A popular strategy for retirees is keeping a number of years of retirement spending in cash and high-quality bonds in case there’s a multi-year bear market. When I posted Easy Early Retirement Portfolio Withdrawals, several readers asked how many years of spending I would keep in cash and bonds. Christine Benz, Morningstar’s Director of Personal Finance, suggested keeping 2 years of spending in cash, and another 8 years of spending in “short-term bonds, Treasury Inflation-Protected Securities, high-quality intermediate-term bonds, and even a dash of equity exposure” (see The Bucket Investor’s Guide to Setting Asset Allocation for Retirement).
The logic behind this strategy is that when the stock market crashes, as it did now, retirees can withdraw their spending from cash and bonds and avoid selling stocks at depressed prices. That will give stocks time to recover. Barring a scenario that stocks won’t recover for decades (“Japan”), the cushion in cash and bonds will tide the retirees over.
When Business Insider interviewed several people who retired before age 40, none of them worried about the current stock market crash or a recession, because they all have several years of spending in cash and bonds.
Because they have about six years of living expenses in bonds and another year’s worth saved in cash, he said they won’t have to sell stocks for “quite some time.”
Business Insider, Self-made millionaires who retired in their 30s say a recession doesn’t worry them. Here’s what they’re doing with their money right now.
In this post we explore the effectiveness of withdrawing from cash and bonds for spending in a bear market. Let’s consider this simple scenario: We start with a $1 million portfolio, $700k in stocks and $300k in cash and bonds. Stocks drop 30% in year one, recover half way in year two, and get back to even in year three. We use inflation-adjusted dollars and we ignore inflation and dividends in these three years. We assume cash and bonds match inflation and have zero inflation-adjusted returns in all three years. We withdraw $40k each year from the portfolio.
Withdraw From Cash and Bonds
Year 1: After a 30% drop, our $700k in stocks is worth $490k (lost $210k). We leave it alone. We withdraw $40k from $300k in cash and bonds. Total portfolio value: $490k in stocks + $260k in cash and bonds = $750k.
Year 2: After the stock market recovers half way, our $490k in stocks goes up to $595k ($105k gain, or 21.4% return). We withdraw another $40k from our $260k in cash and bonds. Total portfolio value: $595k in stocks + $220k in cash and bonds = $815k.
Year 3: After the stock market fully recovers, our $595k in stocks goes back to $700k ($105k gain, or 17.7% return). We withdraw another $40k from our $220k in cash and bonds. Total portfolio value: $700k in stocks + $180k in cash and bonds= $880k. Because the bear market is finally over, we sell stocks and replenish cash and bonds to 30% of the portfolio. We end up with $880k * 70% = $616k in stocks, and $880k * 30% = $264k in cash and bonds.
Stocks | Cash + Bonds | Total | |
---|---|---|---|
Year 0 | $700,000 | $300,000 | $1,000,000 |
Year 1 | $490,000 | $260,000 | $750,000 |
Year 2 | $595,000 | $220,000 | $815,000 |
Year 3 | $616,000 | $264,000 | $880,000 |
We successfully avoided selling stocks when stock prices were low. The portfolio value is $120k less than the beginning value because we spent $120k from cash and bonds.
Withdraw from Stocks Plus Rebalancing
In the alternative scenario, we withdraw $40k from stocks and then we rebalance to 70% stocks and 30% cash and bonds.
Year 1: After a 30% drop, our $700k in stocks is worth $490k (lost $210k). After we withdraw $40k from stocks (sell low!), we have $450k left in stocks. Total portfolio value: $450k in stocks + $300k in cash and bonds = $750k. After we rebalance to 70/30, we have $750k * 70% = $525k in stocks and $750k * 30% = $225k in cash and bonds.
Year 2: After the stock market recovers half way (21.4% return), our $525k in stocks goes up to $637,500. After we withdraw $40k from stocks, we have $597,500 in stocks. Total portfolio value: $597,500 in stocks + $225,000 in cash and bonds = $822,500. After we rebalance to 70/30, we have $822,500 * 70% = $575,750 in stocks and $822,500 * 30% = $246,750 in cash and bonds.
Year 3: After the stock market fully recovers (17.7% return), our $575,750 in stocks goes up to $677,353. After we withdraw $40k from stocks, we have $637,353 in stocks. Total portfolio value: $637,353 in stocks + $246,750 in cash and bonds = $884,103. After we rebalance to 70/30, we have $884,103 * 70% = $618,872 in stocks and $884,103 * 30% = $265,231 in cash and bonds.
