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Making Portfolio Adjustments With Big ERN | Ep 199

Karsten from Early Retirement Now joins the show to share his take on how those pursuing Financial Independence should adjust their investment portfolios based on the recent swings of the market.

Karsten, Big Ern from Early Retirement Now

  • Big ERN shares that it is unprecedented to see the stock market have such a rapid decline in one month. However, a 30% drop in the market is not unprecedented. The market has seen drops of 55% during the global financial crisis and an 80% drop during the Great Depression. The patterns of the market seem to uphold the patterns of other recessions, even if the magnitude and speed of change is unusual.
  • If the market upholds the optimistic forecast that the low point was 33% it recovers quickly, then it is a favorable scenario from a sequence of return risk perspectives.
  • Sequence of return risk is a product of two things, the depth of the bear market and the length of the bear market.
  • For those on the path to Financial Independence, this could be a good opportunity to make progress on your investment strategy. As long as you remain employed and have a solid emergency fund, it can be a good time to invest in the market. When Big ERN worked through the market drops in the early 2000s, he continued to put money in the market throughout the ups and downs. That allowed him to experience a good return on his portfolio thanks to dollar-cost averaging.
  • For retirees, Big ERN recommends taking another look at your withdrawal strategy. Although you may have originally had a low probability of failure, the change in the market could affect things. If you work through your safe withdrawal probabilities again, then you may find that you need to make adjustments to your current strategy. In fact, it is a good idea to reevaluate your retirement strategy once a year to make sure that your withdrawal plan is still working.
    If you choose to incorporate some flexibility into your withdrawal rate, then you can avoid the problem of running out of money. However, you might run into some wild variations in your spending patterns. But there is no easy fix for sequence of return risks, that’s why Big ERN has created a 37 part series that dives into the numbers.
  • Right now is a good time for everyone to do a reality check on their flexibility. Would you be willing to take on a side hustle if the market was down? Would you be willing to cut back on your spending to avoid drawing down your portfolio too quickly?


Table Of Contents

A Closer Look At The Unprecedented Effects On The Economy

Jonathan: All right, everyone, thanks for joining us. We’re speaking with Karsten today and today we’re talking about making adjustments to our retirement portfolio.

The context for this is that there’s individuals in different walks on their path to Financial Independence. You’re starting out, what does this mean for you? You’re halfway there, what does this mean for you? Then you are, you’re right at the door, or you’ve already retired, maybe you have less options available, what are the implications? Should you make adjustments with any?

We’re going to have Carson from Early Retirement Now on the show. He created this incredible resource, the Safe Withdrawal Rate Series. That series takes a look at sequence of return risk, and it does it throughout all of modern economic history. Basically, looking at the stock market, the cycles over the last 100 some odd years.

With all of that data available, coming up with a strategy that will stand the test of time. But we’re in this interesting place that none of his prior models have seen anything like this. This exact COVID scenario that we’re all going through right now.

I thought we could bring him back on the show and see if anything changed. To help me with this, I have my co-host, Brad here with me today. How you doing, buddy?

Brad: Hey, Jonathan, I’m doing quite well. Yeah, last week, we spoke with Karsten, more about the economy of the macroeconomic picture, generally.

Now, we’re going to really dive into what does this mean for individuals? What does this mean for those of us on the path to FI, no matter where we are on that path? Maybe we’ve reached a Financial Independence figure, maybe we’re just getting started.

What, if anything, does this mean that we have to adjust? I think that’s going to be a really cool look. I think it’s going to be a really, really interesting look.

Jonathan: All right. With that, we’re going to go ahead and bring Karsten on and ask him, should we make adjustments to our retirement portfolio.

But before we do that, we’ll be right back.

All right, Karsten let’s just hop right into this, your Safe Withdrawal Rate series, some 28 some odd parts and counting. I wouldn’t be surprised if he told me you’re over 30 parts now.

Big ERN: 37.

Jonathan: You’re at 37 is what you said? Oh, my goodness.

Well, I’ll tell you what, you might need to add another part to encompass this current environment that we’re in right now dealing with COVID. When you take a look at modern economic history as you’ve applied it to the sheets and spreadsheets to calculations that you’ve made, have you seen anything like this before?

Big ERN: Well, as we talked about last week, on the macroeconomic side, probably not.

In terms of the stock market and the drop in the stock market, it’s almost unprecedented to have this rapid decline within basically, one month, you go down from the market peak in February to minus 33% in March, where it almost felt like every trading day return looked like a bad month in some of the other recessions and bear markets. That’s how you move every single day in the stock market. That is definitely unprecedented.

But then again, a 30% drop in the stock market is not unprecedented. We’ve had that before. We’ve had a 55% drop in the stock market during the global financial crisis. We’ve had an 80% drop in the stock market during the Great Depression. Other market patterns also held up pretty well.

