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A combination of high stock valuations and low interest rates creates a challenge for investors contemplating where to deploy their capital. This environment is especially scary for those approaching retirement, worried about retiring at the wrong time. Many contemplate working one more year.

Despite recent market volatility, stock valuations sit near all time highs. Higher stock prices historically mean lower dividend yields and a pessimistic outlook for future returns. This leads to increased sequence of returns risk, the risk of your portfolio being depleted in the early years of retirement to the point where it can’t rebound to fund the later years.

Simultaneously, interest rates remain low by historical standards. Low bond yields create little income, while increasing interest rate risk and inflation risk.

Investors are increasingly looking to real estate investments as an alternative to overpriced stocks and bonds, pushing real estate prices higher as well.

I recently made the decision to retire early. This required assessing different strategies to manage increased risk associated with retiring in these challenging economic times.

Valuations Don’t Predict the Future

Many point to high stock valuations as a sign that a crash is imminent. These same arguments were being made in the early stages of an extended bull run when I began getting serious about planning my retirement in 2013. In the 5 years from March 2013 to March 2018, the S&P 500 returned 76.6%. With dividends reinvested, that number jumps to 94.3%.

Ben Carlson, CFA, shares insight into using historical market valuation data to provide actionable portfolio advice. He notes that high market valuations are correlated with lower average returns over subsequent 3, 5, and 10 year periods.

But, there is a lot of variability. Carlson’s conclusion is that market valuations are poor tools to try to predict and time market crashes or the path of returns.

Carlson writes: Stock market valuations have never worked as a timing tool. They don’t tell you when to get out of the market or when to get back in. This is because markets are driven by sentiment, trends and momentum more than fundamentals over the short-to-intermediate terms. But valuations can help investors better frame their expectations for future market returns. It’s not an exact science, but periods of above-average returns typically lead to above-average valuations that eventually lead to periods of below-average returns and valuations. The tricky part is this is not a precise relationship and it doesn’t work on a set schedule.”

Trying to time the market is risky. Imagine deciding in 2013 to sit out of the market, waiting for prices to fall. Similarly, imagine putting off retirement because you were afraid a crash was imminent.

Predicting Interest Rates Is Equally Difficult

Similar to stock valuations, there is consensus that bonds are expensive. Nearly everyone predicts interest rates must go up. But know one knows how soon or how fast. The ten year treasury rate has not gone above 3% since June, 2011.

Todd Tresidder wrote “The Great Bond Bubble is Now” (emphasis on “now” is mine) in March 2013. None of the fundamentals he wrote about have changed substantially since that time. Rates have increased less than one percent over the past 5 years.

The Challenges of Market Timing

We sense stocks are overvalued and will correct, but we have no idea when or how this will occur. Interest rates and bond valuations are easier to understand, but timing when and how they will change is equally daunting.

If you’re waiting to invest money in a market you think is overvalued, ask yourself at what value you will be comfortable investing. How long are you willing to sit on the sidelines waiting for the markets to drop or rates to go up? What is the opportunity cost if this takes a year? Or five years? Or it never goes that low?

If you’re thinking about taking chips off the table because you believe a market is getting overvalued, your job is even more difficult. You’ll have to time the market correctly twice. At what level is the market so expensive that it warrants getting out? Even if you get that right, at what level do you get back in?

Market timing is a loser’s game for the average investor. It is best to avoid market timing. But sometimes you can’t.

Retirement Is Market Timing

Deciding when to retire is the ultimate market timing decision. Traditional retirement requires deciding when you have enough income to live comfortably. You need to make a decision that you can stop accumulating a portfolio and start spending it down.

You can do everything in your power to make an informed decision. But ultimately, you are still subject to luck.

It’s easy to look back five years, when market analysis was similar to that facing those contemplating retirement today, and know what the right decision was. But the past does not predict the future. The next five years might continue on the same trajectory. Or, there could be a massive market crash tomorrow followed by a reasonably fast recovery. More damaging would be a correction followed by a prolonged bear market. We just don’t know what the future holds.

Lowering Expectations

A general rule of thumb for retirement planning is to start with the 4% rule. This assumes you can withdraw 4% of your portfolio balance in your first year of retirement and then continue taking this amount for at least 30 years, adjusting annually for inflation, without exhausting your portfolio. Using these assumptions, you would need 25 times your annual spending to begin retirement. A household spending $50,000 per year would need $1.25 million.

Retirement researcher Wade Pfau writes in Forbes that in this high valuation, low interest rate environment, a 3% withdrawal rate gives a chance of success similar to findings of historical data that produced the 4% rule. Using a 3% withdrawal rate means you would need 33 times your annual spending to begin retirement. For someone spending $50,000/year, this increases required savings to $1.65 million.

