Your Money Bag Has a SLIT in the Bottom

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Even a small slit in your money bag will destroy your wealth. A lot of what you pour into the top flows out the bottom. You may fill it up if you pour enough in fast enough. But repairing or preventing that slit at the bottom makes a huge difference.

SLIT: a long narrow cut or opening

– Merriam Webster

SLIT can also help you remember the major threats that eat away at your financial success.

S. Sequence of Returns Risk.
L. Longevity Risk.
I. Inflation.
T. Taxes.

S is for SoR

The Sequence of Returns risk is sometimes called SoR.  It relates to the order of your variable investment returns.  Some simplified calculations show stocks returning 8% or 10% per year for every year.  The average return of the stock market over the last century was 10.5%.

What this ignores is that the return is never fixed and consistent.  It varies from year to year.  It might go more like (+32%, +4%, +8%, -2%, -42%).

In our early careers, we are in the accumulation phase. When contributing to retirement funds the order of the returns doesn’t matter much.

The rules are different in the decumulations phase.  Once retired and withdrawing funds the sequence of returns matters a lot.  If you enter retirement after a protracted bear market with plenty of funds, then you will likely be fine.  The initial returns are likely to be positive.  Early positive returns will grow your wealth and protect you against future loss.  

If you have just enough to retire and a protracted bear starts after you retire, things will not go well for you.  Negative returns at the start can devastate your funds.  So, the sequence above would go better than if it were in a different order: (say -42%, -2%, +4%, +8%, +32%).

L is for Longevity Risk.  

We tend to underestimate our own longevity when calculating retirement income needs.  If you exercise and avoid overeating or smoking you may live longer than average. What will happen if you live past 95?  How about age 105.  You may run out of money. Have your models projected that long?

I is for Inflation.  

Inflation has been in check for quite some time in the U.S.  That doesn’t mean that will continue.  Especially with central banks around the world printing money.  Even a 3-4% inflation rate erodes purchasing power over decades.

Are you old enough to remember the 1970’s?  How about those WIN buttons? (Whip Inflation Now).  I remember those difficult times.  Inflation seems to affect the retired elderly even more than the rest of the population.

When working and receiving a steady paycheck, you have built-in inflation protection.  It is harder to get such protection when drawing down a financial portfolio.

T is for Taxes.  

Many financial plans don’t account for taxes upon withdrawal of retirement funds.  When we are young and adding into our retirement accounts we get a wonderful tax deduction. What a sweet deal the government is giving us, eh?

But come time to withdrawal the money we realize that tax-advantaged is not tax-free.  Uncle Sam gets his cut whenever we withdrawal funds (unless they come from a ROTH).  In fact, you must withdraw your funds early and often.  The government has waited long enough and they would like their part of your money

SLIT doesn’t have to prevent your comfortable retirement. But it should remind you to prepare for those powerful forces.

You may have a SLIT in the bottom of your money bag. Are you concerned about returns, running out of money, inflation, or taxes? Do you have a strategy to combat these threats?

 

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6 Comments

  1. Very Nice! The most important risk factors SLIT. What was the inspiration for the post?

    I don’t remember the WIN buttons (before my time) but I hear people mostly wore them upside down. Do you recall such a thing?

    July 23, 2021
    Reply
    • The inspiration was when a financial planner told me I can consider myself “Financially Independent.”

      I agree that I am. But what if it turns out I’m not? It would likely be due to one of these Four Horsemen. No?

      My dad wore his pin upright, but in his beard.

      July 23, 2021
      Reply
  2. Michael said:

    I agree that drawdown risks are critically important;
    I’m seeing “behind the curtain” software simulations that bolster the need for non-correlated cash flows in those SOR down years.

    July 25, 2021
    Reply
    • Michael,
      Thanks for the comment.

      I don’t have the “behind the curtain” view that professionals have. But I have learned from other smart people who model variability scenarios and learned that SOR risk is real.

      It is one of those difficult, abstract concepts. But it becomes critically important during the drawdown period especially. The order of -20%, -10%, -7%, +12% is quite different from +12%, -7%, -10%, -20%.

      We can’t plan our luck. A major market decline at the start of one’s retirement can be devastating. We need to be aware of such risks and put in place a risk management strategy.

      July 25, 2021
      Reply
  3. Rich said:

    Wealthy Doc,
    So how many years of cash do you keep to prevent SoR risk? 2 or 3 years? More?

    July 26, 2021
    Reply
    • Rich,
      That’s a very good question.
      I will have to think some more on that one.

      Some simple rules of thumb come to mind.
      Most financial planners recommend 3-6 months of living expenses as cash. Others, like Suze Orman recommend 8 months.

      A lot of doctors I know would have benefitted by having a year or two of cash on hand.
      During Covid or job loss such cash reserves can provide time and options.

      I don’t recommend investing money in the stock market if you will need it within five years. So maybe having a year of cash and a few more years of high-quality short-term bonds would suffice.
      The rest could be invested in businesses, equity, and real estate.

      Investing heavily in growth assets only works for those who won’t panic and sell after a crash. So your own situation, risk tolerance, and psychology play a big part in this.

      There are several factors that go into one’s optimal asset allocation. Personally, I’m about 25% equity, 50% bonds, 25% other (cash, businesses, and real estate) currently. Most would say that’s too conservative. But I’m very pleased with my portfolio income and growth. I have no need to take on additional risks.

      You can’t really prevent SOR risk. But you can have enough in risk-free assets that you won’t panic and sell the rest at precisely the wrong time.

      July 26, 2021
      Reply

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