How does market dip effect the FI people living off investments?

Question

Howdy Guys!

I listen alot to BP's Money podcasts. I know that the Corona virus has spooked the market down by 12% in the last few days. And I know it is generally held that it won't matter what we do if you hold for the long run. I see it as a fantastic time to buy, yadda yadda.

But it lead me to wonder about the 4% rule, and everything else. How does a correction, bear market or recession effect those who actually LIVE off their funds or dividens? If your portfolio drops from 500,000 down to 440,000 in 1 week, does that actually do anthing significantly negitive for those who depend on their portfolios?

Cheers!

Will Fraser · Answer

Howdy @Hugh Carnaha!  The answer to your question here is going to be based on what the 4% rule is more formally known as: "The Safe Withdrawal Rate" or other similar names including the word "safe."  Within the FI and FIRE communities there is a lack of consensus around 4% specifically and you'll find the more conservative members favoring a lower rule, like 3.6% or 3.8%.

The reason this is considered a "safe" rate to draw down on your investments is that the overall market returns OVER TIME are well above 4%, so if you build your assumptions on numbers that have historically been achievable, then you'll have the highest likelihood of achieving similar results.   During a recession, correction, or coronation (can we call it that?)  the value of investments will shrink but the ideology is based on what happens over the grand scale.  So, short term losses are washed out by years like 2018 and 2019, which "ran" for well above 16%.

There is an element of "luck" here, like any of the FI pandits will acknowledge.  If you are 30 years old, hit your FI number, and handed in your 2-weeks notice to your employer to start out 2020 then your portfolio will have a more significant drawdown affect as a result of having a "down market' in the initial withdrawal period.

For a more robust discussion on this I would recommend  digging into the Sequence of Returns Risk discussions with JL Collins (the FI guy, not the Built To Last guy) and Big ERN from Early Retirement Now

James Jones · Answer

I spend a lot amount of time in fixed income/early retirement circles and I ask this same question a lot. The broad consensus is the the '4% rule' is more of a rule-of-thumb than a proper retirement withdrawal strategy. That being said, many people depend on the 4% rule more than they should.

When I ask these same people what their strategy would be during a downturn, their response is typically that they will tighten their belts a bit and hope for the best. Some folks will simply 'restart' their 4% rule at the market lows. There are many small variations of this. It's safe to say those folks are probably sweating a bit right now.

But the reality is, any time the stock market takes a dip, all retirees will get a little nervous. It doesn't matter what your retirement strategy is or what you're invested in. Even if your retirement savings is largely in real estate, the spillover effects of an economic downturn can't be overstated. In fact, commercial real estate is being hit particularly hard by the effects of the COVID19 crisis.

Given the uncertainty around the 4% rule, I personally recommend dynamic withdrawal strategies and conservative assumptions. I'm partial to annuity-based calculations that factor in the investment horizon and individual risk preferences of the retiree, like this one. If the market falls 3% as it has in the past year, your retirement income would still increase as long as your investment horizon is no longer than 33 years. In other words, for an investment horizon of exactly 33 years, 1 year represents 3% of that investment horizon, so it roughly balances out the 3% reduction of the portfolio. For this year, the net effect would be your payment would stay roughly the same as it was the prior year.

In short, I think the level of nervousness a given retiree is feeling right now directly correlated to the confidence they have with withdrawal strategy. In the case of the '4% rule', I imagine they feel pretty nervous about now.

Will Fraser · Answer

That will vary greatly from person to person.  A 30-year old living the FI life would probably be taking these from taxable brokerage accounts, savings accounts, or distributions from rental real estate.  Once you get closer to the legal withdrawal age for Roth IRA, IRA/401(k)s your options change, and then yet again with social security.

The overall use of the Safe Withdrawal Rate is simply to measure the amount of your portfolio that is considered safe to deplete.  If you have a $500k portfolio then you can "safely" draw $20,000 annually from this without depleting it to exhaustion.  In good years you'll be earning more, hopefully far more, than $20,000 from this $500k, and then in bad years you'll deplete the capital amount some, which will even out over the long haul.

Or so the theory goes . . .

Hugh Carnaha · Answer

That makes good sense. The Safe Withdrawl Rate is in the long term, so the overall many good years would offset the corrections.

It's really a numbers game, but in gerneral, younger investors like your "2-weeks notice" senario would much greater impacted than the folkd in their 50's who have invested longer.

How does market dip effect the FI people living off investments?

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