The well-known 4% withdrawal rate failed for retirements in the late 1960s. Bear markets in 1966 (-22%), 1969–70 (-36%), and 1973–74 (-48%) along with high inflation meant that the strategy of 4% constant dollar withdrawals struggled. Exactly how long it lasted depends on the exact asset allocation used but everyone agrees that it was a dire time for anyone who would have actually been using the strategy.
The intuition is that most of the pain was caused by having to sell stocks at low prices during those bear markets. Is there a way to avoid doing that? One potential strategy is to use a loan instead of taking a withdrawal from a portfolio. You haven’t “locked in losses” that way. But you do have the interest of that loan to worry about.
Let’s take a look at how a strategy like this might have worked in 1966. The basic idea is, if the portfolio falls below its initial value, then we take a margin loan for our monthly expenses. Otherwise, we just pull from the portfolio.
In practice it would look something like this:
For the margin loan let’s use the following assumption:
- We can get a margin loan at the effective Federal funds rate + 1.5%. That’s approximately what Interactive Brokers currently offers, so it seems a reasonable place to start.
What do we do about repaying principal on the loan? Let’s start by assuming we never repay principal. That is, we make interest-only payments and any principal remaining gets paid by our estate when we die.
While this strategy starts out okay, the size of the margin account explodes in the later years. This appears to be caused by two things:
- Our strategy of “use margin when the portfolio falls below $1,000,000” might make sense when we first retire but once we get older, we shouldn’t be as afraid of running down our portfolio a bit. If you are 90 years old would you really rather take a margin loan than have your portfolio go below $1,000,000?
- Never paying back the margin loan results in ever increasing interest payments. By the 1980s our interest payments make up 30% of our monthly expenses.
No brokerage is going to let you borrow that much. And no one would be comfortable borrowing that much. So clearly our initial strategy doesn’t work and needs to be changed.
Before you try that, though, let’s pause and reflect a minute. Imagine we’re a real person really trying this out. Clearly it is harder than it looks to come up with a strategy that not only sounds plausible but actually works in practice. Our initial strategy sounded plausible enough but a real person following it would have found themselves in an unfortunate set of circumstances.
Their net worth would have gone negative in 1989. In the early 1980s they would have had over $500,000 in margin debt. By 1982 (if not sooner!) they would have started receiving margin calls from their brokerage. The interest payments are so large that all of the gains of the early 1980s bull market are eaten up.
It is one thing to hand wave a strategy. “Just use a margin loan during bear markets!” But details matter. If you get the details wrong…how do you know your fancy strategy is any better than just not doing anything at all?
Here’s the spreadsheet I used in case you want to play around with other strategies…