for soon-to-be retirees with the markets high, SORR drawing night, and poor future expected returns…
Thank you. I’m going to add real estate and other sources of income to the list.
What is still true, however, is that after all of your income sources are accounted for, if you are making withdrawals from the portfolio, there is risk of SORR. Say because of income your withdrawal rate is 2%, well that is a nice buffer asset to have!
My jaw also dropped at the 6% withdrawal rate. That was basically guaranteed to fail. I used the 4% to rough out what I needed but my 4% didn’t factor in Social Security or the proceeds from downsizing my home. So I figured I was golden, and a subsequent more accurate spreadsheet formula agreed. Of course my spending plan is not anywhere close to $120K a year.
It’s not surprising that spending less came out as a winner. That’s pretty much guaranteed to improve your chances of not outliving your money.
What was more surprising was that waiting to take SS didn’t make more of a difference, given the handsome increase in SS money gained by waiting and the assumption of living beyond the break-even point. Of course there’s opportunity cost of spending down assets before filing for SS, and the best advice gained here was to adjust your SS strategy based on the general economy; if it drops into the toilet, seriously consider filing SS sooner.
Interestingly, a friend did just that and financially he’s got plenty of savings still, 10 years later.
Did you know RMD takes 3.56% the first year and is greater than 5% by the 10 year and greater than 8% by the 20th year? Each increases means you pay more in taxes and get to keep marginally less. You may think you’ll withdraw 4% but the government has other ideas. There is payback associated with “max out your pretax”
Yes I know the RMD increases over time. My 4% was a theoretical spending amount. I would take any excess RMD money and reinvest it in after tax account.
But I plan to avoid a lot of the RMD bite by doing Roth conversions to fill up a chosen tax bracket for each year prior to filing for SS. You are so right that too much pretax money comes back to bite us later in life. Fortunately the bulk of my pretax contributions were made at a tax rate that I don’t expect to see in retirement.
It is a 3.3% withdrawal rate based on total assets including an expensive piece of real estate, a valuable business, and a cash value life insurance.
The fact that some or all of those can be converted to spending money makes it a more viable plan.
Of course, retiring in the year 2000 makes it less viable!
Best,
-PoF
Being diversified across accounts of differing tax liability certainly gives you much more flexibility. Good point to consider
I’ve got some friends who put off retirement for a few years because their target date was right at the absolute worst time, 2008-09. And the husband was already in his mid or upper 60s. Isn’t that a kick in the pants. He’d already sold his dental practice but was working for another dental office, so fortunately he could just continue working there. A lot of his clientele had moved with him, including me, so there was no shortage of patients.
I had more than a little anxiety about retiring after this long bull market. I figured it would take a dive the day after I turned in my badge. It hasn’t, but I’ve loaded up heavily on bonds and cash as a hedge. Too much cash, really, as it is creeping up near 10% of my savings. But it helps me sleep at night. And the cash is new money from working part time.
As G alludes to above what is the correlation of real (estate) assets value to the the bad sequence of returns. Does owning rental property really hold out or as the entire market drops do rental prices and sale prices drop as well? Does Caroline’s 50/50 real estate portfolio work? I remember my current rental property was underwater during that time and rental income certainly wasn’t what it was today. Obviously belt tightening is key but does diversification into single family home or other small time rental business really work in this scenario?
Well values certainly drop as seen in 2008 however I found rents to be stickier. Vacancies increased some and time to rent stretched. Sometimes I had to lower the rent to a new tenant. On the good side tenants stayed longer and I could get some rehab work done cheaper and faster than say current market. However if you only have a small number of units your “sequence risk” is high. Meaning if you have one vacancy I five you have 20% vacancy and if perpetrated you can get killed. Have at least 10 “doors” or units to mitigate this. In the end I find the high return in cash each month to be comforting when the the stock market gets volatile. I’m at 40% stock 40% RE and 20% bonds and other debt.
I’ve done extensive research into this. My conclusion is two or three portfolios depending on the size of your fortune. I do not believe in a “bucket strategy” per se. I went back through history, a history I mostly lived, the 60’s the mid 70’s the early 80’s the late 80’s 2000 and 2008 were down periods and in need of some years of alternative funding. That’s 6 periods typically lasting 1-3 years over 60 years or about 20% 0r 25% of the time you may be in trouble. That means 75% of the time you are making money. It does not mean this will last since making money is a function of national productivity but assuming productivity is constant or increasing it’s much more likely to make money than loose.
SORR does not start till the portfolio is open to withdrawal. Prior to that in accumulation the portfolio acts like a state function and it’s end value is principal plus interest. You may have more or less interest but the portfolio is not attacked by SORR. Upon opening the portfolio you start withdrawing money, and it’s then SOR can have it’s effect and it’s then you need some ballast against the risk. The other thing that happens when you retire is you reclaim all of your risk. Prior during the W2 period your employer managed much if not all of your risk. When you retire YOYO and you better have that in the calculus. My study showed SORR of -5 to plus 10 was good for a 30 year retirement. Not a 50 year retirement. In the longer 50 year retirement 25 years of exposure seemed the rule. SORR loses steam as you close in on death, and as you age it becomes harder and harder to run out of money before you run out of breath, in other words a mistake you make at 85 won’t manifest till 100 and you’re already dead, but a mistake you make at 50 will have plenty of time to manifest into an Alpo diet at 85. The point is don’t take something like -5 to +10 as an absolute and then you are out of the woods. It all depends. It depends on length of retirement and WR and the amount of risk you carry in your portfolio. More of each yields greater uncertainty.