This is a recession that looks like a demand shock, the economists would call it a demand shock. It would take down stocks and bonds are actually doing relatively well right because there’s less risk of out of control inflation going forward, interest rates are going down. This looks like the standard recession that we’ve had during the Great Depression, during the early 2000s, during the global financial crisis. A lot of patterns are very similar.

Now, magnitudes are different. The pace of the drop is very different. In that sense, every recession will be different. There will be no two recessions that are exactly the same. History doesn’t repeat itself, but it rhymes. This one definitely rhymes with some of the previous recessions.

In a very cruel way, if the economy were to recover relatively quickly. And this is a bear market that went down within one month to a minus 33%, 34%, and then it starts recovering, of course, we can never tell what will happen. By the time this broadcasts, we might have another low point in the stock market, who knows.

But if our optimistic forecasts hold and the minus 33% was the low point, in that sense, it’s actually one of the better scenarios from a sequence of return point of view. Why is that? Sequence of return risk, if you remember our very first episode, My Sequence of Return Series-

Jonathan: 35.

Sequence Of Return Risk Scenarios

Big ERN: 37 parts. Parts 14 and 15, what makes sequence of return risk so dangerous is that you are withdrawing money from your retirement portfolio at depressed prices.

In that sense, if the market were to drop by 33% over one month, and then it starts recovering again and then maybe later this year, or next year, or maybe even in three years, we’re going to see a new all-time high.

From a sequence of return risk point of view, this is going to be one of the less scary sequence of return episodes. Because sequence of return risk is a product of two things. One is the depth of the bear market and one is the length of the bear market.

From a sequence of return risk point of view, this is going to be one of the less scary sequence of return episodes. Because sequence of return risk is a product of two things. One is the depth of the bear market and one is the length of the bear market.

If you have to withdraw 10 years or 15 years worth of living expenses out of your portfolio at depressed prices in the stock market, that’s going to be bad for sequence of return risk, and it’s going to be… Of course, the depth of the recession is also, and the depth of the bear market is also going to impact sequence of returns. But if this is a relatively swift draw-down and then a relatively swift recovery, this could actually be one of the less severe sequence of return episodes.

Again, this is all subject to the constraints, we hope that this recovers relatively quickly, and this is not going to be another Great Depression. In that sense, it could be not quite as bad as say, the Great Depression or the global financial crisis, or the dot-com burst. Which was actually the dot-com burst was one of the worst times to retire too.

In that sense, it looks similar qualitatively to previous recessions. In that sense, it’s not like I have to toss out my toolkit and say, “Oh my God, I have to start from scratch and I have to do something completely different.” This is not an exact repeat, but it has a similar flavor to something that we have seen already before.

Brad: Just to place us here, we’re recording this On April the 14th, because like you said, obviously things can change. We don’t want to… When this publishes, it looks like it’s going to be sometime around April the 27th. It looks, the Dow right now is at about almost 24,000. I guess what, you said it’s down about 18% from the highs, somewhere in that vicinity?

Big ERN: I always look at the S&P 500. This is just my personal preference is a more broadly diversified index. We are down 14% year to date, as of yesterday, the 13th and 18% down since the all-time high. Then today on the 14th, we recovered, I think, probably around two percentage points. Looking even a little bit less scary than that.

Brad: That’s a really interesting point that when this drops so suddenly, but then comes back relatively quickly, your withdrawals are only at those absurdly depressed prices for either maybe zero times or once if it happened to be during that month or thereabout. I never contemplated that. But that makes a huge difference in the sequence of return risk, right?

Big ERN: Right. Again… Actually, the global financial crisis for retirees wasn’t even so bad. If you had retired at the peak in 2007, I think September, October, just around that time was the peak in the stock market, if you had to retire there, you would have experienced a 55% drop in the stock market, but the drop was relatively swift, 17 months until March 2009. Then also a very swift recovery and a very long bull market all the way until 2020.

It’s too early to tell what will happen to people that retired in 2007, and they have a 30 year or 40-year or 60-year horizon. But so far their portfolio is going to look relatively good. The far worse time to retire would have been in 2000, because then you had also roughly 50% drop in the stock market, then the market recovers, but it never really recovers by enough. Then you have the next recession in 2007. You went through two deep back to back recessions in the 2000s.

An even worse time to retire would have been in the late ’60s. In the late ’60s, ’70s, ’80s, you didn’t even have these severe draw-downs like 80% drop, like in the Great Depression, or a 55% drop, as in the global financial crisis. But again, there the length of the draw-down was the problem, not the depth.

