Is Retiring In 2021 A Truly Terrible Idea?
The stock market is booming this year, and at the time of writing the S&P 500 is up a healthy 16% YTD. Along with it, most portfolio balances are reaching new highs. This has put a lot of otherwise smart investors in a very good mood.
Euphoric might be a good word for it.
As portfolios continue to reach new all-time highs, I’m seeing a ton of new folks declaring retirement dates on social media (Twitter, Facebook, etc). And it worries me.
Is now really the best time to pull the plug on your job(s) and “go for broke” with this early retirement business?
We must not forget the volatile nature of capital markets! Don’t just make plans based on the good times — make plans for days when times are tough. Quitting your job during the middle of a booming market (potentially a bubble market) could be a very bad idea…
The Moving Truck
To illustrate this point further, imagine your family has just purchased a beautiful new home in the suburbs. It’s a decent drive away, and you’ll need to drive all your boxes and furniture over in a moving truck.
To get the truck to your new home, you’ll have to cross a river. There are several different bridges on which you can cross.
Being an astute and careful truck driver, you know the truck has a vehicle weight of around 13,000 pounds when empty. The nearest bridge can hold a maximum capacity of 15,000 pounds. On the surface this seems like it won’t be a problem, but we must remember the moving truck will be full of boxes, furniture, and other items from your household.
The contents of that moving truck with cargo could potentially be 2,000 pounds. There’s also the potential for it to be heavier by several thousand pounds, or lighter than 2,000 pounds. You just don’t know!
Would you risk driving that moving truck over the 15,000 pound bridge, hoping your cargo weighs less than 3,000 pounds? (It’s also worth imagining that the bridge is a rundown U.S. bridge, which adds to the uncertainty.)
Or, would you spend the extra hour and drive to the next bridge with a maximum capacity of 21,000 pounds? Personally, I’d spend the extra hour to go over a safer bridge.
The Market Is An Unknown
Clearly, the answer to the moving truck question has a lot to do with your personal risk tolerance, and your ability to estimate the weight of the cargo. Most people will have no skill at estimating the cargo weight, so it makes sense to take extra care when choosing which bridge to drive over.
Just like the weight of that moving truck, the true value of your portfolio is an unknown variable too. We all know that markets continuously cycle between boom and bust periods. The value of your portfolio is going to more or less follow those market cycles over time as well.
Today it could be at a peak, but tomorrow is anyone’s guess!
Historically we see that bear markets have an average loss of 34%. The biggest recent downturn was the 2008 crash, with a 57% drop in the S&P500 (peak-to-trough).
Knowing these big swings can happen, why would you want to retire with numbers from a booming bull market? Well, you wouldn’t, not without some significant and careful planning!
How Much Do You Actually Need In A Bear Market?
Imagine you’ve set your retirement number at $2 million with a 4% withdrawal rate. Those assets (and withdrawal rate) should provide a comfortable $80,000 a year in retirement spending. Fantastic! You can now give your evil boss the middle finger and retire comfortably for the next 50 years, right?
Unfortunately the unexpected happens, and the market crashes by 50% next week. Woops! If you keep spending $80k/year it’s going to be a failure under most simulated market conditions.
Now your portfolio is only valued at $1 million. If you still believe in the 4% rule, and are willing to adjust your withdrawal to match, this leaves you with a mere $40,000 per year to spend until the market recovers. Some serious belt tightening is required.
For most people, this is nearly impossible. Lowering your spending by 50% is a very difficult proposition! Most people could perhaps cut a few thousand dollars out of their budget by eating-out less, cutting-off a few subscriptions, and maybe traveling less.
But cutting by 50%? That’s really hard to do! Nobody wants to live off cat food and rice in retirement! And is it really worth retiring if all you can afford to do is stay at home and watch Netflix?
I’ve said it once, and I’ll say it again — Don’t retire on the bare minimum! Discount the value of your portfolio and spend less than 4%… so that when the bear market actually begins you’ll be a comfortable position.
Discount Your Portfolio
Don’t get me wrong, it’s perfectly OK to be excited when your portfolio reaches a new high. I get it! Congratulations! But the fact of the matter is, a bad bear market can easily come along and clobber your portfolio.
So how much should you actively discount your portfolio by when calculating retirement numbers?
I suggest using the median CAPE ratio relative to current the ratio as a method to determine this. You can find the current market CAPE ratio here.
Right now the current market CAPE ratio is at 37.6, and the median CAPE is 15.85. To find the discount, simply divide the median by the current CAPE ratio:
15.85 / 37.6 = 0.42
This means the median is only 42% of the current market value! This will be our discount rate.
(Note: Technically a CAPE 20 would work here too, but let’s be conservative and use the median.)
Next, it’s time to decide on a more realistic withdrawal rate than the 4% rule. We’re living longer and retiring earlier than the Trinity study ever imagined, so it’s time for an update. Many experts recommend using less than 4%, and I think they’re right. Market conditions have changed since the days of the Trinity study, and we must adapt. EarlyRetirementNow has a good post on this subject, where he argues a safe withdrawal rate of around 3.25% – 3.5% will likely survive 60 years. (Although its worth noting his assumptions have inflation at rates much lower than where they are today.)
To keep things simple (and safe), let’s use a safe withdrawal rate of 3.25%. If we use our earlier portfolio value of $2 million, we now can calculate the following discounted annual budget:
$2,000,000 * 0.42 * .0325 = $27,300 annual budget.
Can you live off that? Admittedly this is something of a worse case scenario, but it could happen.
If you don’t plan on cutting your budget to poverty levels during the next recession, I suggest reversing the equation and working backwards from your minimum annual budget (in this case let’s use $60,000 as the budget floor):
$60,000 / .42 / .0325 = $4,395,604 portfolio value
To maintain that $60,000/year budget in a terrible bear market, you would need $4.4 million in today’s dollars. In most years your spending can be significantly higher than $60k.
Punching these numbers into cFireSim (making sure to set the $60,000 budget floor), we get a 100% success rate, with the lowest annual spending of $61,059 and the highest at $648,783.
Most of the simulated portfolios finished above the $4.4 million starting point too.
This is exactly what we want to see in a strong inflationary environment, where prices are continuously rising. That $4.4 million (or whatever you have left) will have significantly less buying power in 50 years! We need to keep up with inflation even in our elder years!
You certainly don’t want to feel the budget squeeze as you age; you want live a life that gets a little bit better every year. Proper discounting of today’s elevated market values makes a huge difference in the final outcome.
Final Thoughts
While these are all hypothetical numbers, it makes sense to think carefully in scenarios where there big unknowns exists (like higher inflation rates, and bubble-like market values).
The future is always uncertain, and bad things happen. Sometimes this means planning to have a little too much, rather than too little.
I’d much rather drive my portfolio over a bridge that can hold it, and have plenty of room for error. I’m not a big risk taker when it comes to providing for my family.
That said, my discount rate might seem too conservative for folks willing to risk it and retire on less. It’s perfectly OK to be a risk taker, but need I remind you that in 2009 the stock market did actually retreat to the Shiller PE median following the Great Recession. I’m not making this stuff up! It did happen, and likely will again at some point.
Plan accordingly!
[Image Credit: Flickr1, Flickr2,Flickr3]
I appreciate the basic premise of this particular blog post. I agree it is wise to temper expectations during good times as they truly do not go on forever. However, I do think the point would be better served using more modest numbers to temper expectations. Using these worse case scenario numbers, a person will likely quit and through up hands during their quest for FI.
As always personal finance is personal so what your age, your health and how many dependents (loose ends) matter. I think it better to discuss all margins of safety including a buffer in your portfolio. How about Social Security? Maybe you have even a modest pension coming you way in the not too distant future? Maybe you have rental income or a small side hustle? There may even be a modest inheritance in your future?
I would suggest a person think as holistically as possible and act as a rational optimist. But yes, do not forget that there are valleys ahead. We just do not know when.
Totally understand that everyone has different situations! I’m just trying to show people how to bring a stock portfolio back to more “normalized” levels, so they can make good, rational decisions.
The portfolio sizes I’ve discussed here may frighten people away, but we’ve had 12 good market years out of the last 13. Portfolios should be flush!
As an engineer I got stuck on the analogy of course. I’d simply drive the truck to the nearest weigh station, they are common, and see what it weighs and proceed on an informed basis. Which is kind of what you are doing by discounting the current portfolio basis. Also as an engineer those bridge ratings are generally only one sixth of the actual bridge design load carrying capacity. Which is why our decrepit infrastructure has caused so few accidents, so far.
Aww, you took all the fun out of the analogy steveark! 🙂
I’m not an engineer, I’m a lawyer, and my first thought was to drive the truck to the nearest weigh station.
Still having a bit of ways to go before FIRE, I found this post fairly helpful because I never thought about using a “discount” on the portfolio worth via CAPE ratio.
I’ve always thought “hmm yeah 4% is great but how do I KNOW?”
But with the additional variable it seems like you’d be incorporating the nightmare scenario of staying at median over the long term, which I haven’t really ever thought about.
The way I thought about the 4% is that it already incorporates good and bad years based on historical results. But what happens if right when you retire things go very terribly? You’d almost need to get out of retirement immediately. I think the median CAPE takes care of that.
Right. The point of using the median is that (supposedly) stock values will fluctuate around that level (above or below) during your lifetime. Sometimes the fluctuations will be extreme (like they are right now).
In recent decades the median has definitely been rising, but there’s nothing that says this will continue into the future.
The Trinity study merely said that at 4% you didn’t run out of money in 30 years. They called that a success. What if you actually lived for 35 years? Maintaining your buying power even near the end of life is important.
I’m not one to usually harp on examples, but in this case need to chime in. Your representation of the 4% rule is way off base here.
The 4% rule is not that you take 4% of the current value every year for spending. You take 4% of the INITIAL portfolio, adjusted for inflation.
In your example, the retiree would not be cutting their spend from $80K to $40K. They would keep spending $80K….off of a much smaller portfolio. The work behind the origin on the 4% rule indicates that over a 30 year period, they would likely still be ok, but this is obviously a concerning risk……..which is well covered and known as “sequence of return risk”.
IF the 4% rule is going to fail, it usually fails in circumstances like you describe where the first few years have bad returns and you deplete the portfolio so much that it doesn’t recover enough on the upswing to last.
Proposed solutions vary, and a lower withdrawal rate is one of them – which is basically where you get to in the article anyway. But so many people talk about the mechanics of the 4% rule incorrectly, I had to come away from being a passive reader to leave my first comment! Long time reader, first time caller and all that haha
Sure, the Trinity study was originally based off of a fixed amount. No doubt about it. And you know what? Those conditions in the past don’t exist anymore. Let’s collectively move on! This isn’t the 1950’s. Interest rates are under 2%, dividend yields are minimal, and CAPE ratios are near all-time highs.
I guess I am not totally following here. Are you saying do not use the Trinity study? Throw 4% out the window? From what I have read you live are living off of dividends. Do you plan on strictly following cash flow? Why worry about net worth at that point if your dividends cover you expenses (plus a safety margin)?
To be clear I am not trolling. I am a very recent retiree and I am still trying to figure out what is “safe” and what is stupid. I understand a margin of safety is smart but I also struggle how much is too much.
Yep, I’m saying throw it out. We’re living longer, retirements are longer, asset returns are different… hell, even inflation could be wildly different in the period ahead.
The CAPE ratio basically tells us that stock returns are going to be much lower in the future. Lower than 4% in fact. Real bond rates are already negative, and the last inflation number I saw was over 5%.
As long as these conditions persist, there’s no way the 4% rule could work.
Very good read, Mr Tako. I also like the numeric examples.
It caught my eye as well that in my personal environment there are seemingly more people quitting their jobs/start a business/hitting FI.
There is certainly some relation to significantly higher asset prices, a whole lot of people are sitting on high book gains on their portfolio and/or their real properties got a nice value boost.
However I am not sure whether the bull market is the main reason. Let’s not forget that 2020 was a rough year for the whole world, and it changed the way we work and do business. A lot of things got more flexible.
Many people saw that they cannot rely on their jobs etc. They saw that they can earn money as freelancer, they were even forced to make money online. And they saw that it worked. My guess is that these experiences also let people look differently at their finances and their jobs. Today, it’s easier than ever to start own business or at least to earn some money online. My guess is that more people are not seeking full FI but instead want to become „job-free“ earlier in the form of Barrista FI or some kind of variation of that concept. Most of us won’t live solely off passive income from assets but combine it with other sources (social security, insurances, online business etc.) and are prepared to work for instance temporarily.
As said, things got more flexible since the pandemic, and there are plenty of ways to modify the path to FI.
Cheers
SavyFox recently posted…Dividend growth investing as income booster
Good points all-around SavyFox!
The discount idea sounds good. You need some padding because early retirement could stretch to 50 years. Although, I think if you make a little income post-retirement, you’ll be fine. Just keep the withdrawal rate very low until you’re 65. After that, 4% should work.
Definitely, the mechanics of the 4% rule were about shorter time frames, but with added side income it might still work. Totally depends upon future returns of course.
I thought the whole point of using a rule like the 4% rule was that you could ignore valleys (as well as peaks). Part of your post alludes to changing your withdrawal amount based on the market but that would not conform with the spirit of the rule.
To put it all out there I “retired” 4 months ago at age 34 using 3% as my rule. My portfolio was 1.5M so for the rest of my life I plan on taking 45K (plus inflation). To your point I treat the 45K as the max I can withdrawal any one year. I plan to still make side income but in THEORY I would not need to as long as my spending stays below 45K. I have based these numbers on what I read over at early retirement now.
Technically the Trinity Study (the 4% rule) said retirees didn’t run out of money in 30 years when withdrawing the same amount year after year. Maybe they ran out of money in 35 years though…
Being 100 years old and having $0 in my portfolio sounds like a bad idea to me.
It seems like your planning on being retired a lot longer than 30 years, so using a conservative 3% is a pretty good idea. I’d also like to reiterate that market conditions tell us that future returns are expected to be quite low.
I like your discount idea, Mr. Tako but it would be pretty hard to have $4M invested. 🙂
Maybe by utilizing dividend stocks and using dividend income as a slight cushion, you can have a little bit of margin of safety when it comes to withdrawals?
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Technically it shouldn’t make a difference where the return comes from (dividends or capital gains), a withdrawal that’s larger than the annual gain will reduce the capital employed in the collective business holdings.
This is a technicality however, and sometimes a stock won’t drop after it pays a dividend even though the accounting value of the business is lower due to the payout.
Maybe it just takes the market some time to do a DCF calculation. 😉
Ultimately capital is capital, and a smaller amount *actively* employed in a business will produce a smaller return. The market is supposed to value this properly, but sometimes it’s not perfect.
Hello Mr. Tako,
I appreciate your thoughtful post. As I reflect on what you shared, in my thinking, this further makes a strong case for building a portfolio consisting of dividend growth stocks, and then relying on those ever growing and reliable dividends to fund (all or partial) retirement, which doesn’t require one to ever have to sell anything, if they don’t need to. Would appreciate hearing your thoughts and experience on this. Thank you in advance.
Vinay
c: 703-851-9466
Well, yes. A diversified portfolio of dividend growth stocks could last an entire 60 yr retirement period, assuming it was properly managed, and you never took out more than the dividend income.
The big questions that remain are: 1. Can the dividend growth keep up with inflation? 2. In down markets will the DG stocks cut dividends (and thus your income) or pay out more than they should (thus reducing your long-term earning power)?
I’ve thought about this a lot, because as you know I Accidentally Retired, and so I don’t have a lot of room for error.
I think your assessment of the 4% rule and the CAPE Ratio discount are spot on. There is no way that I could stay retired if there was a long and firm bear market.
So how do you fight it? Well, for me, that is using a cash wedge as a buffer. I have two years of expenses stuffed away in cash to fight at least any short-term market crashes.
Then I am going to buy a business with significant cash flow, which will help me to offset any potential negative return years and give my cash buffer an additional “buffer.”
Then of course the worst case scenario would be that I go back and get a job. It wouldn’t be fun, but I’d do it to ride out what sounds like terrible market conditions. I think it ultimately just comes down to flexibility. Stay flexible and prepare for the worst, but hope for the best.
Accidentally Retired recently posted…If you don’t ask, you don’t get
I can really appreciate what you’re conveying in the post. Diversification sounds like the solution to a nasty bear market, both in holdings and income sources. Planning for 100% income from the markets sounds a lot like putting all the eggs in one basket. Maybe this might be the argument for something akin to the boglehead three fund portfolio rather than holding pure domestic equities? Holding some unpopular bonds would reduce the amount one would need to discount their net worth.