Given that predicate how do you protect yourself? To save your fortune you split your income between living and saving. You lived like a resident, practiced parsimony, executed faithfully. Spend down is no different. Your ability to survive depends on you actually understanding your need and the limits of your need and planning around that, in other words a budget and stress testing that budget. Wen I retired I did both. I tracked a budget learned the predictable patterns of my budget and then cut back to see what that was like (with my wife’s permission). Invaluable information. My budget spans 10K/mo to 6500/mo depending on my lean-ness. Below 6500 I start to make substitutes and have to plan expenses. My average/mo is $8500 or so. My fortune will support something like 20K/mo so I’m in no danger, but 8500 is when everyone is comfortable.
In times of disaster say a 30% market draw down I have 2 strategies one is a small portfolio of stocks and bonds that remains closed and is invested in 20/80 or the tangent portfolio, large enough to support 3 years of 6500/mo spending. I don’t “refill” this and haven’t had to use it. It makes some money and I re-balance periodically. The tangent portfolio pays the most return for the least risk. If the market drops in half this portfolio drops 10% or less and is ready to buy me hamburgers break in case of FIRE. My other plan is I own GLD. GLD is a bad bet in accumulation but it has an interesting feature in down markets it tends to soar. I bought my GLD when it was cheap (buy low) and if the market crashes I expect to be able to sell high. Gold is a non correlated asset with either stocks or bonds and in the crash tens to be negatively correlated, just what the Dr ordered. In a major crash I’ll spend the tangent and leave my main portfolio closed. I re-balance anyway around a fixed AA so on the way up I’ve been selling a little value high and stashing that in non correlated bonds (sell high) In the crash I will sell high (relatively) that value and stuff it back in stocks (buy low), and re-balancing forces that automatically, just follow the plan no guessing involved. In the mean time the tangent and GLD are paying the rent.
My third strategy is to Roth convert, close the Roth to withdrawal and let it grow until times of emergency. It acts like insurance but the money stays in my account. If there is a medical disaster we are covered. Protracted down turn, covered. I can risk the Roth however I like, I risk mine at about 2/3 the market risk on the efficient frontier. My entire portfolio lives somewhere on the efficient frontier. If you look at the statistics there are several diagnosis of increasing likelihood as you age for example NDD is 1/10 at 65 but 1/3 at 85. A Roth can grow pretty big in 20 years if you don’t open it to SORR.
If I spend down the tangent and the GLD I won’t refill them, they are dispensable and will have served their purpose, to change the trajectory of my portfolio back toward the sky. I hold cash now while I Roth convert but I won’t hold much in the future once conversion is done. My present cash pile serves a specific purpose, to relieve my future tax burden. Between non correlated assets. Pfau tends toward annuities and reverse mortgages with a strong enough bias to make me wonder about his opinion being funded. Not to say for an individual these may work, but my Mom is 90 and lives in an older community where a LOT of her neighbors are reverse mortgaged and problems ensue when it gets to be nursing home time. It’s better than going hungry but not without danger. As shown above there are alternative ways to protect yourself without giving your money away to insurance companies but it does take a somewhat bigger fortune to implement, but then creating that fortune took some planning as well. It’s not a plan for everyone but should be on the table.
This is a great piece David BRAVO!
Yeah, that’s a long winter. Good to think about.
My winter plan outside of bond funds in AA is not very fancy:
1) Cash reserve
2) Spend less (primarily by cutting travel and “luxury” purchases/activities)
3) Part-time income from per diem work
4) Sell some real assets (assuming value maintained)
5) Reverse mortgage (age 62+)
6) Social Security floor (delay til age 70 if able)
Thanks for the blog.
Well of course if you pick the worst time period to retire and use a 6% withdrawal rate you are doomed.
I do not think it is reasonable to consider your home in your calculations to figure withdrawal rate unless you plan to sell the hole and live under a bridge.
It also seems silly to consider the cash value life insurance if you are not using it.
I wonder what would happen if the couple just stuck to a 4% withdrawal during that same period. It does not seem to bad according to this Kitces post. https://www.kitces.com/blog/how-has-the-4-rule-held-up-since-the-tech-bubble-and-the-2008-financial-crisis/
In the end it is good to know all these options exist. I am not surprised to see that spending less is the most likely to succeed.
I was surprised to see reverse home mortgage but no other real estate mention, especially since owning cash flow-producing rental real estate is nice diversification to a paper portfolio. We are 50/50 real estate/ paper for that reason. If you can build a rental portfolio that cash flows sufficiently to cover everyday expenses, you don’t have to worry about outliving your assets, sequence of return risk, or other risks associated with paper assets.
Thank you. I’m going to add real estate and other sources of income to the list.
What is still true, however, is that after all of your income sources are accounted for, if you are making withdrawals from the portfolio, there is risk of SORR. Say because of income your withdrawal rate is 2%, well that is a nice buffer asset to have!
Agree 100% that you are at risk of SORR whenever you withdraw from a paper asset portfolio, whether you withdraw 4% or even 1%. This is why we added the real estate. Real estate has its own risks too, but they are different and therefore add some diversification. Real estate is also hard to liquidate so you really have to make sure it’s cash-flow producing and you’re not over-leveraged. There is no sure thing with investing!
Really interesting analysis and it highlights the difficulty that retirees have (early or not) with the decumulation phase of their financial life cycle.
Topics like this do raise a lot of fear about SORR and rightfully so. I actually didn’t think the window was as long as stated and 15 years is quite a long time to be in this danger zone.
One of the great benefits of getting passive income streams in place is that they essentially can act as your income floor during hard times and hopefully you don’t have to pillage your portfolio and be forced to sell during bad times. I agree that the greatest tool that a retiree has is the ability to tighten the belt financially during hard times. Just because you plan for a SWR of a certain amount each year does not mean that you absolutely have to. Dropping 1 or 2 planned vacations that year could be the difference between running out of money later on or ending up with a portfolio larger than when you started out with.