5 years of pension expenses

A reader asks:

I am following your post titled “Early Retirement Planning”. My wife (59) and I (65) have been retired for 5 years and follow this strategy: 70/30 allocation invested primarily in index funds + cash reserves equal to 5 years of expenses minus 5-year expected cash flows from dividends /interest /capital gains distributions (our only source of income). The reason behind this strategy is that there have only been eight 5-year periods of negative 5-year net returns for the total stock market since 1924, or about 8% of the 5-year periods. So there is a 92% probability that we will not have to sell shares at a loss. Of course, this may change in the future. However, we are willing to take the risk of a ~8% chance of having to take a loss. Do you see any flaws in this strategy?

There are a few things I like about this retirement strategy:

• You approach it through the prism of expenses.
• You’re probably thinking.
• Combine short-term and long-term planning.

I had to run the numbers for the five-year returns just to be sure (couldn’t help myself).

Here are the 5-year total returns for the S&P 500 since 1926:

By my count, returns were positive 88% of the time and negative 12% of all rolling windows. Most of the red on that chart occurred in the 1930s. Since 1950, less than 7% of all 5-year periods have had a negative performance. Close enough.

You can’t rely on accurate historical probabilities from the past to play out exactly in the future, but 5 years is a pretty good cushion.

There are plenty of other factors that go into the retirement asset allocation decision, but thinking about it in terms of liquid reserves can provide a psychological boost for those worried about stock market volatility.

For example, if you have a 60/40 portfolio and spend 4% of your portfolio each year, you have 10 years of current fixed income spending.

A 70/30 portfolio would represent seven and a half years of current spending.

I don’t take inflation into account in these calculations, and this method assumes you’re spending down your fixed income during bear markets, which means you’re overweight equities and need to rebalance at some point.¹

But the point here is that you want to avoid selling your shares when they are down.

The sequence of return risk can be a killer if you’re facing a nasty soft market in early retirement. So I like the line of thinking here.

Is there a fair amount in terms of cash reserves? “It depends” always seems like a dismissive answer, but it’s true.

A few years ago, one of my readers sent me a detailed version of what he called the 4-Year Rule for Spending and Retirement Planning:

1. Five years before retirement begins to build up a cash reserve (money market funds, CDs) within the retirement plan, if possible (to defer taxes on the interest). Your goal should be to accumulate four years of living expensesnet of any pension and social security income you will receive until your retirement date.

2. When you retire, your portfolio should consist of your four-year cash reserve plus appropriately allocated equity mutual funds. Then, if stock exchange is up (at or relatively close to its all-time high) take your withdrawals for living expenses only from your equity mutual funds, and continue to do so as long as the market remains relatively stable or continues to rise. Don’t react to minor short-term fluctuations up or down. (While doing this, be sure to keep your allocation percentages more or less at your desired levels, pulling in different stock mutual funds from time to time.) On the other hand, if the market is down significantly from its historically high levels or has fallen and is still falling rapidly when you retire, take your living expense withdrawals from the four-year living expense cash reserve.

3. If you’re making withdrawals from your four-year cash reserve because you’re in a severe, long-term bear market, When the market appears again, keep taking your withdrawals from the cash reserve for an additional one 18 months to two years to allow the market to grow significantly (the market almost always grows rapidly in the first two years of a bull market) before going back to taking withdrawals from your equity mutual funds. Then get back to living in your equity mutual funds and also start to top up (over a period of 18 months to two years) your now significant cash reserve to bring it back up to the required level. Once your cash reserve is fully replenished, you are ready for the next severe market downturn when it inevitably occurs.

The stock market won’t always cooperate, but I liked that this plan was rules-based and gave each piece in the portfolio a job.

There is no ideal retirement plan, as sometimes luck and timing can throw a wrench into the equation—both up and down.

How much liquidity you have at any one time should be determined by your risk profile, time horizon and circumstances. There is no perfect answer because the perfect portfolio is only known with the benefit of hindsight.

A successful retirement is a balancing act between the need to beat inflation in the long term, but have enough liquidity to provide for the short term.

We discussed this question in the latest edition of Ask the Compound:



I emptied the inbox this week, covering other questions about getting the CFA designation, the types of bonds you should own in retirement, how pensions fit into a retirement plan, how to spend more money, to teaching your kids about money, becoming a homeowner, using a HELOC as an emergency fund, how analysts rate stocks, and adding international exposure to your portfolio.

Further reading:
Early retirement planning

¹Assuming you want to keep a relatively constant risk profile.