There is a seminal study conducted at Trinity University into retirement planning. This is where the 4% rule, known as the rule of 25, came from. It says that your retirement portfolio should be 25x your annual living expenses. For instance, if you spend $40,000 a year, you need a portfolio of $1M. The conclusion was that this portfolio will last you up to 30 years after you retire at 65.

That is simple enough. What is interesting about this rule is the caveat it came with. The researchers said that this rule had a certain success rate. The rate varied depending on:

1. allocation
2. withdrawal rate
3. returns

There were subsequent updates to the study that showed failure rates ranging from 0% to 6% for 50%+ stock allocation.

It is difficult to tell what the failure rate will be in the future. But, those who fail will reduce their portfolio to $0 before their 30th anniversary. And, this is bad news if you happen to be one of them.

In this post, I will talk about a few strategies you can use to cut your risk of failure.

Cash Stash Fund for the 4% Rule in Retirement

First, the sheer luck of timing will likely determine whether you succeed or fail with the 4% rule. And, future returns will play the most crucial role in your outcome. For instance, retiring before a bull market will boost your portfolio for years.

But, retiring into a bear market is the worst thing that can happen to anyone. Retiring into downturns will force you to sell securities at rock bottom prices. And, this will prevent you from taking advantage of the recovery that follows later.

Here are the steps you can take to shield yourself from this trouble. Essentially, it entails building a separate cash stash fund that will serve as a cushion in bear markets. It will likely be necessary only at the start of your retirement.

1. Determine Market Recovery Time

The first thing is to determine the time needed for markets to recover. Morningstar conducted a study of market cycles in their 2023 article. There, they looked at the length of average time to recovery since 1990. They define the time to recovery as when an index reaches its breakeven after a period of decline. This means that the index must have topped its previous peak. The values they came up with varied, depending on the category.

For instance, take the Large Blend category, where the S&P 500 is. This category had an average time to recovery of half a year based on 49 cycles. The Large Growth category had an average recovery of 7 months with a max recovery of 13 years. They are referring to the dot.com bust here.

Morningstar also showed many other index categories. We see that the intermediate core bond category recovered in 6 months with a max recovery of 2 years.

But, there is a word of caution here. Morningstar based their time estimates on nominal returns. Thus, recovery times can be even longer depending on inflation rates.

So, in summary we have about half a year for a full recovery for both bonds and equities. However, it can be much longer. Most of these recovery cycles happened outside of recessions. Thus, if we look at the previous recessionary episodes, the recovery time can be 2, 3 or 5 years.

Of course, the recovery from the Great Depression was the longest at 25 years. I do not know if we will ever see things turn out that bad, but no one knows.

With that in mind, you can set your estimated recovery time for future dips. Maybe, half a year is too aggressive. Conversely, five years could be too conservative. It all depends on how risk-averse you are. For the sake of our example, let’s roll with four years.

2. Estimate Your Annual Living Expenses for the 4% Rule

Next, you need to know your living expenses. The best way to determine them is to use a budget tracker for a few years. I created a budget app using Google Sheets that is free to download and use.

Alternatively, you can peruse through your credit cards and bank accounts statements. Doing so will allow you to get your approximate annual living expenses as well.

3. Calculate Your Cash Stash Fund for the 4% Rule

Calculating your required cash stash fund for retirement is not difficult. Let’s say your annual living expenses are $40,000. Thus, your cash cushion fund should be $160K ($40K times 4 years).

Where to Keep Your Cash Stash Fund?

What do you do with this money? Preferably, you should keep it in a high-yield savings account. This is not an ideal situation because money tend to rot in bank accounts due to inflation. Rarely do savings accounts pay interest rates above the prevailing inflation rate. But, at least, the FDIC insures savings accounts up to $250K/person.

Another option is to invest in short-term Treasury bills with maturities below 1 year. For instance, you can use the Vanguard Short Term Treasury ETF (VGSH). VGSH will likely have a better yield compared to savings accounts. But, VGSH is not immune to price declines. If the Federal Reserve raises interest rates, VGSH can lose its value.

So, depending on your risk preferences, one or the other can be a better match for you.

