A long time ago I did a cursory investigation about whether you could improve retirement outcomes by using debt to avoid selling equities in a bear market.
That is, when stocks are down 30%, can you borrow money (home equity, margin from your broker, etc) for your living expenses instead of selling stocks. In situations where a plain vanilla 4% withdrawal strategy fails…would that succeed?
The intuition is: by not selling stocks when they are down, you keep them for the rebound. The question is whether interest on the debt (and limits on debt) keep this from being a viable option.
My first pass suggested the strategy didn’t look so great. But one reader suggested that the strategy had room for improvement.
Namely:
- Only use debt once the portfolio falls below 70% of its starting value (in inflation-adjusted terms)
- Stop using debt once you get back up to 80% of its starting value
- We also need to think about when to repay debt but that’s a trickier question…do you do it once the portfolio has recovered to 80%? Wait until 90%? Wait until 100%?
I finally got around to testing out this “guardrails” strategy of using debt.
First the good news: technically it works! You last all 30 years using a 4% withdrawal rate and never go broke.
But if you look at the details, it still doesn’t look great. (To put it mildly.)
Things hum along until June 1970. By that point withdrawals and the falling stock market means your portfolio has fallen to 65% of its original value. So you start using debt instead of further depleting the portfolio.
This removes the pressure from the portfolio and, indeed, by February 1971 it has recovered. It is back up to 82% of its original value.
But you can also see that the recovery isn’t especially strong. The portfolio doesn’t get back to 90% of its original value for nearly 2 more years, until December 1972. At it only stays there for 2 months before beginning to drop again.
That takes us back to the question of when to repay debt.
If you waited until the portfolio got to 100%, you’ll be waiting from 1970 all the way until 1986.
If you begin repayments at 90% then:
- you have two months of repayments in December 1972 and January 1973
- then it is until December 1985 before the portfolio is above 90% of its original value again
So things are still a bit murky around repaying debt. If we wait until 90% or 100%, we could be waiting a long time. On the other hand, if we start repaying debt at 80%…is that putting extra pressure on the portfolio too soon?
We’ll come back to question later. For, let’s assume we had a strategy of “begin repayments once the portfolio returns to 100% of its original value”. In the 1970s, this means we wait until March 1986.
By that time, our portfolio is worth $3.5 million (in nominal dollars). However, our debt has grown to $2.1 million. We currently are borrowing 61% of our portfolio value.
And things are even worse if we look back at our peak debt levels.
You can see that we spend most of our time over 50% leverage…and peak at 84% leverage. In reality, I don’t think any broker is going to let you borrow that much.
What would have actually happened? In March 1980 you hit your margin limits. Your portfolio has fallen to a mere 56% of its original value. Your portfolio is worth $1.4 million but you have debt of $732,000. Your monthly withdrawal is $8,300 (thanks to inflation), meaning you are withdrawing 7.1% of your portfolio.
To top it all off, in March 1980, interest rates were close to their highest ever. Your margin interest rate would have been over 18%. 18% interest on $732,000 in debt is $131,000 a year, just in interest payments.
So there you go: it using guardrails doesn’t leave you in a pretty position. At the lowest point in 1982 your net worth (assets — liabilities) dropped to $269,000 nominal dollars. That was about 26 months of expenses with around 16 years left to live.
Even if someone was able to survive the debt crunch (maybe their broker really does let them go up to 80% leverage) I don’t think any real world person is going to be relaxed & happy going through that.
So I’m back where I was originally: I don’t think the strategy really works in the worst situations. And in less-than-worst situations, you don’t need it, since you’re going to be fine anyway.
Here’s the spreadsheet, so you can play around:
