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I’ve been thinking about a retirement scenario lately, a thought experiment that says something about how I spend my morning drinking coffee in the sunroom…it probably suggests I should go for a run rather than thinking.
Picture this: You’re facing a savage 25% market drawdown that grinds on for a full decade. You’ve been sensible, maintained a proper cash and bond cushion to weather the inevitable storms, but after five years drinking latte’s and ignoring the situation, that safety net has been exhausted.
Now you’re looking at two unappetizing options. Do you start flogging your shares at depressed prices to pay for the weekly shop? Or do you borrow against your home through an equity release scheme, preserving your portfolio in hopes of a recovery?
When you sell shares during years six through ten of this hypothetical nightmare, you’re turning paper losses into permanent ones at the worst moment. Missing any recovery that might materialize in those latter years. Rather painful to contemplate.
But it has some upside. You keep your home debt free and maintain complete flexibility. No interest charges mounting up month after month. And here’s a cheerful thought, if the market never actually recovers, at least you haven’t compounded your misery by paying interest on money borrowed to avoid selling.
The alternative keeps your portfolio intact. If markets stage a comeback in years eight, nine, or ten, those shares you didn’t sell could be worth considerably more. You’ve kept your chips on the table for when fortune smiles.
The problem is you’re borrowing against your home at perhaps 4-6% compound interest for five years. That debt doubles roughly every twelve to fifteen years, even if you don’t draw down another cent. You’re essentially leveraging into equities at the very moment they’re already down 25%. I believe the technical term for this strategy is catching a falling knife while standing on a banana skin.
I admit a 25% drawdown lasting a full decade is pretty improbable . Even the Great Depression saw recovery begin sooner than that, though I’m not sure that’s particularly comforting. Although there’s Japan’s lost decade to think about.
Rather than committing entirely to one path or the other, you might consider a bit of both. Use equity release for years six and seven while markets still have reasonable prospects of recovery. But come years eight through ten, if there’s still no improvement in sight, you may need to accept that crystallizing some losses beats accumulating more debt on your home.
I’m not sure what I’d do. Probably spend the entire decade faffing about debating what choice I’d make or finding a spreadsheet wizard who could figure the best path for me. I suspect as normal I’m overthinking things but nevertheless it’s an interesting thought experiment between SORR risk and debt accumulation during retirement. In the meantime I’m going to drink another coffee and think about something more productive… But what would you do?
I think the popular scenarios that recommend say “3 years of living expenses in cash” to avoid selling equities during a serious downturn are unrealistic.
Anyone who is near to retirement has experience that contradicts that. The double bottom SP500 crash from 3/2000 to 2011 lasted over ten years ( with reinvested dividends longer without). the 1929 crash took decades to fully recover.
You need enough cash to not be forced to sell into a down market. There are tops where the market may makes it back to it’s previous peak but then crashes again.
This danger is particularly acute early in retirement.
A HELO or a second mortgage might be a worse than the alternative alternative but best thing is to look carefully at essential expenses and permanent source of income and keep enough in cash so you can sleep at night.
Your cash allocation is only part of your defensive arsenal. Beyond that contingency, you have your short-duration bond allocation that not only acts as a stability tool for the portfolio, but a source of low-volatility funds during a prolonged downturn. To my mind, most people who have “won the game” should seriously consider having a minimum of ten years’ spending needs between those two asset classes.
So, assuming I take 4% per year, ten years would be 40% in cash and fixed income resulting in a 60/40 portfolio. Hmm… 😉
There’s a reason the 60:40 portfolio is a very enduring, popular choice. Keep it simple stupid (KISS) comes to mind.
I just ran a stress test scenario in Income Lab on how our plan would fare during the Great Depression using our current portfolio setup, balance and spending. The scenario timeframe covered annual spending guardrails and portfolio balance from 1929 to 1970, and showed that although we’d survive it – barely – there would be several downward spending adjustments required during the first half of that time period.
The good news is that the adjustments would take us only somewhat lower than our maximum spending target, which includes around 50% discretionary spending and a 5% per year built-in aging reduction that starts during the Slow-Go years.
The ending balance would be pretty near 0; and the portfolio balance during the last 5 years taking my wife to 100 (8 years after my own dirt nap at 100) would be a bit hair raising.
All of which is to say that our plan would still work – with spending guardrails it always does – but doing a stress test like this emphasizes how important it is to use conservative assumptions when modeling retirement plans and have a written plan in place to follow for whoever it is that’s still be alive when things get hairy.