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First I 100 percent agree the 4 percent rule without a buffer or expected future income is a major risk. Not one I would take with my family. So I agree in principal.
However not sure I can really get on board with the concept of cape as a discount. Technically the cape has been high for much of the last decade as it is driven higher by prior year crashes as well. Yet we see how that worked out.
Now sure it’s likely to eventually be right at its current extremes. But there are better ways imho to walk around any potential crash. Particularly an adjustment in asset allocation to carry safer assets can also offset sequence of returns risk.
I personally believe your example which essentially recommends a sub 1.5 percent withdrawal rate is a bit too conservative for most people.
For reference a combination of ibonds and stable value funds will return more then 1.5 percent.
Actually, that’s not what I’m saying at all.
I’m saying that stocks at a CAPE of 15.85 returns roughly 6.3%. There will be fluctuations of course. However, due to our higher inflationary environment (currently above 5%) this will seriously degrade performance in real (inflation adjusted) terms.
Perhaps we assume long term inflation settles at around 3%. This means that our real return from stocks is only going to be 3.3% …. which is roughly equal to the 3.25% withdrawal rate suggested here.
If inflation works out to be considerably higher over time, our withdrawal rates should be adjusted lower to match.
A CAPE of 37.6 means stocks should only return 2.6% from these levels. Add in inflation and your real return is going to be nil, or negative.
I think we are going to have to agree to disagree given risk tolerance levels. A 60k withdrawal on 4.4 million is a sub 1.5 % withdrawal rate. That’s extremely far below historical safe withdrawal rates from firecalc and the like. That means there has never in history been a worse investing environment then what you are predicting. I just don’t see that in the cards, and I come from a place of pessimism about the market.
The reality is cape is just a ten year smoothed average of earnings and price. If earnings significantly adjust through efficiency, crashes, whatever then the cape will adjust on its own possibly even without a crash. I do believe extreme cape ratios are a bad omen, but I don’t believe the relationship is tight enough to use it as a discount rate. If you have back tested data that shows it is I’m open to changing my thoughts…
Plenty of data on this:
https://www.lynalden.com/wp-content/uploads/CAPE-Returns.jpg
To be clear, I’m not forecasting a crash or anything like that. I’m just saying it’s a possible outcome.
The data above has an r2 of .57. That indicates a moderate mapping to the model which was really what I was hinting at. Thanks for the data
I think this article is very well framed for today’s current market, which is priced to perfection to be sure. The S&P 500 currently trades at 34 times earnings when historically it trades at 16. And it has traded as low as 6 to 8 times earnings. If the market merely went back to it’s long term average it would be cut in half. What if it went back to 7 times earnings? That’s right, you would be looking at an 80% loss. Don’t think it can happen? The NASDAQ lost 75% after the dotcom bubble burst. It was worse during the Great Depression. What would happen to your withdrawal rate if your $2 million dollar portfolio was turned into $400,000? It’s something to think about.
I like the analogy, Mr. Tako! It really is about risk tolerance. I agree with your advice to “discount your portfolio” though I don’t know enough about the CAPE ratio to comment on that.
I just think it’s smart to be conservative and withdraw less than something like 4%… especially if basing your numbers on today’s market values. Sure we don’t know if there’s a crash looming, but I sure feel like the market’s getting overvalued. We have a bucket strategy in place to help in the case of a bear market, but I still feel better by being conservative in our withdrawals.
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This is essentially an argument for paying off the mortgage as fast as possible and having a part-time job/ side hustle that can cover the basic bills…
Doesn’t matter if the value of your house goes to zero as long as you can live in it debt-free..
Cos, ya, 4 million USD in today’s value within 15 years without a windfall or massive increase in income, that is just not going to happen… Saving+investing 100k per year for the next 15 years at 7% return doesn’t even get you to 3 mill..
I do have a buffer built into my numbers… I basically calculate based on 70% of my actual number, ….
But folding everything in half? And then halving that too? So, 100 years of living expenses instead of 25 – 33? Nope….
So has Japanification of the US market now arrived?
Japan’s SWR was one of the few that was below 1% if I recall?