If you draw down for 10 years, 15 years, I think around 17 years, worth of retirement withdrawals at depressed prices, even if they are not that far down, but you draw down for such a long time, then an even relatively mild draw-down, it’s going to be catastrophic for your retirement. In that sense, if it’s short and swift, it’s actually better news for you as a retiring.

Effects For Those Starting On Their Path To Financial Independence

Jonathan: Yes, this is interesting. I wanted to basically say, individuals on the path to Financial Independence could be at different points, they could just be starting out, and they’re like, “Whoa, freaking out right now, what’s going on?”

Real quickly, ERN, for those individuals, as long as you’re employed, which, admittedly, is it a big as long as, like there’s a lot of people unemployed right now, and there will probably be more by the end of this, but as long as you’re employed and have an emergency fund and have runway, this potentially could be a great opportunity right now.

Big ERN: Yeah. I share my own experience, I got my first job right around the market peak in 2000, coming out of grad school. Never had much money before then. I started contributing to my 401k and other savings. The savings initially they took a beating, because the bear market lasted until 2003, then only slowly recovered, but because I did the dollar-cost averaging through that bear market, I made a killing during the 2000s.

Even though the point to point return was not very good, because of dollar-cost averaging, I had a fantastic return, and that was the foundation for my FIRE, not losing my nerve when the market is down. Just put money in, don’t think about it, let it grow. 10 years and you’ll be a millionaire and you’ll retire very comfortably.

Effects For Those Halfway To Financial Independence

Jonathan: Pretty simple, not a lot of nuance that we need to add to that. Stay the course, keep your job, buy new income, great.

It gets a little more interesting. You have someone that’s maybe they’re five to 10 years in. They’re halfway to their Financial Independence number, or at least they were, February 19th. Then the market has… I guess if we net it out, it’s probably what around 12% down, somewhere in that range. Is that close?

Big ERN: Yeah, if they 100% equities, if they do a little bit of diversifications, probably less. A lot of people in the FIRE community, they’re probably 100% equities. You can read off your performance by just looking at what the S&P did that night, because they’re doing… S&P 500 and your VTSAX, they’re probably moving almost in sync.

Jonathan: Okay. This is interesting. I can just talk from my own particular place here. It hasn’t really changed anything for me. I’m not really questioning my asset allocation. I’m very much excited about the idea of in the short term as I’m being able to dollar cost the average of my way through this thing, my horizon is still several years away.

For me, it’s more just again, take care of the basics. Do I have my emergency fund in place? Do I have my income mapped out for the next several months? What’s our economic outlook?

Now, all of that, that’s a completely different story. As an entrepreneur, I tell you, what, I look at the economy, and I’m very much like, all right, we’re going to be checking this month to month. But it doesn’t really impact my investing plan, long-term mindset.

Withdrawal Strategies For Retirees

Jonathan: It’s much more interesting when you’re talking about the retiree. And it doesn’t really matter whether you are talking about a traditional retiree or an early retiree, it’s an individual that’s relying on their investment income for their cost of living, for their expenses.

And they don’t have as much flexibility. They’re not planning on going back to work. This is it, this is what I have, and the asset allocation that I chose, that’s… Anyways, all that being said, I want to actually do two things.

One, map out, if you have an individual, they’ve got a little bit of diversification in place. Maybe it’s a 60-40 stocks to bonds, they had a million dollars at the peak in February. Now, maybe that’s looking a lot like 900,000, somewhere in that range.

That individual, going back they’ve retired in January or February. In this kind of perfect sequence of return risk, safe withdrawal rate approved mode, what is their withdrawal strategy look like? What does it look like as the market’s actually going down?

Let’s just use this as the prototype. Are they making withdrawals once a month? What’s your thought process on how it would look like for this hypothetical case study?

Big ERN: Well, in my Safe Withdrawal Rate Series and in my tool kit that I have posted online, I assume that you make withdrawals once a month. You can change that if you have preferences where you say, “Well, I want to do it only once a year, at the beginning of the year. I want to make it once a quarter. You can adjust that. It actually turns out that if you calculate your safe withdrawal rates, there’s relatively little difference depending on whether you do it once a quarter or once a month.

I assume it’s once a month. Then imagine you picked a 4% withdrawal rate, that means you withdraw 1% a quarter, or 1/3 a percent every month at the beginning of the month. That’s what I assume.

Again, whether you want to do adjustments to your plan depends on what was your philosophy when you initially set up your plan? Actually, before I get into that, I actually want to congratulate you for thinking about that, because obviously you cannot say that, while I retired at the peak of the market and I had a 10% chance of failure. I’m just going to keep that plan on and I have nothing to worry about. It’s only 10%?

Well, unfortunately that 10% might have shifted since then. It’s a little bit like going on a hike, and you check your weather forecast in the morning and it says 10% chance of thunderstorms. Then you’re halfway up to the summit and you see dark clouds coming up. Will you continue what you’re doing, or will you turn around? Is probably you should turn around because that 10% just went to 100%, or 90%.

