The 5% Rule?

Barron's dusted off the retirement bucket playbook in an article while also arguing that a 5% withdrawal rate in retirement can now be considered safe versus the more common 4%. Before I forget, read the comments on this one. Always read the comments. 

First to the buckets. They suggest two years worth of cash invested in cash proxies (my word, not theirs), 5-8 years in income producing securities like bonds and then put the rest in growth like the stock market. Then do the work to maintain the appropriate balance in each. Later in the article, Christine Benz from Morningstar argued for yet another bucket, if you can, that would be untouched to replace buying long term care insurance for possible end of life care. 

For anyone to whom this appeals, they could obviously have different time frames in mind with the buckets. With the cash bucket, maybe one person would think 18 months is sufficient while someone else might want a longer period. I might argue longer than two years considering the bear market from 2000 took 30 months to find a bottom. Also the 2000's being a bumpy ride to nowhere for the S&P 500 might lead people to view this part more conservatively too. 

If someone likes this idea and can avoid repeating behavioral mistakes then it probably works out just fine, I can't knock it on that basis. It does feel like it adds a layer or three of complexity versus just maintaining a diversified portfolio (whatever that means to the end user) and some cash set aside to help avoid being done in by an adverse sequence of returns. 

I think the concept underlying that middle bucket of 5-8 years in fixed income can be replaced with a smaller allocation to holdings that will very likely be up when stocks are down or at the very least are likely to not go down with stocks. Starting with a hyperbolic example. If a portfolio has 50% in the S&P 500 and 50% in an inverse S&P 500 fund and then the market falls a lot, that inverse fund will likely be up a lot and selling some for income needs avoids selling anything low and at least partially rebalances back to 50/50. 

The example is absurd for quite a few reasons but now dial back the exposure in something that has attributes similar to an inverse fund to a small percentage and then maybe have some exposure to things that seem to always go up just a little bit (lagging bull markets, outperforming bear markets). These holdings can be a source of funds if some how the cash gets exhausted and stocks are still down. 

Pivoting to whether 5% is a sustainable withdrawal rate instead of 4%, yes it probably is. The way the math works out, 4% has a success rate in the low 90's based on simulations and has never failed looking backward. "Success rate" is defined as lasting for 30 years with a 50/50 split between equities and fixed income. At 5% the success rate drops to what I recall as being 88%. 

The difference is not dramatic. More important than the 100 basis points is building in some resiliency with something like adding a third income stream, the first two being Social Security and retirement savings, to bolster resiliency in case something crazy happens with one of the other two. By crazy, I mean like Social Security actually getting reduced or a longer than normal bear market for equities. 

Real estate is a simple first place to look but there is risk, it is capital intensive as far as a down payment, making upgrades every so often and fixing things. We've had mostly good luck personally with real estate beyond our house but while looking into this sort of investing is very worthwhile if you can find the right situation, I would be cautious around pie in the sky view points (read the comments in the Barron's article).

Creating an income stream by monetizing a hobby is one we've been talking about for more than 15 years. Is there something you've invested a lot of your time in doing? If so, you'd be able to figure out whether there is a path to monetization, there may not be, but if there is, get started now. 

The importance here is that an additional income stream can relieve some of the burden from your investment portfolio. In the random year or two that stocks are down a lot, having the flexibility to take less or maybe nothing from your savings as you ride out some sort of stock market calamity would lower stress considerably. As a reminder, just because you might have to take an RMD, you don't have to spend your RMD.

My own biases here involve not wanting to have to worry about money, that's pretty high on my list. Living below my means and creating some sort of additional income stream seems like the simplest path the financial underpinning I hope to achieve. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.