Stocks | Cash + Bonds | Total | |
---|---|---|---|
Year 0 | $700,000 | $300,000 | $1,000,000 |
Year 1 | $525,000 | $225,000 | $750,000 |
Year 2 | $575,750 | $246,750 | $822,500 |
Year 3 | $618,872 | $265,231 | $884,103 |
I copy the previous table here for easy comparison:
Stocks | Cash + Bonds | Total | |
---|---|---|---|
Year 0 | $700,000 | $300,000 | $1,000,000 |
Year 1 | $490,000 | $260,000 | $750,000 |
Year 2 | $595,000 | $220,000 | $815,000 |
Year 3 | $616,000 | $264,000 | $880,000 |
The total portfolio value in year 1, after the stock market crashed, is the same in both scenarios. When the stock market is back to even, our portfolio value is higher in the second scenario ($884,103 versus $880,000), even though we took our withdrawals from stocks when stock prices were low.
How come we end up with a higher portfolio value if we sold stocks during a bear market? The difference is we rebalanced when the stock market was low. Even though we sold low for withdrawals, we also bought low for rebalancing.
Withdraw From Cash and Bonds Plus Rebalancing
Can you also rebalance after you withdraw only from cash and bonds for spending? Theoretically yes, but when you see your cash and bonds as the source for spending in a bear market, because you don’t know how long the bear market is going to last, you tend to want to preserve the cash and bonds for additional years of spending.
When you start with 7 years of spending in cash and bonds, after one year in a bear market, you are down to 6 years of spending in cash and bonds. If you rebalance, you will have to deplete your cash further. Now you are down to 5 years of spending in cash and bonds. If the bear market drags on another year, you may be down to 3 years of spending in cash and bonds at that time. It cuts into your comfort level twice as fast when you use your cash and bonds for both spending and rebalancing. It goes against your confidence of having X years of spending in cash and bonds and being able to weather a lost decade.
If you overcome this psychological hurdle and actually both withdraw from cash and bonds for spending and use them for rebalancing, you end up at exactly the same place as selling stocks plus rebalancing. When you withdraw the same total amount from the same portfolio value, no matter which part you take the withdrawal from, you end up with the same total value afterwards. After you rebalance, you have the same allocation again. In our example, after our $700k in stocks goes down to $490k, we have $790k total. After we withdraw $40k, whether all from stocks, all from cash and bonds, or from a mix of the two, we always end up with $750k. After we rebalance to 70/30, we always end up with the same $525k in stocks and $225k in cash and bonds. It doesn’t matter where we take our withdrawal as long as we rebalance afterwards. If we withdraw 100% from stocks (“selling low”), we will buy more stocks when we rebalance (“buying low”). If we withdraw 100% from cash, we will buy less stocks when we rebalance. It all evens out.
Conclusion
Rebalancing in a bear market sets you up for growth on the path to recovery. Having X years of spending in cash and bonds and withdrawing only from cash and bonds in a bear market scares you off from depleting additional cash and bonds for rebalancing. The psychological comfort ends up costing you. If you brace yourself and use the cash and bonds for both spending and rebalancing, you end up at the same place as selling stocks for spending and rebalancing. Having X years of spending in cash and bonds and withdrawing only from cash and bonds in a bear market isn’t any better, and it can be worse.
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Ray says
Great analysis if the market recovers in 3 years, what does it look like if it takes 5 to recover, perhaps 7?
Always good to plan for worst case and be happy with better case.
Harry Sit says
You can do that exercise with different numbers in the same way I did here. You will see the results are the same.
ERIC LANCE GOLD says
I think this analysis suffers from not including the opportunity costs involved in holding 8 years of bonds and cash in the years leading up to the crash.
Harry Sit says
We assume the same asset allocation leading up to the crash. We are only looking at the withdrawals during the crash before full recovery.
Joel says
If you consider a variable bond allocation due to rising equity glidepath or just CAPE based allocation rules, you will get significantly different results.
But more importantly, one big reason all your numbers look the same is because in “Withdraw from Stocks Plus Rebalancing” you are rebalancing at the same time as selling, which negates the stock sale entirely and results in selling bonds/cash regardless and comes out slightly ahead because you’re also buying low.
FinancialDave says
Harry,
To be clear in the second case you didn’t really “sell stocks” in year one when they were low you bought stocks to rebalance and you funded your withdrawal with bonds. (As Joel points out above)
Look at it this way as to what happened:
Stocks went from $490k to $525k by buying them with $35k bonds (or cash).
Bonds went from $300k to $225k ($40k to withdraw, #35k to stocks).
Selling stocks only to buy them back in a second transaction is not the proper way to look at this, as this “double transaction” is just a way to lose money in a volatile market.
Sell the asset class needed to rebalance the portfolio (in this case bonds in year 1) and if this isn’t enough to rebalance within your target range then you can continue the rebalance.
