Decumulation in FIRE
Decumulation is the opposite of accumulation. Decumulation refers to the stage in life where you have achieved FIRE (Financial Independence Retire Early) and are living off or spending down your asset portfolio.
Bill Sharpe, the US economist and Nobel Prize winner, called it “the hardest, nastiest problem in finance”. The problem of how to drawdown money, or decumulation from a retirement fund, is simple to state but not easy to tackle:
How much can you sustainably withdraw from your pension pot?
What is a sensible way to allocate assets in it?
How long will you live?
What return will you earn on the money?
How much income will you need?
How long will you need it?
What will inflation look like?
How much will you want to leave to your beneficiaries?
The questions go on….
Accumulation: working towards FIRE
When you are working towards FIRE, you are in the accumulation stage; putting aside enough assets to live off when your income stops. History has shown that the best way to do this is to be 100% in Equity via low cost global index funds for the long term – buy and hold.
There is some argument that you can ‘tweak’ the type of Equity you hold to provide incremental gains and these incremental ½ or 1% gains per annum can make a significant difference over a 20-30 year accumulation period; for example, having a percentage of small-cap value in your portfolio. If you want to know more about this, there is a wealth of information available on the Paul Merriman website. Mr. Merriman even provides a free ebook We’re Talking Millions which is well worth a read!
What to do pre FIRE
It is a good idea to move away from 100% Equity a few years before you reach the finish line. Equity is a high volatility asset which can average 7% growth per year over a long time span but during that time it can decrease suddenly, without warning, sometimes by as much as 50%, and then take as long as 3 years to recover. You do not want this to happen to your portfolio just as you FIRE!
Therefore, it would be wise to move some of your portfolio into cash and/or Bonds in the preceding years to reduce the risk of a sudden large shrinkage to your portfolio.
How will you know if you have reached FIRE?
Retirees face a scary question: how much money can I safely withdraw from my portfolio without ever running out? This is called the safe withdrawal rate (SWR).
The Gradragstoriches blog ‘what is the FIRE movement?’ covers the 4% rule of thumb which is generally agreed to be a good base for working out how much you need in your retirement portfolio to be able to live off it without running out of money - with 4% being the SWR.
For example, if you have accumulated a portfolio of cash/Bonds/Equity to the value of £1 million, by the 4% rule of thumb this can provide you with an index-linked income of £40,000 per year.
Just a pause for caution - this is a simplified explanation. There are numerous articles that will explain the 4% rule in detail along with its limitations and options. Retirement finance and decumulation is way more sophisticated and complicated than accumulation, and there is no one size fits all.
Time to FIRE: Sequence of return risk
There is one fundamental fact that has been derived from numerous studies on safe withdrawal rates and that is market volatility matters in decumulation. Even when long term returns average out over the years, if the sequence of volatile returns is unfavourable, there is a danger that bad years early on could deplete the portfolio before good years return. This is known as ‘the sequence of returns risk’.
Numerous financial applications attempt to model various scenarios, but the sequence of investment returns will never be certain. As an example, let’s say you start out with £1 million invested purely in Equity and take an annual income of £50,000 with a 2% annual inflation adjustment.
In Scenario 1, you experience negative returns at the beginning of the investment horizon, while in Scenario 2, the sequence is flipped and the negative returns come at the end:
The long term average return in both scenarios is the same, but with vastly different outcomes. Scenario 1 runs out of money, but Scenario 2 grows to £1.6 million. This situation reflects the sequence of returns risk in retirement.
Taking a more flexible approach to withdrawal rates can mitigate the negative effects. For example, in bad years withdrawing a fixed percentage of the portfolio but not adjusting for inflation; currently, Equity and Bonds are down and inflation is running at over 10%, so a decision may be made not to inflation link the 4% withdrawal this year.
Another dynamic SWR strategy is to use a ‘guardrail’ approach in which withdrawals are increased in good years, and reduced in bad. For example, guardrails are set at 20% above and below the withdrawal rate, so for a target withdrawal rate of 5%, the lower guardrail is 4% and the upper guardrail is 6%.
Decumulation using The Bucket Strategy
Sequence of returns risk is much less of an issue for a well-diversified portfolio of cash, Bonds, and Equity. The Bucket Strategy is designed to reduce sequence of returns risk, and volatility risk, by avoiding market timing i.e. having to sell assets when they are down. It aims to balance cash-flow safety with investment growth.
Bucket 1 holds cash for near-term withdrawals - anywhere from six months to two years’ worth of cash to live on; cash that you can draw upon when it’s not a good time to sell Equity. Having this cash buffer provides peace of mind; you shouldn't be rattled during periods of short-term market turbulence because spending will be relatively undisturbed and the rest of the portfolio can recover when the market eventually does.
Bucket 2 consists primarily of Bonds, preferably a low cost global bond index fund that offers higher long-term returns than cash with much lower volatility than Equity - up to eight years worth of portfolio withdrawals.
Bucket 3 is the long term component in Equities, preferably a low cost global equity index fund offering higher potential returns than buckets 1 or 2 but with higher expected volatility. This is filled with the remaining value of the portfolio.
