For those who aim to retire early, protecting our retirement is a must.
All of us have the same fear – running out of money as we live out our twilight years whilst chained to a hospital bed.
One of the common ways for an Early Retirement Plan to fail badly would be based on what is called a “sequence of return” risk.
Imagine facing a recession within 2 years of leaving the workforce – your investments have not made much in the way of returns yet, but you are forced to draw down on your retirement capital.
When the market recovers later, you’ve eaten so much of your capital that you cannot exploit the bull market that follows.
Take a look at the table below.
The timing of the negative returns matters a whole lot. I cannot emphasize this enough.
Brown: If you retire and are immediately hit by a recession as you continue your withdrawal rate, your portfolio will eventually deplete to nothing.
Green: If you retire and you’re lucky enough to not be retiring early whilst in the midst of a recession, you will be quite fine indeed
There is one piece of good news on our side.
Since the 1990s, every local market crash that had a severity above 30% has lasted less than 2 years, with the Asian Currency Crisis of 1997 being the longest at 700 days from peak to trough.
This means that statistically speaking, we must be ready to last two years at the minimum without withdrawing from our portfolio.
Thus, in preparing for a recession, which represents a market bear, we shall craft a bear trap.
Inspired by Kristy Shen and Bryce Leung’s book Quit Like A Millionaire, a bear trap consists of two components: a cash cushion and a yield shield.
First Component: Cash Cushion
A cash cushion is basically enough cash in a bank deposit account to last 2 years.
If you are a 55-year-old retiree who requires $1,721 of living expenses a month, then your cash cushion is simply (12mths x $1,721/month x 2) or $41,304.
Before reading Quit Like a Millionaire, this was my original bear trap. The problem of having a cash cushion as your bear trap is that money in the bank is not money that is working for you.
So how do we optimise further, whilst retaining safety?
Component Two: Yield Shield
Enter the yield shield.
If you have dividends to cover your living expenses every year, then you may not need such a large cash cushion.
In the original book, it is recommended that two years of annual dividends be deducted from the cash cushion so that more money can be deployed in the markets.
This leads to a new problem: For financially independent guys like myself, my dividend yields cover all my expenses and then some.
Does this mean that I don’t need a cash cushion at all?
In my opinion, the correct approach is that dividends from different sources should not be treated the same way.
My version of the yield shield only accounts for dividends that are fixed and have a high probability of being paid out during a recession.
This excludes dividends from REITs and Business Trusts.
Here is What Can Contribute to Your Yield Shield
- Dividends from preference shares such as DBS 4.7% preference shares.
- Interest income from Singapore Savings Bonds
- Coupons from retail bonds rated A by Fitch – Temasek 2.7% bonds, Astrea series of bonds
Assuming the same scenario above, where the retiree requires $1,721 of living expenses a month, this retiree can now instead purchase 500 shares of DBS 4.7% preference shares, and he can expect 500 shares x $4.7 x 2 or $4,700 of stable dividends over a 2-year recession. He can reduce his cash cushion in size from ($41,304 – $4,700) or $36,607.
The more shares he is able to acquire, the larger his yield shield will be, and the better he will be able to defend against unwanted drawdowns of his portfolio – especially when his/her investments will need every dollar at work to ride the bull market up once the recession has abated.
In summary, there are comprehensive solutions to dealing with the sequence of return risk during retirement.
In deriving our very Singaporean version of the bear trap, I took a book written in the Canadian context and adapted it for local investors.
The Bigger Picture
For those of you who aim to retire early, protecting yourself against Sequence of Return Risk is simply one piece of the bigger puzzle that is Early Retirement. There many variables to address when retiring.
- How do we develop new and viable investment strategies in tougher economic times?
- How do you retire in a safe yet expedient way utilising leverage?
- How do we allocate our assets?
- Within our chosen assets, what do we invest in?
- How do we decide what to invest in?
These are all questions people who wish to retire early must find answers to. Unable to trust others and unable to outsource the answers to these questions, I took it upon myself to find and answer these questions.
- I took a Masters in Applied Finance at NUS.
- I cleared the Chartered Financial Analyst Exam Levels, 1, 2, and 3.
- I spent 14 years in the market, surviving and ultimately benefitting from the housing bubble crisis from 2007-2009.
- I mugged for hours upon hours after work, consuming investment literature and testing quantitative strategies for stock selection.
All of these were not in vain. If you are prepared to do the same, I would encourage you to do so. It is a highly rewarding path.
For those of you who do not wish to go through such a painful process however, I have an alternative.
Consider if its right for you. If it is, I’ll see you at the introductory class.
Good luck. And remember to build that bear trap.
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