How to Not Run Out of Money during Early Retirement

In my previous article, I wrote about the 4 simple principles to follow in order to retire early.

The 4% Rule works great if the money you’ve invested continues to grow each and every year.

But what if it doesn’t – what if as soon as you retire the stock market plummets like before?

Thankfully, there is a solution to this – in the form of Portfolio Income and a Cash Reserve.

When you retire, rather than reinvesting your dividends, you will use this money as income.

You should also have a Cash Reserve so you don’t sell assets when the market is down.

Portfolio Income and a Cash Reserve makes your money last even during a market downturn.

In this post, I talk about the problem with the 4% Rule and how to switch on Portfolio Income.

I also talk about how to increase Portfolio Income and how much to have in your Cash Reserve.

Finally, I talk about what actions to take next and where to go to find out further information.

The Problem with the 4% Rule

The problem with the 4% Rule (which I explain in my previous post) is that it’s not a guarantee.

The formal definition of the 4% Rule states that withdrawing 4% of your starting portfolio each year, adjusted for inflation, yields a 95% success rate over a 30 year retirement period.

Sounds good right? Not exactly. This means that 5% of people who retire based on the 4% Rule end up running out of money at some point during their retirement. How can this be?

It all comes down to luck. If you retire right before an economic boom, congrats, you will be part of the 95%. But if you retire right before an economic bust, you end up part of the 5%.

The last thing you want to do is sell off assets from your portfolio when the market is down. But when you’re retired you have no choice, you need to sell in order to fund your expenses.

Thankfully, there are 3 strategies you can implement so that you don’t end up part of the 5%.

Strategy 1: Switch on Income Mode

When you first start investing in index funds you are given 2 options: accumulation or income.

When you’re first starting out and building up your portfolio, you choose accumulation mode.

This means that any dividends you will get paid are automatically reinvested into your funds.

This is how you portfolio grows: capital appreciation, reinvested profits, and compounding.

When it’s time to retire, you can then switch your fund from accumulation to income mode.

There are a few reasons for doing this: First of all, your income can cover your yearly amount.

If your income equals your yearly expenses, you may never have to sell from your portfolio.

The second reason is that you will have the same income even if the stock market is down.

This is because the income (also known as yield) is determined when you first buy the assets.

This is the beauty of switching on income mode when you retire, which you can even increase.

Strategy 2: Increase your Income

Not all assets (stocks and bonds) are created equally: some simply pay out more than others.

Shouldn’t you just invest in those assets then? No, because they may not perform that well.

However, in a market downturn, the second strategy involves temporarily shifting your portfolio into higher-income assets. Why temporarily you ask?

Because the 4% rule only works when you are invested in index funds.

So what are some of these higher-income assets?

The first are Preferred Shares, a hybrid of a stock and bond, which offer a higher income.

Next you have Real Estate Investment Trusts (REITs) which also offer a high income.

You also have Corporate Bonds, like government bonds but companies, which tend to have a higher income.

Finally you have Dividend Stocks, from large established companies, which pay a high income.

By shifting to these when the market is down, your portfolio can generate a higher income.

Strategy 3: Have a Cash Reserve

You’ve switched on income mode – but it is not enough to cover your annual expenses.

So then you increase your income – but it is still not enough to cover your annual expenses.

What else do you do, when the market is down, to get the remaining income without selling assets?

The last strategy is having a Cash Reserve. It is simply a pile of cash that you have in a savings account that you withdraw from to make up the rest of your income during a down market.

By having this, you will not be forced to sell assets when your portfolio is down. Simple right?

So how much money do you need in your cash reserve? It depends on your portfolio income.

Say you need £40k a year and your portfolio income is £35k. That means you need £5000 extra.

Usually you’d get this money by taking £5000 from your portfolio – but not in a down market.

So then you take this £5000 from your Cash Reserve for that year.

Multiply this figure by 5 and that is how much you should have in your Cash Reserve i.e. £25k. Why 5?

Because the worst market downturn lasted 5 years, but on average it’s 2 years, so 5 years’ worth would be plenty.

Don’t be Part of the 5%

The good thing about these strategies is that you don’t need to worry about them now, unless you are planning to retire soon.

However, these strategies do give peace of mind that there are actions you can take to prevent ending up part of the 5% during a market downturn.

What you now need to focus on is building up your portfolio, investing in Index Funds, and make sure your funds are on accumulation mode, not income mode, so that your money grows faster.

By the following the 4 principles, you will be on your way to a much earlier retirement!

To find out more about these strategies in detail, check out the book: Quit like a Millionaire.

The authors talk about the journey to early retirement and what early retirement is really like.

Are you on the path to early retirement? How is it going? Please share in the comments below.

If you want me to explain anything in more detail, please let me know in the comments below.