In that sense, because well, sometimes the 10%, that’s the whole point about probabilities. The probability is something that you do ex ante and then some uncertainties are being resolved. Then that 10% initial could become either a 0% or a 100%. That’s what could have happened to some retirees. They retired at the peak and they said, 10% failure probability, that’s fine for me. They should probably redo their exercise and check well, do I still have a low enough failure probability, or do I still have a high enough success probability going forward with my current portfolio and my current withdrawal amount? Maybe you want to lower that a little bit.

Now, a lot of retirees I know, they would not be okay with a 10% failure probability. They ask, “Well, what would have been the fail-safe withdrawal strategy that was even safe, even during the global financial crisis, even during the 2000s, even during the 1970s, even during the Great Depression? If you had started with that withdrawal, and that is probably going to be a little bit… At least for most people, might be a little bit lower than 4%, it might only be 3.5%. Now, your portfolio is down by 10% while your 3.5% withdrawal rate if you keep up that same withdrawal amount, maybe it’s now up to 3.9% or 4%.

Well, the question is, is that 4% rate now safe? Because you retired, back then you had a 3.5% “safe withdrawal rate” and now you’re at 4%.  So the question is, now that your portfolio is down by say, 10%, 12%, 14% do I have to go back and readjust my withdrawals back to 3.5% times that reduced portfolio level?

The good news here is that if you had picked a very cautious initial withdrawal rate that would have been safe, say even during the Great Depression, even though you are now withdrawing more than that initial rate, you could also argue, hey, the market is now no longer at the all-time peak.

The question is no longer, do I recalculate my withdrawal rate subject to, I’m safe even at the all-time high, right before the global depression. What you shouldn’t be doing is, well, what would have been my safe withdrawal rate if I had retired a little bit later than the peak at around the Great Depression? Also at about 10%, 12%, 14% downdraft in the portfolio.

What you’ll find is that well, if you keep up that slightly higher withdrawal rate back during the global financial crisis of the 2000s, or the Great Depression, suddenly that higher safe withdrawal rate would have still been safe, because you’re no longer starting your retirement at the peak, right before the Great Depression.

What I’m trying to say here is that imagine you woke up today, you’re already two years into retirement, and you ask yourself, “Well, what if I retired today, with my portfolio today, and with my withdrawal amount today, would I still be able to retire today?”

It’s like the movie, Groundhog Day. You wake up every morning and you think it’s the first day in your retirement. Maybe you don’t do it every morning, but maybe once a year or once a quarter, if you’re retired, you should probably re-evaluate if your retirement strategy is still working.

Then basically what you should be doing is that if we’re going from one all-time high to another, you should definitely ask yourself, well, is this retirement strategy still safe conditional on being at the all-time high? But today, we’re no longer at the all-time high. You should ask yourself, is my retirement strategy still safe, conditional on being already 10%, 15%, 20% below the all-time high for the stock market.

Then conditional on being way below the all-time high? It actually turns out that you don’t have to be quite as cautious anymore with your safe withdrawal rate. You might be able to afford a higher percentage withdrawal rate today.

Jonathan: I want to say, that’s actually the point of encouragement here. It’s a pain point if you’re a statistician because you’re trying to find one number to rule them all. But it doesn’t account for the fact that humans can make some changes. There is some flexibility baked into our daily lives, with the choices that we make.

To your point, what you were just saying, a few points about, I guess the 4% rule, or if we’re going to do the 3.5% rule. Basically, when you retire, the 4% rule says you take a look at your portfolio, and if you’re going to go with 4%, you say you can withdraw 4% of that portfolio each year and every year and that’s an inflation-adjusted dollars. It doesn’t really matter what the market does, you still can draw that same amount in inflation-adjusted dollars each year.

Then with the 3.5% rule, you’re saying, well, that might be a little too aggressive, especially for someone with an extended timeline. Let’s bump that down to 3.5% to account for the longer timeline that these individuals have and be a little bit more conservative, because this will be even more foolproof? But if we just say, okay, well, hey, we retired at the peak of the market and the market’s down right now.

What you’re saying is if you were to then say, “All right, well, what’s 4% of my new number, of this number after it took a blip here in March after it went down.” If you can live off that 4% number, then you’re good to go. In fact, if you just took 4% of your portfolio each month, you would never run out of money, regardless… I’m sorry, I said that wrong. If you took 4% of your portfolio each year based on what that portfolio was, it was a mathematical certainty, you could never run out of money, but it’s a volatile ride. It’s something along those lines, right?