This is how I work my TR7 portfolio of 7 ETF’s. In fact all I needed to do at the end of March was sell 7 shares of my TLT and 1 share of IEI to bring my bonds closer to balance:
https://seekingalpha.com/article/4315135-profitable-year-dgi10-and-tr7-continue-to-outpace-4-rule
In most cases I will only bring the portfolio back into total balance at the end of the year as rebalancing too often has been shown to sometimes do just the opposite of what you would expect.
Rick says
I use a withdrawal/rebalancing method similar to the proposed. It is nice in that even in a “normal” year – stocks up a few pct, bonds up a little – you follow the same mechanical procedure:
– Take your withdrawal and simultaneously rebalance to your target allocation.
The exact asset transfers vary depending on what assets are up and which are not.
KJ says
I think the net-net you withdrew $120k over 3 years and the value in both scenarios of the entire portfolio ended up about $880k. So that sounds pretty flat. You didn’t “lose”. So we are good I think.
On the other hand, if you withdrew say 70% from stocks, and 30% from bonds every year for 3 years (without rebalancing) would you be worse off? ie less than $880k?
Scott R says
I love your site Harry, but this quote from your post really bugs me (just like it bugs me when I read it on so many other articles from other people, not necessarily in relation to the current events):
“The logic behind this strategy is that when the stock market crashes, as it did now, retirees can withdraw their spending from cash and bonds and avoid selling stocks at depressed prices.”
This statement basically makes the assumption that the crash is over, the bottom has been reached, and selling stocks now is foolish because you’re “selling at the low.” You don’t know that to be true. For all we know, the recent “recovery” from the crash could be false and short-lived, and the real bottom could be far lower than it is today. In which case, selling stocks today is still selling at a high point, when looking back over the course of the last 10+ years.
Harry Sit says
I don’t make that assumption. We are still in the middle of a crash, which only started a few weeks ago. Who knows how long it will last or how deep it will go. If only the word “did” gave you that impression, I’m open to changing it. Does “as it’s doing now” make it more clear?
Scott R says
OK, good to know. Yes, I think rewording that way would be better. However, can you elaborate on this part of your statement: “…and avoid selling stocks at depressed prices.” Isn’t the consideration of whether stocks are/aren’t at “depresesed” prices relative? They’re depressed compared to 3 months ago. They’re not depressed compared to 10 years ago (presuming a person may have been allocated with them that long)? But maybe I’m just misunderstanding.
Harry Sit says
All prices are relative. “Depressed” is only relative to the recent past. It’s not a value judgment for whether one should buy or sell.
FinancialDave says
Harry,
Just a couple of cautions here:
Rebalancing only works when the asset you are rebalancing actually does recover. In this simple two asset case if you make 3 years of down markets and you rebalance you will have less than if you had not rebalanced until year 3 because you will be buying more of a declining asset.
This “caution” translates into the “real world” when you try this scheme on your account with 5 or 6 funds or more, in which some don’t always recover. That is why many real studies show that in many cases rebalancing can decrease your assets rather than increase them, especially if done too often or in a long down market.
Gotit says
Hi – This is interesting. Wondering if you’ve considered the CAPE Median method? When CAPE is above its long term median draw 100% from stocks and when CAPE is below its long term median draw 100% from bonds. From what I’ve read this can lead to even better results over time. Of course YMMV…
Harry Sit says
Is the CAPE above or below the median now? When did it change from below to above or from above to below last time?
Gotit says
Currently CAPE is at 23.03, which is below its 5 yr median of 29.25.
It looks to have gone below the median between Feb. and March this year.
You can find historical CAPE here: https://ycharts.com/indicators/cyclically_adjusted_pe_ratio
Larry Ragman says
I have not been to the site for a while and am enjoying myself catching up on the posts. This one is both illuminating and thought provoking. I am starting to give my retirement withdrawal posture serious consideration and this is a useful counterpoint to my “cash bucket” default plan. Thank you.
MW says
Hi Harry,
I enjoy your site. Thank you for all of the great articles. I have been very busy working and just bought and hold for the last 25 years. The recent life changing event has given me the opportunity to learn to manage my portfolio.
It seems typically when the stocks are down, bonds go opposite direction. In the crash like we have now in 2022, the stocks and bonds are going in the same direction. What will be the best withdrawal strategy?
Harry Sit says
As this little exercise shows, where you take the withdrawal from doesn’t matter much as long as you rebalance. The more important factor is how much you withdraw. I use a variable withdrawal method that automatically adjusts the amount of the withdrawal with the market. It doesn’t matter whether stocks and bonds go in opposite directions or in the same direction. When the total portfolio value is lower, I withdraw less. It’s not necessarily the best, but it works for me and I accept its tradeoffs. See Easy Early Retirement Portfolio Withdrawals.