Ultimately, we don’t know what we don’t know. We can’t determine our “correct” withdrawal rate until after the fact. Using a 3% withdrawal rate may be far too conservative. Or it could still be too aggressive. Any strategy that involves selling off assets is essentially a game of chicken, because your portfolio could be exhausted before you die.

The True Safe Withdrawal Rate

Financial Samurai argues the only truly safe withdrawal rate is one which does not touch principal. I am financially conservative and have a long retirement horizon, so I ascribe to this line of thinking. But with dividend yields and interest rates so low, how much more more do you need to save if you only want to spend dividends and interest produced by your portfolio, without touching principal?

The current dividend yield for the S&P 500 is now less than 2%. This means you would need an all stock portfolio to be more than fifty times your annual spending to start retirement.

The current rate of a ten year treasury is approximately 2.8%. This means you would need a bond portfolio value greater than 33x your annual spending to produce enough income to live only on interest without needing to sell any bonds.

If we assume a portfolio of 50% stocks and 50% bonds, the yield would be under 2.5%, meaning you would need a portfolio value greater than 40 times your annual spending to start retirement with a truly safe withdrawal rate. For someone spending $50,000 annually, this would require saving over $2 million, compared to $1.25 million suggested by the 4% rule.

Equity Glidepaths

Early Retirement Now (ERN) published original research suggesting that sequence of return risks for early retirees could be reduced by utilizing an equity glidepath. His finding showed optimal financial outcomes were obtained starting with a portfolio of 40% bonds and 60% equities and systematically increasing equity exposure to 100% over time.

This strategy decreases sequence of return risk by lowering equity exposure in the early years of retirement. It also allows for portfolio growth to sustain spending and match inflation over the 40-50 year retirement timeline possible for an early retiree. ERN’s work is built upon similar findings by Michael Kitces in research based on a traditional retirement timeline.

An equity glidepath is compelling. But this strategy is not foolproof. Nor is it a free lunch. If market returns are high early in retirement, ending balances will be less than with a simple static portfolio.

The research from ERN suggests not exceeding a 3.5% withdrawal rate in these times of high stock valuations. A .5% difference in withdrawal rates translated into dollars means a household spending $50,000 per year would need $1.43M to begin retirement. This requires an additional $180,000 savings compared to the assumptions using  a 4% withdrawal rate.

Weighing Alternative Risks

Running out of money is obviously a massive risk when making your retirement decision. But it’s not the only one.

If you are contemplating early retirement, it’s safe to assume you’re not doing the thing you most want to be doing with your time. There would be no reason to take the financial risk of retirement if you were happy with your current lifestyle.

If you’re trading time for money, it’s important to look at what you’re getting in return for making that trade. Is it worthwhile to work longer to save more for retirement?

Retiring when valuations are high and interest rates are low is risky, but what if we flip the equation? Isn’t it also risky to trade your time for money, when that money is being used to buy investments that are poor values? How much longer would you have to work to save an extra $100,000? Is it worth it to trade that time for an asset that will pay you only $2,000-3,000 per year?  Would it be easier to go out and earn an extra $2,000-3,000 per year in retirement?

Our strategy was to choose a non-traditional retirement. This allowed us to hedge our bets. It also freed up time to pursue a more active investing style in retirement that should enable us to achieve higher returns than we could get with passive investments.

Hedging Strategy

Our first strategy was to have some ongoing earned income that would insure we could live off income (dividends and interest) produced by our portfolio without touching principle. This would allow us to have the best of both worlds. We could get many of the benefits of retirement, while eliminating sequence of return risk and the accompanying stress.

Some may say this is “not really retiring”, because it requires ongoing work. Let’s explore.

We began with the assumption we needed 25 times our annual spending to retire. Our portfolio is heavily weighted towards equities, so we used 2% as our “true safe” withdrawal rate. This means we would need enough income to produce the other 2% until our portfolio grew.

Our annual spending (with paid off mortgage) is about $50,000 per year. This means we would need to produce an after tax income of about $25,000 per year, or roughly $2,000 month.

We discussed several options. When we began planning, our first option was for me to maintain my physical therapy license and work 3-4 months of the year doing traveling assignments. Another option was having my wife do consulting work. We also discussed each of us doing simple, low-stress jobs that would produce income and simultaneously decrease expenses. An example would be working part-time at a ski resort to produce income and simultaneously cut spending by getting free season ski passes.

Retiring early requires a high savings rate to accumulate wealth. This means most people contemplating early retirement have some combination of relatively high earning power and low expenses which allow similar options.

Full Disclosure

I decided to retire early as a physical therapist. My wife continues to work 30 hours per week in a location independent job that she enjoys. This gives us financial security, providing most of our living expenses and our health insurance. This is more than we planned for either of us to work, but it gives us a great lifestyle with a lot of flexibility.