Big ERN: Right. What you just mentioned that is called the constant percentage withdrawal rate, withdrawal strategy. You reevaluate every month or every year. You look at your portfolio value and then you withdraw a fixed percentage of that portfolio. Unfortunately, that would also mean that your withdrawals are going to become just as volatile as your portfolio.

You are now talking about say, a 60-40 or a 70-30 portfolio, that’s going to have something like a 10% annualized standard deviation. You’re looking at potentially a lot of volatility in your withdrawals. Again, you’re not going to completely run out of money. Then you have to cross your finger that if you withdraw 4% of your portfolio every year, that your portfolio is actually able to generate 4% real returns on average. You will never completely run out of money, but you might run out of purchasing power parity over the years and decades, if your portfolio doesn’t generate, on average 4% returns every year.

Anyways, on top of that, obviously, that strategy is also not very well suited for people who are totally willing and able to draw down their assets. Why would you want to withdraw only 4% of your assets if you are 89 years old? Towards the end of your life, you should then start to almost think of this as amortizing your portfolio. Then you could dig a little bit into the principal.

Especially for older retirees with say, a horizon of maybe 20 years or less, now you can start making significantly larger amounts than just your projected real portfolio return because you can also factor in that obviously, you can start withdrawing a little bit of the money and drawing it down.

It’s never even a zero, one thing, because you could say, I still would like to leave maybe a quarter of my nest egg to my kids, or for charitable purposes, but the 75%, I’m willing to draw that down over time. Again, if you do that fixed percentage rate, the concern is that you have a very volatile spending pattern. That could mean that you thought you’re going to retire in your 40s, and you’re going to have a fantastic, very generous lifestyle and then a recession and a bear market comes up, and you’re going to live a very lean FIRE that way.

There’s pros and cons of all sorts of different approaches to the withdrawal rate. The tradition of 4% rule, you have a very flat spending pattern, but the problem is you have the chance of running out of money after 30 years, whereas with some of these more dynamic approaches that rely on flexibility, you solve the problem of running out of money eventually, but then you have some wild variations in your spending and withdrawal.

There’s pros and cons of all sorts of different approaches to the withdrawal rate. The tradition of 4% rule, you have a very flat spending pattern, but the problem is you have the chance of running out of money after 30 years, whereas with some of these more dynamic approaches that rely on flexibility, you solve the problem of running out of money eventually, but then you have some wild variations in your spending and withdrawal.

There’s really no easy solution. It’s like squeezing a balloon. You think you solved the problem of running out of money eventually, but then you create these horrible horrible downdrafts and drought periods in your withdrawal that could last for years and potentially decades.

There’s really no easy solution. It’s like squeezing a balloon. You think you solved the problem of running out of money eventually, but then you create these horrible horrible downdrafts and drought periods in your withdrawal that could last for years and potentially decades. There’s no easy fix for sequence of return risk. That’s why I’ve been writing for 37 parts in my Safe Withdrawal Rate Series.

It’s not it’s not an easy problem, and it’s not an easy problem for households. By the way, a lot of other institutional investors, they have the same problem. I’d imagine you’re endowment or you’re pension fund, everybody faces this problem that you want to invest for the future, withdraw money regularly. The asset market returns are very volatile. The higher the average return, the more volatility, but you don’t like volatility in your spending. You want to have a more or less flat spending path.

It is very hard to generate a flat and fixed paycheck out of your retirement portfolio. The only way really is well, you hand your money over to an annuity, to an insurance company and they generate an annuity for you. But then again, we talked about that last year in an episode. There are all sorts of drawbacks for that, too. These are some of the tradeoffs you have to make here.

Is This Market Drop Different?

Brad: Karsten, across the two episodes now, we’ve been talking obviously about just the economic condition. I have to say, I’m heartened by the fact that, and I don’t want to put words in your mouth, obviously, but you seemed fairly unperturbed about this whole situation. We’ve seen this before. There’s no need to freak out right now certainly.

Obviously, while admitting we are in this, “death zone” that you’ve talked about. It sounds like you’re not freaking out by any means, but I also know you’re not one to rest on your intellectual laurels.

What, if anything, and frankly, I’m emphasizing if anything, would make you go back and say this time actually is different or maybe I need to look at this model that has worked for all of time. Is there anything, or is it just simply like, this is what’s built into the model even for crazy Black Swans. That might make people feel better, if that is the case.

Big ERN: My approach has always been, I want to be prepared for my retirement portfolio and my withdraw strategy would survive a repeat of the Great Depression. Then you could say that… Would I then say that I have a 0% probability of failing in my retirement? No, I don’t. I have a 0% probability, assuming that going forward, we have nothing worse than the Great Depression or the 1970s.