Aways good to prepare for difficult situations. After 20 years of retirement, we have been very fortunate, except for the 2000, 2001, 2002 scenario. My portfolio decreased 44%, YIKES. The good news, my 10 years of cash savings came in handy. Sold NOTHING, not one stock, and within 5 years the Bull market started. Now surviving a 10 years drought would only come from my cash, that bull market has provided a welcome increase in the portfolio. At 80 years old now, no worries for me. That is right, I am 85% Equities, 15% cash. You need some balance to weather any storm, that is what counts. There are an infinite number of ways to do it. But remember one thing BALANCE.
Can you describe your approach (time, source of funds strategy) to replenish /maintain your 15% cash allocation?
This is exactly the scenario that concerned me when I retired (12 years ago now). I wouldn’t mortgage the house (yet) but I did structure my piggy bank differently along with creating another income stream that was not dependent on the market. In particular, if this happens shortly after retiring, it might also ruin the so-called “go-go” years. That is why we chose to take the “safety-first” approach to retirement income planning. We partially annuitized our portfolio, treating 1/3rd of it as a self-funded “pension” (using single premium immediate annuities). The criterion was to create the necessary income stream from that annuity such that when combined with my SS benefit (as the higher income earner) would cover our essential expenses. I also set up a CD ladder as a supplemental income bridge to the start of my SS benefits (removing that income bridge from market volatility). This still allowed us to use my wife’s SS benefit (claimed early) for discretionary spending. Under these conditions, all withdrawals were now discretionary and could handle a variable savings withdrawal rate. This strategy helps mitigate sequence of return risk. To further minimize the impact to our go-go years, we allocated 30% of our portfolio to non-equity assets (CDs, MYGAs, bonds, bond funds, and some buffered ETFs with downside protection). It turned out that in combination with my wife’s SS benefit, we needed roughly 3% of our portfolio to have a comfortable discretionary budget (mostly for travel). As such, the 30% “bond allocation” can potentially cover up to 10 years of an equity downturn where no equities need to be sold at inopportune times. This preserves funding for our “next” 10 years of discretionary spending. With this approach, our investable portfolio maintains a 70/30 asset allocation.
While the annuity income was “sized” for SS benefit at my FRA, part-time work and spousal benefits allowed me to wait until age 70 to claim my SS. That 32% boost in SS benefits (along with the annuity income) pretty much covered all expenses except for major travel. Alternatively, this boost can also be viewed as an inflation hedge in that the annuity income has no COLA. We continue to use 3% (portfolio) withdrawal since that satisfies our RMDs now (given our Roth accounts). An interesting artifact due to this low withdrawal rate is that if the equity market were to drop 50%, we still appear to be in “good” shape according to the Boldin retirement tool. Our portfolio will continue to grow given the equity weighting and low withdrawal rate. This drop was one of the stress-test scenarios I created (along with the 10-year downturn scenario).
I’m with you. Ten years of spending needs outside the market and an annuity is the same strategy I’ve implemented. When you’ve won the race, why take the risk?
If the retiree is relatively young in their 50s or 60s, going back to work would be my approach, and/or scaling back on discretionary spending (less travel). I am in my mid 50’s and retired, and contemplating the same general thoughts…what if this happens. I believe we would adapt and change our plans as we did during our careers that got us to this early retirement. I abhor debt and being a slave to the lender, so that would be way down on the list for me personally.
I’ve actually had to make that choice. It wasn’t a market crash but rather a crash on the soccer field that had me in financial trouble many years ago. I desperately needed a $50K back surgery that my health insurance company wouldn’t pay for because it was too soon after a previous procedure.
The choice was easy. Taking a reasonably-priced second mortgage was vastly preferable to halving my portfolio, especially in a falling market.
It worked out. The surgery worked great and the home rose so much in value over the next 13 years that I barely noticed paying off the extra loan when I sold it.
A classic example of health far outweighing wealth. I’m curious, would that situation be normal in the US? A genuine health insurance claim being refused because you had a procedure in the recent past?
Since I moved to the CCRC I no longer own a house. However, for quite some time my asset allocation has been 50% stocks, 50% bonds and cash. I also plan to rebalance if I am off my allocation by more than 5%. Therefore in your scenario (which would be a twelve and a half percent draw down for me) I would be buying stocks at depressed prices, not selling them.
