Here at Mr. Tako Escapes, we try to be realistic when talking about financial independence. No false/fake optimism here! Today we’re going to talk about failure. Specifically, the possibility that our financial independence plans could completely fail. What exactly would a failure like that look like? Is there anything we can do to mitigate such a failure? Do we want fries with that? So many questions to answer…
Failure happens to everyone at some point in their lives. Usually more than once. At this point in life, I’m nearly an expert at failing. Practice makes perfect (and all that).
To be clear: We haven’t failed at financial independence yet, and we don’t plan to. The hard reality is – It’s very possible we could fail at financial independence through no fault of our own. Despite our savings and planning, it could happen.
Failure when you are financially independent can be caused by a few things:
- Health Problems. We could develop severe health problems. Health insurance helps cover a large chunk of the cost, but not all of it. Continuously paying large medical bills for long periods of time could definitely put a dent in anyone’s early retirement plans. The only thing that can be done here is to eat healthy and stay fit.
- Catastrophic Natural Events. Earthquakes, tornados, tsunami’s, and massive meteors hitting the earth all have the possibility to derail financial independence. Insurance can help in some of these situations, but they are hardly predictable or avoidable. Cover your eyes and hope for the best.
- Running out of money. This is the most likely scenario. It happens when a reasonable withdrawal rate (like the 4% rule), does not adequately cover our expenses. Let’s look at this one in more detail…
The Market Doomsday Scenario
Everybody’s greatest fear in financial independence has to be running out of money. Sure, historically we know the 4% rule has worked most of the time, from the Trinity study. What if it doesn’t work out this time? I have no doubt that global GDP is going to rise eventually, but what if Mr. Market is a giant jackass for the next 20 years? Market returns could be 0% or negative for 20+ years. Corporate profits would go flat or negative, year after year. Stock prices would decline, as earnings declined.
Don’t think it can happen? Think again! Markets don’t always go up. Look at the Nikkei (Japanese market index) for the past 20 years:
The Nikkei has been flat since the early 1990’s (20 years!?!). There’s probably several things going on here causing this underperformance: Japan faces the unfortunate reality of a shrinking population, and very little immigration. Japan has also been dealing with deflation during much of that same 20 years. Two sides of the same coin, I say.
This is our doomsday scenario for a financially independent early retiree. A flat stock market for 20 years would probably kill most retirement plans. Most plans accept market volatility as a fact, but few are geared for this level of under-performance. Surviving on portfolio returns when there are no returns for 20 years is near impossible!!
Can this happen in other parts of the world, like the United States? Yes, it absolutely can happen. Our country’s government could make changes that would have a terrible impact on markets. For example: Our government could stop any form of immigration (giant wall anyone?). The government could start taxing multinational corporations to the point where they become globally uncompetitive. There’s dozens of possibilities. Feel free to dream up your own if you want nightmares.
Changes like these could effectively kill growth at large U.S corporations, and stock market performance. Don’t think it can’t happen here*.
So how are we going to beat this ugly hypothetical scenario? Let’s take a look at some of the different strategies…
* Note: Extended periods of non-performance have already occurred in the United States (several times): From 1920 to 1942 and from 1965 to mid 1982.
Living Off The Dividends
In previous episodes, I’ve mentioned how we intend to live off dividends rather than market returns. Normally this is around 3% of our portfolio, which is less than the 4% recommended in the Trinity study. I still think this is a good strategy, but it may not work-out well in our doomsday scenario.
Dividends would have the effect of shielding us from market declines in the beginning of this economic scenario – we wouldn’t need to sell at low prices when markets are down. Potentially we could reinvest excess dividends to maintain some compounding in the early years. However, during really long declines, dividends may be cut if corporate profits decline. This would eat into our income, and that leads us back to the ‘running out of money’ scenario again…
One way to avoid running out of money in financial independence is to just ‘save more’. Some people can get pretty crazy about this…. Instead of the 4% rule, they plan and institute a 2% rule, or a 1% rule. This can also lead to “One More Year” syndrome where the saver is trapped in a cycle of endless saving for ‘one more year’ to ensure retirement safety. When is it safe enough? When you hit 1%? When you’re dead?
Yes, it is possible to avoid failure by saving more. It’s also possible to save too much money for retirement and waste years of life as a corporate slave. I could try to tell you how much you need to save, but that’s a very personal decision. I’ll just say “choose the withdrawal rate you feel comfortable with.”