My failure probability is exactly equal to the probability that the future is going to be worse than what we observed in the past. Nobody can say for sure what the future holds. I still think that in the future, there will be certain patterns that will persist. The patterns will be that equities, on average have a very decent real return. That real return is going to be… It’s actually significantly higher than real GDP growth. There’s a macroeconomic mathematical certainty that real equity returns have to be higher than real growth. If that’s not, there would have to be something seriously, seriously wrong with the economy and your economic modeling.

I use that. I don’t think that will change anytime soon. I also think that what is not going to change anytime soon is that stocks are going to return more than bonds on average. The other thing that will not change is that stocks and bonds are going to have a varying correlation pattern.

There is actually something that is a little bit of a risk on the horizon, because we have become accustomed to a negative correlation between stocks and bonds. That has been the case for the last 30 something years. Whenever we have a recession, stocks go down bonds rally. But there was a recession in the 1970s and ’80s, where you had stocks and bonds, they went down at the same time because we had an inflationary shock. We had stagflation. A stagnation of the economy and an inflationary shock.

That’s obviously something that I’m a little bit concerned about that. What if stocks and bonds become much less of a diversifier? There was a little bit of concern. There was even a Wall Street Journal article in March where they said, oh my God, stocks and bonds are no positively correlated and stocks and bonds are no longer… Bonds are no longer a diversifier for the stock market.

Basically, what they looked at, is they had something like two consecutive days where stocks and bonds were co-moving together. I said, “Okay, give me a break.” If you look at the monthly returns, between the stock and the bond market or even take weekly returns, there is a very, very persistent negative correlation between stocks and bonds. That is still the same.

But again, it’s on my mind, but even if that changes, again, it’s not something that’s out of the realm of history that we have observed because we’ve had recessions where you had a positive and a negative correlation between stocks and bonds. That would not rattle me.

The other thing that seems to hold even in this bear market is that gold… For example, gold has been a decent diversifier even during the current Black Swan event.

There was a bit of a concern, people right at the beginning in late February, they said, “Gold is no longer a good diversifier.” But it has held up relatively well. Again, obviously, what’s happening right now, it could be something completely out of the range that we have ever observed, and we’ll see how things work out. But I think chances are still pretty good that this is still within the parameters, within the whole spectrum of possible outcomes that we have seen during the last say, 100 years.

Again, if your withdrawal strategy was safe or would have been safe during the Great Depression in the 1970s and the early 2000s, I still have some reasonable confidence that we’ll make it through this one too. This is why I’m not too nervous yet.

In fact, I retired in 2018. As of right now, our net worth now is higher than the net worth we had when we initially retired. Now, we have… We already ran down the clock by two years. In that sense, I’m not too scared.

Again, if the stock market goes down by 50% from here, I might be singing a different tune. Right now I’m not too worried about our own withdrawal strategy.

Building Flexibility Into Your Withdrawal Strategy

Jonathan: Someone that… We’re going to go through a couple different strategies that people have mentioned in coming episodes. There’s a bucket strategy out there that Fritz from Retirement Manifesto is a fan of, I know Bryce and Kristi have talked about a yield shield. I’m not even looking for commentary on these, but I’m just saying in terms of… ERN.

Big ERN: Don’t get me started.

Jonathan: ERN, I know.

Brad: ERN’s brain just exploded.

Jonathan: I know.

But ERN, with your general approach, which is you don’t time it when you’re investing, why would you time it when you’re getting out? You’re not sitting on multiple years of cash, you’re just doing month to month withdrawals based on that initial allocation.

Let’s just say though, this individual, they retired in February, a million dollars, they’ve hit their 4% number. They were planning withdrawing $40,000 a year.

Jonathan: One month in, it took a bite. They’re saying, this is a blip. Hopefully it comes right back, we don’t know, but it’s hopefully… They take their monthly withdrawal, whatever that percentage was this month. Maybe next month they’re still there.

How many more months would that individual go before you go like we need to actually adjust down and adjust down quickly. What else can we do? How dynamically should someone who just barely hit their 4% number, but recognizes they can be a little bit flexible? How quickly would you advise them to reel it in and try and wait this thing out, because you were just barely there?

Big ERN: This is a point I’ve made on my blog too. I think the title of the post is can the simple math make retirement more difficult? If we retire, just waiting to hit exactly that 25X. If you look at what different retirement cohorts over time, what their experience would have been, they are clustering more around some of the market peaks.

If you follow that Mr. Money Mustache approach, you’re setting up yourself to retire closer to the peak, and you’re probably not going to retire at the bottom of the bear market. Because if you had 25X at the bottom of the bear market, you would have had 36X at the top of the bull market. There are very few people would be retiring at the bottom of the market.

You definitely have to keep that in mind, if you run this simple math and you run this target, I want to reach exactly 25X and then exactly I retire, that you raise the probability a little bit that you retire right at the market peak. This is why I always suggest that you want to not… The 4% rule is obviously a great rule of thumb. If you see people that are just starting out as FIRE, absolutely, I tell them, target 25X and run with that.