If this is a serious question, rather than a thought experiment, might I suggest a less aggressive asset allocation? You appear to have “won the game”, why are you still playing? (Bernstein)
Definitely a thought experiment. I have at least ten years of expenses covered outside the market, plus an annuity. Taking a belt-and-braces approach seemed sensible when retiring in my late fifties.
Excellent post with some very thoughtful comments.
So glad I retired into an up-market a decade ago.
This is why I am a dividend investor. Even during the toughest markets, stocks like utilities and oils continue to pay out every quarter.
In fact, at the very bottom of the Great Depression, if you owned the Dow Jones index stocks, you could collect a 14% dividend. Nobody had any money to buy stocks, so they stayed way down.
I keep considering dividend funds. Currently, they make up about 20% of my equity portfolio and have performed extremely well over the past 18 months.
We need a couple more facts to comment. How long ago did this retiree retire? What is their asset allocation plan? How many years of annual expenses were covered by their retirement assets at retirement?
Having been retired for 25 years, I am looking at a group of financial assets that are 350% higher than at retirement. A 25% drop would only shave a relatively small amount off of these gains. Thus, your scenario is not dismal enough to keep me from selling whatever I would need to continue to live. If I needed to sell assets, I would still be paying capital gains tax.
Furthermore, the absolute total value of the retirement portfolio might provide plenty of cushion. Someone with $5M before the market drop would still have $3.75M thereafter.
And, the asset allocation is also a factor. Most of those who speak about 4% annual withdrawal lasting for 30 years want 40-50% in cash and fixed income assets. Someone with 4 years of cash and 100% of the balance in equities might have a problem.
So, I suggest that you consider a Japanese style bubble/crash if you want a more realistic/horific problem to consider. Their market dropped 45% in 1989 and didn’t regain its level until 2021. Fortunately for us, we don’t have an insular culture and the other issues that confront Japan.
There are Black Swan events that could happen for which there is no way to make a practical response plan. You cannot worry about them.
Stella99… I just thought the scenario up over a black coffee. To flesh it out that deeply, I would need a full jug of coffee. By that stage, my internal thoughts would be a mile-a-minute; I’d be vibrating, sketching complex diagrams on the walls, and talking to the furniture. The result would be either an instant Booker Prize or a restraining order, but you can bet the details would be thorough. 😁
We could rob the Lourve.
I already did that last month!
Mark, I experienced a variation of this during the 2008-2009 financial crisis. My daughter started at a private university in the fall of 2008. We had saved to fully cover the cost- mostly in a 529 education account (which was invested conservatively (in a target date fund) but still dropped in value significantly I’m guessing because I wasn’t paying some of the education for 4 more years. Fortunately, we had a home equity line of credit which I tapped for about 12-18 months to give the 529 account time to recover at which time I paid off the HELOC. At the time, no one knew the future, and I didn’t know if I would end up paying off the HELOC with the depressed 529 account, and taking on some student loans to cover the gap that was created by the financial crisis. At the time I didn’t think the market meltdown could go beyond 2-3 years, but that was unknown at the time. So I guess it’s always good to have a plan B!
After 2000 dot.com bust, my company started laying off employees big time. I talked to my husband and decided it was time to get a HELOC loan for just in case. At the time, there was a Bank of America branch in my work building, so I went there and got a loan just on my name only.
The day after I signed the HELOC papers, there was a big layoff and my coworkers from the next office were all laid off. I kept this HELOC for many years after that and paid only $50 admin fee per year. Eventually, I cancelled it.
Bill, that HELOC certainly got you out of a bit of a pickle by all accounts.
Indeed. Always good to have a Plan B. In retrospect, all would have worked out, even if we had to draw the 529 down in a falling market, but the HELOC added flexibility to our options.
I keep 10 years of portfolio withdrawals in cash (2 years), and bonds (8 years). If we have longer than a 10 consecutive years of market declines I think we’re all in a heap of trouble. I’ll contemplate what to do at the beginning of the 9th year if the scenario were to ever to be on the brink of actually occurring.
May I suggest that rather than thinking you try some meditation. 😁
I’m the same, ten years outside of stocks. If I meditate during the morning, I’ll never think of another article idea… although that might be a good thing. 😉
They’re not everyone’s favorite financial product, but I would be reading up on reverse mortgages in this scenario.
Aaron, I’m not (usually) a fan of reverse mortgages, however, this would be an option I would consider.