Last night there was an interesting interview with Bill Bengen, the originator of the 4% rule, on Rebel Finance School. During the interview he talked about the 4% rule being based on a scenario where the user holds mixed assets - some stocks and some bonds.
Traditionally, bonds have been seen as the go-to solution to Sequence Risk. They behaved in the opposite way to stocks during a crash - they'd go up. So a dose of bonds would, it was hoped, help smooth out the volatility in your portfolio, suppressing big drops. But bonds give a lot lower return than stocks, so this measure is painful at the best of times. Part of your portfolio is unproductive, so you end up staying at work for longer in order to have the bonds in there.
Broken Bonds
In recent history, and I'm thinking here of the 2008 crash and during the Covid pandemic, governments have used "quantitative easing" to help cope. QE means printing money. It's a desperate measure, and like all desperate measures it has knock-on effects. Governments printing money causes higher inflation - a pound is now worth less.
This inflation isn't great for people, whose wages don't go as far, so they chase pay rises, shops put prices up to deal with their increased wage bill, and so on throughout the economy, and there's a spiral of inflation.
But for the government, this means that their debt is easier to repay. They can continue overspending by stretching the boundaries. So they do it, safe in the knowledge that most people don't look at economics, and will instead be pleased by pay rises.
How does this relate to bonds? Well, many people think that in this era of QE, bonds no longer function as hoped - their market price no longer behaves as it once did. When once they would go up in price during a crash, now it seems that the market now realises that governments will inflate away their value, making them less attractive.
So for me bonds are no longer a solution.
What Would Warren Do?
Equities - that is, stocks - remain the asset of choice. I'm not alone in this. My perspective has been formed by studying Warren Buffett. On investing decisions, I think it's often useful to ask "What Would Warren Do?" Both financially and ethically this generally leads to a good answer. Buffett has said as recently as in last Saturday's annual letter to his shareholders that his strong preference is to own stocks in good companies, over other types of assets.
In the context of the Rebel Finance School, Alan and Katie are careful to inform people of their various choices for Sequence Risk mitigation, including bonds as well as cash buffers and flexible spending. But I note that their own choice has been the same as mine - to keep away from bonds.
Stocks are great, they represent ownership in the profitable companies which are the backbone of our civilisation. They're the escalator we ride up, making us wealthier. The idea of having all your money in stocks has a lot going for it. Bonds, on the other hand, leave a sour taste.
Inflation Is The Enemy
Bill Bengen also said that the key driver of Sequence Risk is not, as people generally assume, market crashes but is instead the inflationary environment. The worst moment to retire in historical times wasn't the 1929 Wall Street Crash, it was 1968 just before 1970s "stagflation", a long period of inflation without growth.
If inflation is the enemy to be feared the most, this steers me back again to Warren Buffett's words. He has said that the best defence against inflation is to have your capital invested in the shares of profitable companies. Particularly companies with strong economic moats which lead to them having superior pricing power. When an Apple customer needs a new phone, they are fairly well locked in to Apple's ecosystem, maybe they're running a Mac and an Apple watch and they use Apple's cloud functions. To an extent this means that Apple can set the price of the iPhone higher and still not deter their core customers. This is pricing power. When inflation causes increases to Apple's costs, they can raise their prices and maintain their profit margins. They are the most immune thing to inflation.
I think this fits with what Bill went on to say about only using bonds during your period of Sequence Risk - his suggestion of starting to move back toward stocks from the start of retirement leads, he said, to higher safe withdrawal rates overall.
That leads me to treat bonds as tainted. Getting bonds out of the picture is a good thing, but you must address your Sequence Risk somehow.
Ultra Safe
Bill made clear that his 4% rule was a measure of how to be ultra-safe. Most retirees could draw more than 4% and be just fine. His method was to look at historical retirees lined up in order of success and failure. His mix of stocks and bonds led to 4.15% being the point at which "portfolio failure" was experienced by the first of the historical retirees.
If bonds no longer work for us, we have to change the maths a bit. If we look for the "first man to fail" when using a portfolio made up of 100% stocks, I think the ultra safe figure is about 3.5%.
This doesn't mean that we need to switch to a 3.5% withdrawal rate. 4% works fine in most cases, it's just the "ultra safe" test that it struggles with. It leaves us with some Sequence Risk to deal with to get to the ultra safe level.
When you retire on a 4% drawdown rate, you hope to experience some "normal" years afterwards. In the normal course of things the market grows at an average of about 7%, net of inflation, and the difference between that 7% and your 4% withdrawals is padding out your portfolio.
Note that the 4% figure is used once, at the start of retirement. You look at your £500k pot, see that 4% gets you a £20k withdrawal, and then in subequent years you adjust the £20k for inflation increases. You don't go back and pull 4% from whatever the portfolio total is at that point.
This means that your withdrawal rate should be diminishing, in terms of your portfolio total. About five average years leads to about 15% growth in your portfolio and brings your actual withdrawal rate down to about 3.5%. Looking at the portfolio afresh from that position, 3.5% is ultra safe so you are now free of Sequence Risk.
Getting past Sequence Risk is about getting that extra bit of growth, somehow. If you get a crash, it's all the more important not to eat into your portfolio more than necessary, but even in normal years any help you can give it to reach that 15% growth from your starting point will speed you to safety.
The mix of assets you choose is up to you, as is the way you choose to get past Sequence Risk. I like the Rebel Finance School approach of keeping things simple by holding one global equities fund. For me it makes sense to extend this strategy into the Sequence Risk problem too, and just keep on keeping on, being careful with your spending till you're past whichever level of "safe" lets you sleep soundly at night.