Then when it comes time to actually retire, and you’re close to retirement, you should probably look at well, what are equity valuations? Are we at an all-time peak? Are we at very high price earnings ratios? Are we at very high cape ratios? If we are, then you should probably target a little bit higher than 25X.

Now, of course, the point is that if you did retire at 25X, and now your portfolio is at 22X and you’re still withdrawing your 4% of that initial portfolio and your portfolio is down by only 10%, 15%, probably you don’t have anything to worry about yet.

When it gets to 30% down, you are withdrawing instead of 4%, you’re withdrawing 4% divided by 0.7, whatever that is, I think that’s about 5.5% or so, and your portfolio is 30% less than what you thought it should be.

Then you have to ask yourself, okay, do I keep doing this and risk running out of money in 27, 28, 30 years, or should I do a side gig? Should I do a side hustle? Should I reduce my consumption? I made this point earlier in a blog post. I think even if you’re not retired yet, now would be a good opportunity to just get a reality check of your flexibility. Would you want to do a side hustle? I could always do an Airbnb with my house. Well, you’re not going to do Airbnb right now? There’s very little trouble.

I could always become an Uber driver. Well, Uber and Lyft are probably don’t have much traffic right now. I could always do a Starbucks barista FI. Not a lot of Starbucks baristas are being hired. If you were hoping to do this flexibility business, even if you’re not retired, it’s a good time to do a reality check of that right now-

Jonathan: I want to point out that reality check’s a great idea, but the flexibility cuts both ways. It actually points to the flexibility being on the spend less side as opposed to the earn more side.

You have a lot less control over earn more in a significant economic downturn, but if your FI number was based on spending up to a cushion amount, and that cushion amount doesn’t really reflect what your core expenses are, then nothing that you mentioned, none of those factors you mentioned affect your ability to spend less if you built that into your budget.

Great point, I completely agree with you, but worth pointing out the other side of the coin.

Big ERN: Again, I think the spending valve might be the easier thing to do, because a lot of people probably budgeted very generously for traveling. Maybe people aren’t going to travel that much. My wife just cut my hair.

Jonathan: Looks good.

Big ERN: But it looks good.

Jonathan: It looks good.

Brad: It looks good.

Big ERN: Our spending might be down by 30%. If your portfolio is down by 30%, and your spending is down by 30%, hey, maybe that’s all the flexibility you need. Again, it’s probably easier for somebody who picked say a FI somewhere in the $50,000 to $100,000 a year range. That spending flexibility might not be so easy if you pick say $20,000 to $30,000 a year. Good point.

I definitely noticed that our spending is down. This is partly… This is not partly, this is entirely due to the shutdown. It’s not really by choice. We no longer go to bars and restaurants. It’s not even our choice, we definitely cut our expenses.

Considering Tax Vehicles

Jonathan: Yeah. This is great, I appreciate you walking through this. If you don’t mind, it’s kind of a curve ball question, but I feel like we haven’t done a great job covering it, but I actually wanted to get your input.

Yes, we’re going to be withdrawing our money, but which bucket are we actually withdrawing from? Is there any advantage to having your stocks versus bonds parked in your 401k, your Roth IRA, et cetera? We’ll get to that, but before we do, we’ll be right back.

We’ve talked about asset allocation in the past; stocks to bonds and other diversification tools that you might use. But one thing we actually haven’t really covered is the tax shelters, the tax vehicles that your investments are actually in, as they pertain to maybe draw-down.

What I mean by that is, yes, you could be in stocks and bonds, but your stocks and bonds, would you rather that be in your 401k, or would you rather that be in your taxable accounts? Your bond… As someone is right here at the cusp, and is planning for this or even now is recalculating where they want to be, is there any thought in terms of how to best situate your investments, to take advantage of and maximize the tax treatments as they lie?

Big ERN: That’s a great question, because see, when we have… Very broadly speaking, let’s assume there are three different types of accounts.

One is your 401k, traditional IRA that is tax-deferred. You take the money out, it’s going to be taxed at your ordinary income tax rate. You have your Roth IRA, Health Savings Account, money grows tax-free and you can take it out tax-free.

Then you have your taxable accounts where your stock returns, dividends have to be taxed every year. Capital gains, only taxed when you take them out. Then also at a lower rate. Dividends and long term capital gains enjoy a reduced federal tax rate. Even some states have some incentives for capital gains and dividends.

Whereas bonds, bond interest would be taxed at your ordinary income tax rate. There are definitely some ways of shuffling around your assets. Imagine you have a 60-40 target asset allocation, doesn’t necessarily mean that you have 60-40 in all three buckets, right? Taxable, tax-deferred and tax-free.