Equity over a 10 year time period has been pretty reliable, so the bucket strategy provides a 10 year cushion of cash and Bonds if needed.
The strategy is designed to be customised based on your risk profile and expected withdrawal rate. For example, following the 4% rule, someone withdrawing £20,000 from a portfolio of £500,000 could earmark £40,000 in cash (two years' of withdrawals), £160,000 in bonds (eight years' of withdrawals), and the remaining £300,000 in stocks. This gives a 60/40 portfolio: 60% Equity with 40% Bonds/cash. Studies have shown that a balance of between 50-75% Equity is the optimum in decumulation when following the 4% rule.
Bucket Strategy decision rules
The Bucket Strategy for retirement income appears to be a model of simplicity, at least on the surface. The key premise of bucketing is that by maintaining bucket 1, a retiree can preserve a stable standard of living while also holding a diversified pool of more volatile assets to take advantage of investment growth. That sounds straightforward enough, but things start to get more complicated when it comes to ‘bucket maintenance’.
For example, if the stock market drops and bucket 3 Equity value falls from £300k to £200k, do you maintain your holding until it recovers, or do you rebalance from Bonds to maintain the 60/40 balance - buying when the market is down and selling when the market is up?
When do you refill the cash bucket 1 and from which bucket?
Should you simply transfer money from bucket 3 (Equity) to 2 (Bonds) to 1 (cash) on a regular, preset basis? This strategy is simple to understand, and because bucket 3 is apt to decline as a percentage of the portfolio over time, it reduces risk in the portfolio as the investor's time horizon grows shorter. The big drawback to mechanically selling stocks and bonds on a calendar-year basis is that it doesn't take into account whether it's an opportune time to sell a given asset class.
Or, should you refill bucket 1 with rebalancing proceeds, selling those holdings that have performed the best, to bring the total portfolio's balance back in line with targets?
The big advantage to this approach is that it forces the investor to sell appreciated assets on a regular basis while leaving the underperforming assets in place to recover - or even adding to them. The potential disadvantage is that rebalancing too often may prompt a premature scale back on an asset class, thus reducing the portfolio's total return potential.
Alternatively, there are those years when almost nothing performs especially well; 2022 for example. Holding a cash bucket provides a buffer if nothing is ripe for pruning giving the retiree more discretion over when to sell assets for rebalancing. Spend the cash bucket and refill it when Equities and/or Bonds recover.
The general principle is this:
If stocks are up, sell stocks.
If stocks are down and bonds are up, sell bonds.
If both stocks and bonds are down, continue to draw down Bucket 1 (no refill).
Rebalance buckets 2 & 3; or wait until they recover from a down market, then rebalance.
Have a decumulation plan
This just shows that there are still a number of ‘decision rules’ that you have to decide upon, hence the importance of having a written financial plan. Knowing this at the outset can help determine how you rebalance your portfolio and what you do with excess funds above and beyond what you need for living expenses.
You will need to consider how you want your portfolio’s assets balance to change over time. You may not want your asset allocation to remain static throughout retirement. You may want to become more conservative or even more aggressive. You may wish to maintain the value of your total portfolio or be happy to spend it down to zero throughout your retirement: most retirees tend to underspend, leaving much more in inheritance than expected.
On an annual basis, record cash flow forecast against actual, and track the portfolio value over time to ensure it stays on track. Keep a record of the portfolio asset mix so that you know when to rebalance. Remember to consider other items that can be included in your net worth calculation and how these will affect your cash flow and withdrawal rate going forward, for example, the value of property you own and future state pension.
By planning ahead you could avoid paying Income Tax by withdrawing from a mix of ISA (no Income tax) and Pension (pay income tax above the personal tax-free allowance at 20%). By taking money out of pensions using UFPLS, you can take up to £16,000 P/A tax-free by using the personal tax allowance and a tax-free lump sum. Above this, you would pay 20% in tax.
Decumulation using annuities
Primarily the retirement fund is used to generate income for the lifetime of the retiree, but that time horizon is impossible to predict. The only way to eliminate longevity risk is to insure the retirement income stream with an annuity.
An annuity converts some or all of the retirement fund into an annual pension, giving a guaranteed income for life, or for a specified period. For example, £100,000 could buy a lifetime annuity providing a guaranteed income of £6,000 each year for life (or slightly less if inflation-linked). This is obviously advantageous if you live a long life as you will know exactly how much you will have to spend no matter what happens in the stock market or with inflation…but, if you get knocked down by a bus two years after signing the contract, there is nothing to pass on as inheritance.
This is only a sample of the withdrawal strategies that can be utilised. As Bill Sharpe, the US economist and Nobel Prize winner called it “the hardest, nastiest problem in finance”. You may be able to manage this yourself, if not, employ a financial planner to devise a plan (NOT move your funds to their ‘recommended funds’!). While some may argue that returns could be improved by using other strategies, I like the Bucket Strategy approach for the value of peace of mind during turbulent times.