What is sequencing risk you ask? It’s having bad/negative returns on your portfolio at the wrong time, typically at or near retirement which is normally when you’ve got the most money in your portfolio. For the average Non FIRE person this generally means having negative returns on their superannuation about 5 years either side of 65 assuming that’s when they retire. Why does this matter you ask? Because that’s when you’re likely to have the most money at risk, and it can have a huge impact on your income in retirement.
If you’ve managed to save a million dollars in your superannuation at age 65 and the market halves (as it came pretty close to doing from peak to trough back during the GFC) then all of a sudden you only have $500,000 saved for retirement and you have very little time to make that up, assuming you haven’t already retired and are too old to get a job. Realistically, you’re almost certainly not going to be able to do so. Now most non FIRE people don’t have 100% of their superannuation in shares and hopefully some of the more defensive investments in their portfolio will mitigate the losses somewhat, but it’s still going to have a huge impact on the amount saved and the income that can be derived from it.
Not to worry you say, I’m into FIRE and I’m just going to be getting my income from the dividends anyway, so I don’t really care what happens to the capital so long as the dividends keep coming. In which case this chart (http://www.sharedividends.com.au/STW) is not what you want to see.
This is for STW because VAS and most other Aussie market ETFs that people are using in their portfolios didn’t exist that far back, but it’s just another index tracking ETF so the results should be much the same. As you can see dividends went from $3.66 a share to $1.39 a share which is a big drop in anyone’s books. If you were getting $40,000 a year from that $3.66/share dividend you’re now only getting $15,191.25 a year. That dividend investing strategy isn’t looking so great now and I guess you’re going to have to sell some shares unless you can really tighten your belt. To be honest I’m pretty doubtful that anyone can tighten their belt that much as their fixed living costs are likely higher than this (https://aussiehifire.com/2018/08/17/fixed-living-costs/).
I’m actually not entirely sure why the STW dividend dropped so much from 2008 to 2009 and looking at the chart it appears that 2007 and 2008 dividends were a big jump up from previous year payouts. Perhaps there was a lot of capital gains or special dividends those years that got distributed to shareholders? Looking at dividends for some of the major constituents of the index like the banks although they did drop dividends in the GFC they weren’t by anything like as much as STW.
The LICs like AFI and ARG held dividends steady or dropped them slightly although that is presumably because they smoothed out the dividends using reserves? So I may have picked out an anomaly here but given most FIRE advocates are using STW equivalents like VAS (which only started in 2009 so doesn’t include the GFC) I feel like it’s a possible although not probable representation of what another GFC could look like for the FIRE community. Even if we use the 2006 dividends the drop is from $2.32 per share to $1.39 per share in 2009 or a 40% drop in income or $40,000 down to $23,965.52. Ouch!
I was ready to publish this post but thought that the drop in dividends during the GFC from STW seemed unfeasibly large and wanted to look into it further. Looking at this publication from the RBA (https://www.rba.gov.au/publications/bulletin/2016/mar/6.html) dividends certainly did drop from 2008 to 2009 as per Graph 1 but nowhere near as much as the actual drop from STW. Graph 7 gives a better breakdown on what happened with the top 10 largest dividend payers which were the banks, probably BHP and RIO, Telstra and Woolworths having slight drops and a much bigger drop from the rest of the ASX200.
Just eyeballing the charts as I don’t have the underlying data it looks like total dividends went from a bit over 50 billion to maybe 45 billion? Call it a 10% drop in income, so if you were pulling in $40k pa annually you’re now down to $36k which probably keeps you above your fixed costs but would certainly reduce your discretionary spending.
It’s important to keep in mind here that the GFC barely touched Australia in terms of job losses etc and only a very small fall in property prices. If we do have mass unemployment and/or a crash in property prices expect the banks earnings (and their share prices) to take a beating and for them to stop or reduce those juicy dividends. In any case to summarise the drop in dividends from STW does seem to be much larger than it should have been, but if you had been using dividends from it as an early retirement strategy back in the late 2000’s this is what you would have had to deal with so it’s a real situation.
