Using Financial Guardrails to Make the Most of Financial Independence

there are many strategies that investors have used over the years to make the most of their nest egg both before and after they've reached financial independence we've covered several of them on this channel over the years and today we're going to be doing a deeper dive on one of the strategies specifically the use of financial guard rails and how they can help you make the most of your golden years whenever you decide to begin them to get a sense of how financial guard rails can help us we'll be examining a few key factors first is the amount of income and sdg would have been able to generate using financial guard rails compared to if they used the more conventional strategy of simply picking an initial safe withdrawal rate and adjusting that withdrawal for inflation each year next is how stable those incomes were over the years because as great as having an initial six-figure income would be it doesn't help us too much if that income is constantly decreasing year after year to the point that we end up living below the poverty level later on in life and third is risk more specifically can we mitigate the risk of running out of money by using financial guard rails and finally and perhaps even more interestingly can we do it consistently under varying economic conditions and asset allocations without totally tanking our income because again obviously we don't want to run out of money in our nest egg after reaching financial independence but we also don't want to find ourselves in a situation where we're forced to live on a few thousand dollars a year just to ensure that we don't run out of money to ensure that we get a good scope of the range of possibilities we'll be examining how the two strategies stack up to each other in these factors using a variety of different time periods and asset allocations for the asset allocations we'll use a fairly aggressive all stock allocation a more balanced stock and bond mixture and a fairly conservative allocation in the form of the permanent portfolio for time periods we'll be looking from 1927 through 1990. why only 1990 because most projections for those who reach financial independence go for at least 30 years that's a fairly typical length for a retirement in many financial models and for those who are actively pursuing financial independence it's fairly common for them to achieve it somewhere in their 50s or 60s so they presumably still want to plan for the money to last them at least a few decades with that being said let's get started but before we get going be sure to like this video if you haven't already as it really does help out the channel a lot and subscribe with notifications on for more money related videos like this one every single week and if you want to further support this channel you can check out some of the links i've left in the description below which includes a link to the investing platform m1 finance get started investing for free today so it's been quite a while since i last touched on financial guardrails and the channel has grown a lot since then and i've never actually done a dedicated video on them until now so for those who haven't heard of them before allow me to briefly explain what financial guardrails are and how they work financial guardrails are basically there to ensure that your withdrawals from the nest egg never get so high that you run a big risk of running out of money too early but also help to ensure that they never get so low that you end up with a nest egg that's several times the size of what it was when you first retired which can sometimes happen with the more conventional safe withdrawal rate strategies the idea is that if your projected withdrawal for the upcoming month or year or whatever time frame you're using for your regular withdrawals is above or below a certain threshold then you will adjust that projected withdrawal by a predetermined amount to put actual numbers to it let's say that you started off with a one million dollar nest egg and you decided you were comfortable using a five percent initial safe withdrawal rate however you decide that you don't ever want to be withdrawing more than six percent of your nest egg in any given year as you fear that would eventually lead to you burning through your savings too quickly but you also never want to be withdrawing less than four percent of your savings in any given year because you feel that that would lead to you building a mountain of cash that you would never be able to enjoy that six percent figure would be your upper guard rail and the four percent figure would be your lower guard rail if at any point your projected withdrawals were above six percent or below four percent of your remaining nest egg you'd adjust that projected withdrawal by a specific amount to hopefully get back inside of those guard rails the amount that you actually choose to adjust by is somewhat arbitrary you can pick pretty much any amount you want but for this video we'll assume that you adjust your withdrawal by 10 up or down depending on whether your projected withdrawal is too high or too low in the first year of john's financial independence he would withdraw five percent of his nest egg to live on or fifty thousand dollars in this case since he had a one million dollar nest egg this leaves him with a nest egg valued at nine hundred and fifty thousand dollars following the withdrawal let's say that john's investments had a really good year and grew by thirty percent to one million two hundred and thirty five thousand dollars let's also say that inflation for the year was three percent john's projected withdrawal for year two assuming he was adjusting those withdrawals for inflation which is what we'll be assuming today would be fifty one thousand five hundred dollars that's approximately four point two percent of the total value of his remaining nest egg at this point so he is on the lower end of things but he's still above that four percent lower guard rail so no adjustments need to be made he'll withdraw the 51 and a half thousand dollars and move on with life the next year john's investments continue to do really well rising by another 20 to approximately 1 million hundred and twenty thousand dollars assuming an inflation rate of three percent again john's projected withdrawal would be about fifty three thousand and forty five dollars or around three point seven percent of the new total value of his nest egg at this point he's below the four percent lower guard rail which means that he would have to adjust that projected 53 045 dollar withdrawal to try