It’s worth noting that she would likely not have taken this position if we were committed to a traditional retirement, because it was a risk to leave her previous job. She made a lateral move from a secure position to her current position as the seventh employee for what was a brand new company. The appeal was the potential of having employment that offered location independence.

This demonstrates that planning is fluid, and looking at things creatively can open opportunities you may not otherwise consider. As Dwight Eisenhower said, “In preparing for battle I have always found that plans are useless, but planning is indispensable.”

Matching Investment Style to Lifestyle

When earning a reasonably high salary and investing regularly, low cost index investing can be an effective tool to passively grow wealth. I followed this approach when a combination of full-time work and personal interests dominated my time and mental bandwidth.

We are not limited to investing only in publicly traded stocks and bonds. We also don’t have to limit ourselves only to passive income from stocks, bonds, annuities, social security, pensions, etc. to fund our retirement. There are other options with higher potential returns.

Once freed of the demands of work, I have more time to pursue investing strategies that can produce superior financial returns. This also provides non-financial benefits such as mental stimulation, social interaction, and a sense of purpose vital to a retiree. I plan to pursue two such paths of active investments in retirement.

Investing in Real Estate

Real estate investment trusts (REIT) enable passive investing in real estate, but they are subject to the same market dynamics as publicly traded stocks and bonds. Comparing privately held real estate to publicly traded funds is like comparing apples to oranges.

Investing in individual properties allows an individual investor more control over their investment outcomes. It’s a mix of business and investment that can allow lifestyle flexibility while providing outsized returns.

I asked real estate investor and educator Chad Carson what the minimum return he would expect to entice him to invest in rental property. He would “look for a 6% return or better for a cap rate (i.e. income return if I paid cash) on a quality single family house. A commercial property or apartment building would need to be even better – in the 8 to 10% range.” This means a $100,000 real estate investment would be expected to produce $6,000-$10,000 income per year after expenses, compared to less than $2,500 for a 50/50 stock/bond portfolio.

IDEAL

Income is only one way to make money on an investment. Carson uses the acronym IDEAL to explain the different ways real estate investors make money.

  • Income: From rent or interest on private notes.
  • Depreciation: A required accounting expense that lowers your taxable income.
  • Equity: If buying property with financing, tenant pays for part or all of the asset.
  • Appreciation: Real estate prices and rents tend to keep pace with inflation. You can also create appreciation by buying below market values or improving properties to increase value.
  • Leverage: Use of debt to multiply returns.

We recently dipped our toes into real estate by renting our future home in Utah for a year while preparing for our cross country move this summer. This experience has been educational. Pulling it off from across the country using a property manager showed us real estate investing can be profitable while requiring little work beyond finding a good deal on price and financing.

In retirement, I have time I didn’t have when working to find real estate deals. I plan to expand my real estate investments, which I’ll be writing about as I continue to learn and experiment.

Investing in Personal Business

Since retiring in December, I’ve been experimenting in a variety of new endeavors. One is working on this blog. Another is working on a book.

Creating a lifestyle business in retirement has multiple benefits. Income is certainly one of them. Making a small income in retirement can reduce stress on an investment portfolio. A small business has other benefits as well.

Creating a small business can create social connections and provide a sense of purpose. Early retirement is not all rainbows and puppy dogs. Many work hard to retire, only to experience social disconnectedness, deterioration of health, and decreased sense of purpose. A job can be a solution to some of these problems. Being your own employer can provide more control over when you work, how much you work, and what projects to pursue.

Having a personal business also provides tax perks. Some personal expenses can be shifted to business expenses that offset taxable income. The computer I’m typing these words on is one example.

The other benefit of having a business is you can create an asset. When you work, you are trading time for money. A job may be an easier way to make money quickly, but it requires the ongoing trade of time for money.

This blog is not passive. But it does produce small amounts of income, and in the process is creating an asset that could eventually be sold. Likewise, writing a book (or creating other scalable products) is a tremendous amount of work for no immediate pay. But once completed, these assets can produce income indefinitely.

A retiree has the freedom to pursue projects having potential upside without the pressure of needing immediate income or risking financial resources.

Getting Creative to Reduce Risks

Making the decision to retire is never easy. It involves making assumptions about variables you cannot know or control. You never have certainty. Current market conditions make this decision even more challenging.

You can’t change the math, which can be unforgiving when small errors in assumptions can compound for decades. You either have to accept more risk or work longer to retire more securely.

However, you can change how you choose to work with the math. You can escape an unfulfilling job to pursue your passions sooner if you don’t limit yourself to traditional definitions of what retirement should be and what investments you can use to achieve and navigate retirement.

[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at chris@caniretireyet.com.]

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