Another issue with sequencing risk, in particular for the FIRE community, is that the time you’re most likely to be declaring early retirement is when you’re several years into a bull market and a bear market might be coming up soon. Why is this you ask? Well you’re probably not building up a huge amount of wealth (and income) if you’ve got all your money in shares when they’re going down. Don’t get me wrong this will definitely be a bonus down the track when you’ve bought investments cheaply, but your net worth probably isn’t going up a huge amount if the value of your investments is going down.
The math on it obviously depends on your personal situation, but chances are pretty good that you’re not retiring after a down year because if you were close to your FIRE number already then any downturn is likely to knock you back more than what you’re putting into the market. Let’s take an example of someone who has built up their savings to a million dollars, is saving $50k a year and experiences a 5% downturn. You’ve dropped $50k on your investments but replaced that with $50k of new money, so you’re back where you started and no closer to FIRE. If you’ve got more money saved then the impact of that 5% drop is even higher so you’d need to have an even higher savings rate.
Now maybe you’re saving more money than the $50k I’m using as an example, but maybe the downturn is more than 5% as well. It’s all hypothetical at this point, but in any case as a generalisation odds are it’s fairly unlikely that you are retiring after a down year and much more likely that you are doing so after a good year.
This depends to some extent on where you are in your FIRE journey of course. If you’ve got $100k invested already, are putting another $50k a year in and the market goes down 20%, then you lose $20k on your investment but put $50k in so on a net basis you’re still up $30k. If you’ve got $800k in the market and are putting in that same $50k with the market going down the same 20%, the value of your investment has dropped $160k and your additional investment only increases it by $50k so on a net basis you’ve lost $110k.
Conversely if we say the market went up 20% instead of down and hold everything else constant, your $800k is now worth $960k, your additional investment of $50k pushes your overall portfolio up to $1.01mill and happy days you’ve reached your FIRE goal assuming it’s a million dollars and it’s early retirement. So one good or bad year in the market can easily be the difference between deciding to retire now and working for another 3 or 4 years. The point is though that you’re pretty unlikely to be retiring after a bad year (or a string of them) and are much more likely to be retiring after a string of good years in which case a bad year is potentially just around the corner.
Now obviously there is no knowing when a bad year is coming. You may have a bull market that goes on for several years after you pull the pin on work and retire early. Even if there is a drop in the market it may be a less severe one, dividends stay the same and it’s all fine although a little nerve wracking.
But chances are pretty decent that you’re retiring after a string of good years because that’s what has helped you build up your wealth to the point where you have declared FIRE, and at some stage in the future there will be some down years. What you really want to avoid is having big down years right after you retire, and unfortunately there is just no way of knowing when that will happen. Which is another reason why I’m planning on HIFIRE so that there is plenty of room to tighten the belt just in case the market goes down just after I retire!
What do you think about sequencing risk, the perils of relying on dividends, and retiring at the end of a bull market? If you liked this post and would like to read more like it then please subscribe!
Hence why I use AFI ARG and MLT instead of the index
All of those still rely on getting dividends from their underlying investments though. Sure they keep the dividends nice and smooth by using reserves or selling down assets, but at the end of the day they still own most of the same stocks as are in the index. If dividends stay low for long enough they run out of reserves and they would have to cut their own dividends. Another way to think of it is that LICs pay you less now than they otherwise would, but they will try and maintain a steady income over time. It’s a tradeoff, but not necessarily a solution.
Great post for getting potential FIER’s to think more deeply about their plans, especially with so many blogs being dominated by people who have recently retired during an amazing bull run – it has been all gravy to them and they have not been tested yet!
I think this is why goals based on numbers is important but should not be set in concrete. A couple of big bull years might get you to fire sooner but either going longer for a bigger buffer or building up a year or two in cash reserve (in a HISA of course) would make sense. That way if your dividends are cut you can ‘top up’ with cash and leave the capital alone until it recovers. Yes you are missing out on growth and a little yield if the bull run continues but if the market does crash that cash buffer just went up in value to you.