There are definitely some ways of shifting around. I did some calculations on that, and it all depends on your tax situation. It depends on what’s your marginal tax rate for ordinary income, and what’s your marginal tax rate for dividends and long term capital gains?

Some people would argue that you keep bonds in your tax-advantaged accounts because they generate income and it can… You could keep your bonds in your retirement accounts because that’s where they accumulate tax-free, and you keep stocks in your taxable account.

Others would argue that well, why do you want to keep the highest return asset in the worst possible account, which is your taxable account in some way? Why don’t you just keep that in your Roth IRA, where it can grow the fastest and with the with a zero tax rate?

Again, there is no clear answer. Depending on what your tax rates are, some people would prefer to pack all of their bonds into a Roth IRA, and then live off of that and keep the interest in the Roth, and the equities in the taxable account, and then for others, it would be the other way around. Then there’s some other considerations too. A lot of people want to keep stocks in their taxable accounts, because stocks are very volatile. You could do some tax-loss harvesting. That’s a whole other dimension that opens up there.

What to keep where, there is no clear answer. I think that is part 35 of my Safe Withdrawal Rate Series.

Brad: Too many to remember.

Big ERN: I went through some of the scenarios and I was amazed at how different the results can be. Sometimes you wanted to keep your bonds in your Roth IRA, and your stocks in the taxable and sometimes it’s the other way around.

Then some people throw in some other curve ball. Well, you could also do your bonds as muni bonds, then you keep the muni bonds in the taxable account, that’s tax-free. Then you keep everything else in your Roth. There’s so many different angles that you can look at, is actually really quite complicated.

Jonathan: That poses an interesting question, because I imagine one of the variables would be well, what money are you drawing down on, which we haven’t really talked about.

For an individual that has 60-40 bonds, are they drawing evenly from their stocks and bonds? Are they drawing from bonds because bonds are less volatile? I guess, depending on what your decision is there, I’m interested in your input, that would also impact which one of the vehicles that you’re going to have this money parked in as well, because the rest of them, they’re staying the course, right?

Big ERN: Right. Again, there are many different angles to look at this.

First of all, your 60-40 portfolio might now have become a 55-45. Stocks are down, your bonds are up. Now would be, for example, a good time to diversify. Again, now would be a good time to rebalance your portfolio. You would then withdraw from the asset class that is up the most.

So now, bonds are overvalued. You take it out of your bond allocation. The other question is, well, what if I don’t want to take money out of my Roth yet, but I have to take money out of the assets that are in the Roth, but I want to keep the Roth untouched for now, I want to keep that for later, what do I do then?

Of course, you could always argue money’s fungible. Imagine you have a lot of bonds in your Roth and you want to sell bonds, but all you have is stocks in your taxable account. Well, what you could do is you could sell the bond fund in the Roth, but keep the money in the Roth and put it in stocks, and you sell the same stocks in your taxable account. Then effectively you have taken it out of your bond portfolio, but you have shielded the assets in your Roth. Always keep in mind that money is fungible.

Brad: That’s a brilliant concept. I don’t think people necessarily think of that. The interplay between rebalancing, and where you’re pulling this money out of, that is a cool, cool look of you can accomplish both. It doesn’t just by definition have to be I’m selling, so I need to pull that money out. That is a fantastic point.

How To Connect

Jonathan: ERN, thanks for joining us on the show. We cover a lot of content over the last couple of weeks and I’m very excited to have had the chance to dialogue with you about this. People hearing about this, maybe they want to follow up on something that we discussed, they want to find out more about your Safe Withdrawal Rate Series, or find out more about some of the content that we talked about specifically today. What would be the best way for them to do that?

Big ERN: Go to my homepage, and you see the most recent articles.

At the top menu, there is one menu point, Safe Withdrawal Rate Series. That’s the landing page you can see. Probably you don’t want to read them in sequence one through 37. There’s some guidelines of different people, different preferences, what they should read first, but it also has the entire list of all the different articles. Then part 37 is how to deal with bear market in retirement.

Jonathan: Awesome. We’ll have both those linked up in the show notes for this episode. ERN, thanks for coming on, man.

Big ERN: You bet, thanks.

Jonathan: I hope you got value from this episode. If you haven’t yet, go to our homepage, Check out our financial resilience toolkit and get started on your own path to Financial Independence. All right my friends, stay tuned and stay subscribed as we continue to go down the road less traveled.

Choose FI has partnered with CardRatings for our coverage of credit card products. Choose FI and CardRatings may receive a commission from card issuers. Opinions, reviews, analyses & recommendations are the author’s alone, and have not been reviewed, endorsed or approved by any of these entities. American Express is a ChooseFI advertiser. Disclosures.
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