How to Minimize Your Cash Cushion Fund Size

Thus, you must have $160K in liquid funds. This is especially important in your first 4-5 years of retirement. If markets enter the bear territory, you have your cushion to wait it out. If not, your risk of failure may go up.

Next, let’s discuss things you can do to lower this high cash shield requirement of $160K. After all, this is a rather large sum of money to have just sitting around. Actually, there are several ways, if you ask.

1. Dividends and Interest

First, consider the dividends and interest that you receive from your portfolio. Let’s say that 60% of your 4% rule portfolio is in the S&P 500 ETF and 40% in the Intermediate Treasury Bond fund (VGIT).

The S&P 500 ETF pays about 2% in yield, while VGIT has a yield of about 3%. Of course, these numbers will vary from year to year. But, let’s assume that this is what you will get in your first 4 years.

If your portfolio value is $1M, this produces $12K in dividends and $12K in interest income, or $24K in total. What you can do is to subtract $24K from your annual living expenses. Why? Because this is the annual investment income you will get to cover your living expenses.

Cash Stash Fund = ($40K of expenses – $12K dividends – $12K interest) x 4 = $64K

That’s a big reduction from $160K to $64K. Wait a second, you may say. Then, maybe I should invest all of my money into bonds or high-yield stocks. But, be careful here. You will be facing trade-offs by doing so. High-dividend stocks and bonds may not exhibit strong total returns compared to the S&P 500. This alone can hamper your portfolio growth and increase the risk of failure.

2. Investing in REITs

If you wish to juice up your portfolio yield even more, you can invest in REITs. One popular example is Realty Income Inc (NYSE:O). Realty Income offers a yield of 5.8% in 2023, which is higher compared to SCHD with a 3.8% yield. Just know that REITs’ distributions are taxed as ordinary income in taxable accounts.

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3. Investing in Preferred Shares Income ETFs

A more extreme method to increase portfolio yield further is to invest in preferred shares ETFs. Preferred shares ETFs come with higher expense ratios. But, they offer a higher yield.

For instance, take iShares Preferred and Income Securities ETF (Nasdaq:PFF). Currently, PFF has a yield of 7.4% with an expense ratio of 0.46%. Be aware that preferred ETFs are not riskless due to their long maturity profile. This makes prices of preferred shares ETFs very sensitive to changes in interest rates.

Example of 4% Rule High-Yield Portfolio

So, let’s say that you reallocate 10% ($100K) of your 4% rule portfolio from the S&P 500 to PFF.

This produces the following dividend income and the required cash cushion result:

Cash Stash Fund = ($40K of expenses – $10K S&P500 dividends – $12K bond interest – $7.4K preferred dividends) x 4 = $42.4K

This is almost $18K less than our estimate of $64K. So, as you can see, we were able to reduce the cash cushion amount from $160K to $42.4K.

But, as I said, a large allocation to high-yield dividend-earning assets should be temporary. The core of the portfolio should be the S&P 500 index at 50%+ allocation for the majority of your retirement.

More Ways to Minimize Cash Stash Fund

Actually, there are a few more methods you can use to lower your cash stash fund size even further.

1. Passive Income Streams

One way to cut the required cash stash fund is to have streams of passive income. It could be anything that does not need your active participation on a regular basis.

Examples of passive income include affiliate income, royalties from books or other intellectual property and rental income from investments in real estate.

2. Continue Working in Retirement

Alternatively, you can continue doing some work in retirement. Many retirees still do side work even after leaving their companies. It could be a part-time job or consulting for your previous employer. Anything you earn will further reduce your required cash cushion size.

3. Temporary Lower Living Expenses

Finally, a more extreme measure is to cut down on your expenses in years of market downturns. This is not an ideal situation. But, if you desire to come out of a crisis unscathed, this could be a viable alternative. It all depends on what you can cut. If you are already spending only on bare necessities, this is not an option.

4% Rule Final Takeaways

Retiring into bear markets is the worst thing that can happen. This will force you to sell securities at rock bottom prices and miss out on the following recovery. Thus, it becomes crucial to have a dedicated cash stash fund early into your retirement. The stash fund should cover your living expenses for the duration of market recovery. Doing so will help you wait out downturns and take full advantage of market growth that almost always follows.