We like a withdrawal rate 3%, so that’s what we’re using. It’s more conservative than the Trinity study, but doesn’t require saving twice as much money.
If instead we chose to keep working and saving during the 20 year doomsday scenario, we would be nearly 60 years old at the end of that period. I don’t consider that an acceptable solution.
Another strategy I often hear about is global diversification. Hitching your wagon to more than one economic star. Global diversification is a good strategy, and happens to be one of the reasons why we have to pay foreign taxes on certain investments.
Why is global diversification good? Economies won’t necessary go bad in all parts of the world, all at the same time. Some pockets of the world may see good returns for those hypothetical 20 years. Certain pockets of the world might bounce back faster than others. Companies that have spread their wings globally will also have more opportunities to escape that 20 year malaise.
Global diversification isn’t a hard strategy to implement either. We currently do this by owning companies headquartered in different countries, or by owning globally diversified multinational companies. Ideally, both if we can get it!
At different times, we’ve owned companies headquartered in Canada, United States, Bermuda, Cayman Islands, Monaco, Netherlands, U.K., and China. Their operations span much of the globe. This strategy appears to be working well. In 2015, we outperformed the S&P500 by 4%.
Another idea that gets passed around a lot, is to avoid keeping everything in the stock market. Rental real estate is one alternative that comes up frequently. Investing in a small business to diversify income away from the stock market is also a pretty good idea. Be careful though. Many of these investments use high amounts of leverage and are inherently risky due to their small size. It’s also important to remember that most some small businesses are not a passive investment.
We don’t currently own any rental real estate (prices are too high in our area), and our small businesses don’t return any income. This is definitely an area where we need to spend more time developing.
Getting Another Job
OK, we don’t actually want a full-time job, but if all else fails (market declines, dividend income declines, and small business ventures completely fail), we have the option of going back to work. It’s not ideal, but we could survive it.
In our hypothetical bad market, there should be some dividend income to partially cover our expenses. A part-time job might be adequate to cover the shortfall. Ideally, if we go back to work, we’ll direct some of those earnings into savings to replenish our investments at the new low prices.
Even if this “market failure” never happens, we’re going to have some form of ‘work’ in the future. We won’t just sit on the couch. Instead of taking jobs based upon what they pay, we’ll take a job because we’re interested in the work. Maybe we’ll start small businesses that we enjoy.
What happens when we’re no longer interested in the work? We quit, and move on to the next thing.
Adjusting Expenses Downward
An important part of making our financial independence plan work is the ability to reduce our expenses if the economy gets bad. If the economic environment goes badly in the United States we have several different options:
Reduce Regular Expenses – Right now, we live a pretty luxurious lifestyle. We eat pretty much whatever we want, and don’t even bother to budget. We definitely have the ability to live cheaper than we do now. Our family spends gobs of money on minor luxuries that can be eliminated. Travel can be put on hold until better times. We could go completely vegetarian, and eliminate costly meat expenses. We could get a slower internet package. We could move into a smaller house (we actually plan to do this as part of our Long Term Plan) to reduce expenses. There’s tons of things I can think of to reduce expenses.
Move For Lower Cost of Living – We already plan to implement this one. When we were shackled to our corporate jobs, we had to live in this high-cost area. Now that we’re free, moving is an option. Housing costs are high in the Pacific Northwest, and neither Mrs. Tako or I really like the place either. People are way too status conscious, and luxury SUV’s (and homes) are the norm. We plan to move to a lower-cost region in the next few years. We just haven’t decided where…
Move Overseas For Lower Expenses – There is the option of living in a different country permanently (if we like), or temporarily in some countries (nomad style living). This can drastically lower expenses if you’re willing to do it…and we are. We are seriously considering moving overseas, at least for a few years. I’m not certain if the nomad life is for us though. I think we’ll most likely take the more permanent option.
Things You Can’t Control
All the strategies we’ve discussed may have some financial impact. Will it be enough to deal with our doomsday scenario, and stave off a failure of our financial independence? That’s really hard to say! Good thing our doomsday scenario is pretty unlikely.
Just like those “cover your eyes and hope” natural disasters, there are innumerable things about life you cannot predict and control. Generally, I like to analyze everything and over-plan. At some point, after countless hours studying and researching, you just have to say, “To hell with it!”
You can’t plan for everything. Go live life, and deal with the problems as they come up.
Show me a thoroughly satisfied man, and I will show you a failure. –Thomas Edison
[Image Credit: Flickr, mods by Mr. Tako ]