An alternative which i am considering would be to retire and sell some shares if your portfolio has gone past your FIRE number as the tax hit will be smaller due to no working income, 50% CGT discount etc. For example your portfolio has shot up to $1.1m when you were aiming for $1m. Sell $100k and $50k will be tax free. The other $50k will depend on dividend income and couple vs single etc but let’s say you end up with $30k of it. Now you have an extra $80k total and should the market tank and dividends get cut by 40-50%; you will be ok for 4-5 years. Then a new bull run and your portfolio looks amazing all of a sudden – how much was that $100k worth now? It might have saved you twice as much by not selling during a down turn and now the compounding of those savings during this new bull run is huge. Now sell down soke more to top up the buffer again. I think the stress reduction alone would be worth it. Your thoughts HIFIRE?
Hi Adam, thanks for stopping by!
As you say most of the people who are hitting their FIRE number and retiring now have benefited from a very long bull market in pretty much any asset class but in particular shares and property. What will happen if either/both markets crash will be very interesting to see. You’ve also hit the nail on the head about not setting numbers based goals in concrete. We don’t know what’s going to happen in the future, and relying on the past is fine up to a point but doesn’t guarantee that everything will be ok. It’s one of those things where you are going to have to be ok with some uncertainty.
I talked a little in the comments of my 4% article (https://aussiehifire.com/2018/08/20/the-4-rule/) about planning on having a couple of years worth of living expenses sitting in cash (HISA). Yes it may delay retirement by a year or two but it probably gives you a lot more margin of safety if there is a market crash. And depending on how much you’re drawing down and the dividend yield on your investments it will probably be pretty much self sustaining.
Your alternative strategy of selling down shares once you get past your FIRE number is also a viable option and as you say you’re probably going to be paying a pretty minimal amount of tax on that, particularly if you can split the tax bill between two people and even more so if you’re going for a lower income FIRE. Whether you do it would depend on your personal circumstances and what income strategy you are looking at using, personally I would probably prefer not to sell assets which are generating a good income stream but that assumes that I also have a cash buffer as I mentioned above. If you don’t have that cash buffer but you want the additional security that it offers then selling down some shares might be a quicker way of getting it rather than working another year or two. As I said above the cash buffer may well be self sustaining after that. If you’re using the 4% rule (there are problems with that as per my post but it’s not an unreasonable guideline) and getting that from dividend income then you may not need to sell down more shares over time to keep that topped up. In which case you can certainly take some money off the table if you want to, but you probably don’t need to.
I agree 100% that minimising stress in your retirement is huge. If you’re sitting there every day worrying about if the market will crash then you’re probably not going to be enjoying life much, and personally I’d rather work a year or two longer so that I don’t have to worry. Looking at my calculations for FIRE it would literally be another year more of work to have a cash buffer of two years worth of living expenses. Unless I’m really hating work at that stage, that’s a very easy decision to make in my opinion.
Thanks for the detailed response, it’s great airing out thoughts and gathering opinions to flesh out strategies. I’m actually surprised by the low amount of comments you have in general due to quality of your posts.
I think the selling off a small percentage of the shares will also depending on the makeup of individual portfolios. Some stocks may be way over valued if picking some individually or one of your Lic’s might be trading at a big premium to NTA providing an opportunity to harvest some gains.
I think you have the luxury once you go past $1m due to how fast the portfolios is growing at the pointy end as you have pointed out in a few articles. The trade off of losing some growth is easier compared to the start of the journey when having cash on the sidelines can really slow you down.
As you have pointed out the beauty of hifire/fatfire is your near bullet proof compared to leanfire. In a downturn your biggest compromise would probably just be to holiday in South East Asia and delay Europe to another year 🙂
That’s very kind of you to say Adam, hopefully the amount of comments picks up over time! My blog is only fairly new so I’m hoping that over time I’ll keep writing good article and the blog will build up to the kind of reach that people like Aussie Firebug or Strong Money Australia or the FI Explorer and some of the other bigger names have. And if it doesn’t, well I enjoy the intellectual stimulation of writing and going back and forth with people like yourself!
It would make sense that what you do would depend very much on what your portfolio looks like. If you can sell out of some LICs at a premium and build up cash or put it into undervalued LICs then happy days I say, but it’s really going to come down to your individual approach to FIRE. I seem to see a fair number of posts on Reddit worrying about getting the perfect portfolio from the outset when really the key is to start investing. If you end up putting $50k into Argo instead of AFIC or VAS instead of A200 or now think VDHG etc would be a better idea then it’s very unlikely to make much of a difference over the long term and you can always change course along the way anyway. If you end up with some smallish odd lot holding, so be it.
And yes, I very much want to have a large safety net to play with! I’m thinking that it’s more a case of just one trip to Europe rather than two for me in a downturn! 😉
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Have a look at the very strong rise in dividend distributions prior to 2008 (the extra mone could have been kept in cash until needed). Don’t just look at the drop in dividends after the GFC. One must look at the whole picture, not just one part of it.
I agree that the dividends obviously had a dramatic increase just prior to the GFC, but invariably there would be people who would assume that would go on forever. Also the dividends had a dramatic increase from 2005 onwards and still hadn’t really recovered to that level even 10 years onwards.
Really enjoyed the read. I think its a topic most haven’t thought about or really understand in too much detail, due to the simplicity of the 4% rule and/or a lack of financial understanding and probability.
For my own FIRE calculation I have considered a number of factors to derisk my FIRE date (albeit pushing it out) to withstand the types of issues you cover.
The two factors I adjust are:
– what happens if my asset values are 80% of their value [adjusts for a 20% reduction on day 1)
– what happens if I drop my safe withdrawal rate to a real 3.15%, (aka 5.4% return less 2.25% CPI)
I find that changing these two items in my scenario planning results my FIRE date changing from say 2 years to some 7 years if I use both factors at the same time.
I find that understanding the scenarios allows me to reduce the fear associated with a market crash or black swan event, resulting in me staying the course. I also understand the above scenarios may be overly conservative – however its good to know what the above changes would do to my ability to FIRE. I also think its a great way of acknowledging that I may have hit fire today but adding an additional year in a bull market or otherwise + additional contributions makes the probability of your money lasting a lifetime that much better.
For instance assuming safe 4% withdrawal rate / real return rate and 40k in contributions (50% of income)
y0 1m portfolio
y1 1.080 portfolio = 40k return + 40k contribution + 1m portfolio
y2 824k portfolio = -40k withdrawal – 216k decrease (20% crash) + 1.08m portfolio
vs
y0 1m portfolio
y1 1m portfolio = 40k return – 40k withdrawal
y2 760k portfolio = -40k withdrawal – 200k decrease (20% crash) + 1m portfolio
Difference 1 year makes = 64k or more than a year and a half of withdrawals (assuming 40k for simplicity). The above assumes 100% of portfolio is in equities.
In addition it doesn’t take into account the bumper year usually following years of bad investment returns – having the higher portfolio balance in the first example will have an exponential impact on the subsequent years, likely offset the loss significantly.
Hi J, glad you liked it! The idea of stress testing your scenarios is great, I think more people should be thinking about this as they get close to hitting their FIRE number.
An extra year of working actually tends to make a much bigger difference in how much of a safety net you have because it’s pretty rare if the market doesn’t give you negative returns that you don’t get a double digit year of positive return. So you’re likely to start with more like 1.15m or even more by working another year. I talked about it in this post, and working one or two more years most of the time will get you from being able to fund a given level of income at a 4% withdrawal rate to a 3% withdrawal rate, which is much safer! And if it doesn’t well then that’s probably because there was a big market drawdown in which case you’re probably happy that you’re still working rather having pulled the pin right when a bear market started.
And then you also need one year less of income in retirement which helps out as well, although not as much.