and get back above that lower guard rail we'll say that he adjusts his withdrawals by 10 percent so instead of withdrawing the fifty three thousand and forty five dollars he'd withdraw something like fifty eight thousand three hundred and fifty dollars in this case that would be about four point one percent of the value of his total nest egg this has a double whammy effect on john's income going forward first he obviously withdraws more in that third ear than he would have had he not been using financial guard rails his future inflation adjustments will also be more substantial because he'll be using that 58 350 dollar figure to make the adjustments for inflation instead of a 53 000 figure that he would have been using in a more conventional safe withdrawal rate strategy obviously this is a bit of a double-edged sword as if john's investments had performed poorly he may have had to adjust his income lower at some point and then his inflation adjustments would be using that lowered income level as well but that's the basics behind the financial guard rail strategy now let's see how that strategy stacks up to its competition historically as i noted earlier in the video in these simulations we're going to be looking at a few factors the average income generated from the nest egg how often those incomes rise or fall from year to year and what the net worth looks like at various points in time based on different asset allocations and initial safe withdrawal rates portfolios will be rebalanced annually and the time frame we'll be using is every possible starting year from 1927 through 1990. all simulations will be run through to 2020. we'll have john follow the simple safe withdrawal rate strategy where the only change from year to year is the actual raw dollar amount that he's withdrawing based on whatever inflation happens to be jane will utilize financial guard rails and adjust her withdrawals by 10 up or down just like we illustrated a minute ago if she happens to get outside of her financial guard rails her upper guard rail will be 50 above whatever that initial safe withdrawal rate is so if the safe withdrawal rate starts out at four percent her upper guard rail will be six percent if the initial safe withdrawal rate is five percent her upper guard rail will be seven and a half percent and so on and so forth her lower guard rail will be twenty percent below whatever that initial safe withdrawal rate is both john and jane will start with a one million dollar nest egg the first allocation we're going to be looking at is an all stock allocation represented by a simple total stock market index fund we're going to be using initial safe withdrawal rates of three percent four percent and five percent in our three scenarios respectively with an initial safe withdrawal rate of three percent averaged across all the possible starting years and cycles would have been approximately 133 000 the median clocks in at around 113 000 the average income in the worst year of each cycle would have been around twenty nine thousand three hundred and fifty dollars and the average income in the best year would have been about two hundred and ninety three thousand dollars his raw dollar income would have increased in roughly sixty four percent of all years thanks to inflation it would have decreased in about four percent of the years and held steady in the remainder of years his average ending net worth would have been around 1.1 billion dollars it's at this point i feel i should note that the net worth figures are not being adjusted for inflation only the withdrawals are as that's how it would go in real life his net worth falls to around 838 thousand dollars at its lowest point on average and at the 30 40 and 50 year marks his net worth typically clocks in at around 14.25 million 36.6 million and 113.4 million dollars respectively there are no instances where john ran out of money by 2020. jane as you can imagine given that the stock market has generally gone up over the long haul generated higher average incomes from her nest egg than john and it's by a pretty substantial amount jane's average annualized income was over 1.1 million dollars her median income was a lot lower at just 376 thousand dollars a year but that's still north of triple john's median income in this comparison her lowest income clocked in at around 29 000 so a tad lower than john's but nothing too extreme and her highest income just under 5.39 million dollars as if that wasn't impressive enough jane's stability metrics came in at almost exactly the same mark as john's with their income growing in 64 of all years falling in four percent of all years and holding steady in the final 32 percent so there's no doubt that historically speaking jane's use of financial guardrails gave her lifestyle a fairly sizable boost under these assumptions her net worth of course was not quite as monumental as john's but it is still considerably higher than the 1 million nest egg she started with on average her net worth by 2020 would have been around 263 million dollars her net worth did fall to around 838 400 at its lowest point on average and at the 30 40 and 50 year marks her net worth typically clocked in at 11 and a half million 23.25 million and 53.9 million dollars respectively just like john there were no instances where jane ran out of money by 2020. so in the end jane gets a higher income on average the stability of that income is roughly equal to that of john's and while her net worth figures were lower they were still considerably higher than what she started with and given that neither person ran out of money by 2020 i don't think john's edge there carries much weight for most people i think most of us would happily take the extra income and only see our net worth climb to 200 times its original value instead of having the lower income with a net worth that's 1100 times its original value but is that the pattern we see at different safe withdrawal rates because three percent is fairly conservative in the majority of cases lower initial safe withdrawal rates also make it more likely that jane will shoot past her upper guard rail more frequently which allows her to raise her income so let's take a look at what would have happened under a four percent initial safe withdrawal rate using a four percent initial safe withdrawal rate we see that jane's income figures fall a bit from the heights they reached in the previous scenario and john's income figures rise due to the higher starting point the stability metrics also falter for jane though not by a significant degree under these new assumptions her income increases in 62 