Retiring in a Pandemic: The Yield Shield, the 4 percent rule, and Sequence of Returns Risk A Year On
While we all want to be financially independent, retire early, and live off our investments (using some version of the 4 percent rule), we are also painfully aware that retiring at the peak of the financial markets right before a downturn or crisis can leave our financial health in a mess. This is what Sequence of Returns Risk, or Sequence Risk, does to retirement investment portfolios. And with the COVID-19 pandemic causing havoc in the financial markets this year in 2020, how do we even hope to be retiring in a pandemic and surviving Sequence of Returns Risk using a Yield Shield portfolio?
However, all the research on this retirement problem (including ours so far) has looked backwards, showing how a 4 percent rule (or more likely a less sexy 3% rule) can survive a deep downturn. What about now, during the COVID-19 pandemic that we are facing? Can we afford to retire and yet survive financially in a pandemic? It is of little help that most commercially available investment or insurance products for retirement do not commit to anywhere as high a withdrawal rate as 4%, nor do they adjust for inflation, all the while leaving a significant amount of the initial investment still available for a bequest.
To see if a DIY approach may be better, fourteen months ago in late February when the COVID-19 virus was surfacing across the world, right before the breath-taking plunge in global stock markets, we did the unthinkable: retiring in a pandemic and setting up a Yield Shield Portfolio for 2020 to test whether our research can stand the test of a pandemic. How have we done so far, a year on?
Revisiting the Yield Shield Portfolio
“Let’s rewind for a moment to understand why the 4% withdrawal rule may not work and how the Yield Shield may. Decumulation using the 4% rule is like doing Dollar Cost Averaging in reverse or Dollar Cost Ravaging! Since 4% of the initial portfolio is withdrawn every year, you have to sell more shares when prices are low.
“So this is where the Yield Shield comes in. If the portfolio has a high dividend yield, say 4.5%, the retiree can simply withdraw the 4% from dividends alone. This leaves the shares in the portfolio untouched, allowing the portfolio to regain its value when the market recovers.
To test our faith, we shall set up a new Yield Shield Portfolio at the beginning of March 2020 with the aim of withdrawing 4% of the portfolio’s initial value every year, adjusting for inflation of 2%. The average trailing dividend yield on this portfolio selected is 4.9%, with which we will draw 4% annually, adjusted for inflation of 2% per year. Note also that of every $100 put into the portfolio, we invest only about $98. The remaining $2 is held in cash to meet the scheduled monthly withdrawals ahead of the receipt of dividends.”
How has the Yield Shield Portfolio fared over a year?
So, how have we done, retiring and surviving in the pandemic over the past year? Has the bottom fallen out from beneath our Yield Shield portfolio and destroyed all our hopes of retiring early? We did a quick check 6 months into the retirement here, and back then the downturn was really hurting portfolio values, but the portfolio could still make the payouts without selling any stock.
Here’s how the total value of the portfolio (and the control which is the Straits Times Index STI ETF) has evolved over the past 12 months.
Total Portfolio Value of the Yield Shield (Blue) and STI ETF (Red)
Over the first 6 months, the Yield Shield portfolio kept pace with the STI. But in the last 6 months, the STI took a life of its own, outperforming the Yield Shield by a wide margin. Looking at the numbers, the STI ETF has had a total return of more than 12%, outperforming the Yield Shield by the same margin, i.e. by more than 12%!
|Portfolio||Start Value||End Value||Dividends||Yield||Total Return|
For the Yield Shield, the actual dividend yield falls far short of the projected yield in Mar 2020, when the Yield Shield had a trailing yield of 4.90%. For the STI ETF the trailing yield was at 3.40%, which is exactly where it ended up in the past 12 months. Hence we can trace the underperformance of the Yield Shield to two sources:
- Poorer dividend yields, due to the cutting and withholding of the dividends from banks and REITs
- A heavier weightage in REITs and Business Trusts, which have yet to recover fully from the impact of the COVID-19 downturn, due to the slow recovery of many businesses, and higher interest rates, and a lower weightage in Banks, which have staged an amazing recovery
- A third reason may be that the choice of Suntec REIT and NetLink Business Trust in the Yield Shield portfolio, both of which are in the STI reserve list. These would have received a boost if they were chosen to replace the outgoing components of the STI (SPH and Jardine Strategic). In the end, they were not chosen, the replacements in the STI being Keppel DC REIT and Frasers L&C REIT
What have the Portfolios paid out for the retiree?
But retirement portfolios should not be judged by the total returns alone, although it is tempting to do so. Rather, they need to be assessed on whether they have been able to make the necessary payouts to the retiree and still maintain the original portfolio value. Being ale to do so is a critical test of whether the portfolio is able to withstand Sequence of Returns Risk early in the retirement period. Let’s look at the payouts first:
|Portfolio||Total Payouts||Payout Rate|
|Yield Shield||$4.44 per $100||4.44%|
|STI ETF||$4.45 per $100||4.45%|
The original target for the monthly payouts when the Yield Shield portfolio was set up was 4% of the original invested amount, rising by 2% to account for inflation every year. Over the past 12 months, both the Yield Shield portfolio and the control STI ETF portfolio have in fact paid out roughly 4.45% of the invested value. The additional 0.45% can either represent fees if the portfolio were managed externally, or additional income if it is self managed. Hence, in both cases, the portfolios have outperformed their initial benchmarks of paying out 4% annually in monthly instalments. Time will tell whether this is sustainable as the portfolios now have to pay out a slightly higher amount going forward to account for inflation.
Stability of the Cashflows
While both the Yield Shield and STI ETF portfolios have been able to make the 4% annual payouts on a monthly basis without fail, we are interested in whether the cashflows are stable as well. Recall that when the portfolios were set up, 2% (or 6 months’ worth of payouts) was left as cash balances in order to meet the monthly payouts ahead of the payment of dividends on the portfolio. Has this cash buffer of 2% been sufficient to maintain a stable pool of cash? The chart below shows the cash balances over time:
Cash Holdings of the Yield Shield (Blue) and STI ETF (Red)
The cash balances of the Yield Shield portfolio remain fairly steady over time, as it is continually replenished by the flow of dividends, even though these were diminished over the course of 2020. In fact, if the rights issues of the components of the Yield Shield portfolio are ignored, the cash balance never falls below 0.9% of the invested amount. This indicates that a lower cash buffer, say 1.5% or 4.5 months worth of payouts can be retained at the start without jeopardising the stability and dependability of the cashflows. Alternatively, the extra cash held can be used to participate in rights issues, which was the approach taken for the Yield Shield portfolio (Mapletree Logistics Trust and Ascendas REIT both issued rights over the past 12 months).
On the other hand, the cash balances of the STI ETF are less stable, falling steadily from the start for 5 months before they are replenished by the semiannual dividends, and then falling again until it drops into the red in February 2021. At this point, the sale of a small amount (1%) of the portfolio was needed in order to meet the monthly payouts. Fortunately, this sale happened as the portfolio had already recovered strongly in value, and was done at a profit.
The following chart of the dividends paid to the two portfolios shows clearly the more regular profile of dividends for the Yield Shield portfolio. In contrast, the semiannual dividends of the STI ETF means that a higher cash buffer, say 2.5% may be needed to avoid selling investments. This is so, because being able to avoid selling when the market is low, is key to outlasting Sequence of Returns Risk in practice.
Dividends of the Yield Shield (Blue) and STI ETF (Red)
What’s next for the Yield Shield Portfolio?
So far, in a rather eventful year, we see that retiring in a pandemic with either the Yield Shield portfolio, or the STI ETF would not only been able to withstand the impact of Sequence of Returns Risk for the retiree, but also assure a dependable stream of monthly income totaling more than 4% of the initial investment and rising with inflation. Hence, despite the outperformance of the STI ETF over the Yield Shield in terms of portfolio value, the Yield Shield still comes out a little ahead for the stability of the cash flows and balances.
At this point, it is also useful to look at the composition of the Yield Shield portfolio and see if there are any changes which need to be made. Here is a look at the performance of the individual components of the Yield Shield in numbers:
Performance of the Yield Shield components
|Current Price||Dividend Paid||Total Return||Weight|
Within the Yield Shield portfolio, the largest component is DBS, with a weightage of 12.2%. This is above the threshold of plus or minus 2% of the weight of 10% for each component of the portfolio. However, DBS is also a lumpy investment, with the highest share price. As a result, it may not be so easy to rebalance the portfolio back to more equal weights. In light of this, no rebalancing of the portfolio is deemed needed at this stage.
We set out 14 months ago to test whether our hunch that retiring in a pandemic with a Yield Shield portfolio may survive Sequence of Returns Risk in retirement. And all the while paying out at least 4% of the initial investment. Thus far, the Yield Shield portfolio has done so, although the control portfolio of the STI ETF has also achieved this, and outperformed as well! Also, the Yield Shield portfolio may in fact be able to succeed with a lower cash balance (and hence higher invested amount) than the 2% set initially. So 6 months of expenses in case is still a relevant dictum, although in a pinch, 4.5 months may also be possible. However, for a portfolio like the STI ETF, with its less regular dividends, a higher proportion of cash, say 7-8 months may be safer.
But these are early days yet in our retirement portfolio tests. So let’s return to this issue in another years’ time, and see how they go!
In the meantime, you may be interested in our earlier work on this topic:
- The 4 percent rule for Financial Independence
- Does the 4 percent rule work in Singapore?
- How Sequence of Returns Risk Messes Up Retirement and the 4 percent rule
- Does the Yield Shield protect retirement finances?
- The Yield Shield, 4 Percent Rule and CPF Life – A Perfect Retirement Combo?
- A Yield Shield Portfolio for 2020
- Retiring and Surviving in a Pandemic – The Yield Shield 6 Months On