percent of all years and falls in six percent of them the net worth figures is where we get our first noteworthy insights obviously they are a bit lower for both john and jane which is to be expected given the higher initial safe withdrawal rates but unlike last time jon did occasionally run out of money before 2020. it actually happened a grand total of seven times or 11 of all scenarios those were the scenarios that started in 1929 and 1930 which comes as no surprise given how bad the great depression was for the stock market as well as 1965 1966 1968 1969 and 1973. this was due to a combination of high inflation that we experienced throughout much of the 1970s and into the 1980s and fairly stagnant growth in the markets from 1965 to 75 in particular jane never ran out of money using financial guard rails and this pattern continues even if we up our initial safe withdrawal rate to five percent the gap between john and jane's typical income continues to shrink john continues to gain ground instability metrics with jane seeing decreases in her income nearly 10 of the time and average net worth figures continue to fall as expected with john's failure rate continuing to increase with a 5 initial safe withdrawal rate there were 18 such scenarios where john ran out of money before 2020 that's about a 28 failure rate however what if we switch up the asset allocation to something a little less aggressive do we still see the same pattern play out well to a certain extent yes say we used the classic 6040 strategy represented with 60 of our investments going towards this total stock market index fund and the other 40 going towards a total bond index fund we do see that jane's strategy of using financial guard rails gives her a commanding edge in terms of income generation especially at those lower initial safe withdrawal rates and we still see the stability metrics shift over towards favoring jon as those withdrawal rates get higher and we even see the net worth figures for the most part favoring jon though again unlike jane there are still scenarios in which jon runs out of money before 2020 at those higher initial safe withdrawal rates the only material difference that i notice anyway is that using this more balanced allocation john does manage to completely close the income gap at the higher five percent initial safe withdrawal rate at least if you're looking at median income figures the average does still favor jane by a very small margin if we move further down the portfolio volatility scale to something even more conservative like the permanent portfolio represented by four equal parts in the form of a total stock market index a long-term treasury bond cash and gold we see that the income metrics shift even further in favor of john he has the higher median income at all three safe withdrawal rates almost doubling jane's median income by the time we reach a five percent initial safe withdrawal rate and jane holds a narrow edge in terms of average income at the three percent rate but loses it when moving up to the four and five percent scenarios the same can be said for peak incomes the stability metrics favor john at all three rates with jane actually seeing her income decrease once every roughly five years on average when using the higher five percent initial withdrawal rate however due to the comparatively lower returns of the permanent portfolio which in some of these scenarios is artificially held down due to the fact that the price of gold was held constant throughout much of the 1900s and the higher withdrawals from john the net worth figures flip in favor of jane sure john holds an edge at the 30 and 40 year marks under a three percent withdrawal rate but he also runs out of money before 2020 in a significant amount of these scenarios over 70 percent of them when using a higher 5 initial save withdrawal rate so what does all this data tell us well to me it suggests that generally speaking financial guardrails can help boost the income you can reliably take from your nest egg but this does depend on a few factors foremost among them is how good your portfolio's long-term returns are how long you'll be withdrawing money from your nest egg and what your safe withdrawal rate is to start historically speaking the all stock portfolio had the higher average long-term returns between these three mixes we examined today so it tended to produce the widest gap between the two strategies and generally speaking the lower your save withdrawal rate is to start the more often you're going to shoot past one of your guard rails and thus have to adjust your income using financial guardrails will occasionally mean that you have to adjust your income down when our investments crash however this effect can be more pronounced when you start with a higher safe withdrawal rate and are utilizing an asset allocation that doesn't produce the highest returns long term in some cases as we saw with the permanent portfolio this effect can actually override the value gained from using financial guard rails when it comes to your average income on the plus side using financial guard rails can significantly lower your chances of outliving your savings as we saw today regardless of what asset allocation jane was using she never once ran out of money before 2020. now there is a possibility that if she started with too high of a withdrawal rate and or experienced a combination of very poor returns and higher inflation for a prolonged period of time she could find herself in a situation where the strategy says that she needs to lower her income but she can't do that and still put food on the table it would take a pretty extreme case for that to come up and obviously we didn't see it play out here but that is still possible however it does still seem clear that it's a fairly significant improvement in this area compared to a more traditional safe withdrawal rate strategy but what do you think are financial guard rails worth the potential trade-offs let me know in the comments section below but that'll do it for me today once again if you enjoyed this video be sure to smash that like button if you haven't already subscribe and hit that bell next to my name so you'll be notified of all my future uploads i generally upload every single monday and if you have a friend that would be interested in this kind of content be sure to share it with them let's really get this information out there and start our own financial revolution

Channel: Next Level Life

Views: 35,063

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Id: VFLK8bNRP6A

Length: 17min 26sec (1046 seconds)

Published: Mon Feb 15 2021