The ERN Family Early Retirement Capital Preservation Plan

Fritz at The Retirement Manifesto suggested we start a series covering how different FIRE bloggers plan to implement their drawdown strategy. I realize we are a bit late to the party given how many fellow bloggers have already contributed:

• The Anchor: Physician on FIRE: Our Drawdown Plan in Early Retirement
• Link 1: The Retirement Manifesto: Our Retirement Investment Drawdown Strategy
• Link 2: OthalaFehu: Retirement Master Plan
• Link 3: Plan Invest Escape (PIE): Planning for Success: Drawdown versus Wealth Preservation in Early Retirement
• Link 4: Freedom is Groovy: Freedom is Groovy
• Link 5: The Green Swan: The Green Swan
• Link 6: My Curiosity Lab: Show Me The Money: My Retirement Drawdown Plan
• Link 7: Cracking Retirement: Our Drawdown Strategy
• Link 8: The Financial Journeyman: Early Retirement Portfolio & Plan
• Link 9: Retire By 40: Our Unusual Retirement Withdrawal Strategy
• Link 10: Early Retirement Now:  The ERN Family Early Retirement Capital Preservation Plan (This will land you back in this post. Make sure you don’t end up in an infinite loop! 🙂 )
• Link 11: 39 Months: Mr. 39 Months Drawdown Plan
• Link 12:  7 Circles:  Drawdown Strategy – Joining The Chain Gang
• Link 13:  Retirement Starts Today:  What’s Your Retirement Withdrawal Strategy?
• Link 14: Ms. Liz Money Matters: How I’ll fund my retirement
• Link 15a: Dads Dollars Debts:  DDD Drawdown Part 1: Living With A Pension
• Link 15b: Dads Dollars Debts:  DDD Drawdown Plan Part 2: Retire at 48?
• Link 16: Penny & Rich: Rich’s Retirement Plan
• Link 17:  Atypical Life:  Our Retirement Drawdown Strategy
  
• Link 18:  New Retirement: 5 Steps For Defining Your Retirement Drawdown Strategy
• Link 19:  Maximize Your Money: Practical Retirement Withdrawal Strategies Are Important
• Link 20:  ChooseFI:  The Retirement Manifesto – Drawdown Strategy Podcast
• Link 21:  Coach Carson:  My Rental Retirement Strategy (or How to Not Run Out of Money)
• Link 22: Accidentally Retired: How I Planned my Early Retirement Withdrawal Strategy After I Accidentally Retired Without a Plan

So, better late than never: here’s the ERN family contribution. To begin, we are intentionally not calling this a drawdown plan. We will draw from our investments but hopefully never significantly draw them down. So, we are more in the PIE camp, trying to maintain our capital. Even if we were comfortable with leaving nothing to our heirs and charitable causes in 60 years, the drawdown over 60 years would be so small (especially early on, think of this as the initial amortization in a 60-year mortgage!) that we might as well plan for capital preservation rather than drawdown.

Our FIRE plan will take place over the following four stages:

Stage 1: The remainder of 2017

• Make sure that we max out our pre-tax 401k contributions.
• Make additional post-tax contributions into the 401k plan. That’s money we can later roll into our Roth IRAs.
• Big ERN has an old Rollover IRA sitting at Fidelity that has kept him from doing any Roth conversions. Roll that into the 401k at my current employer. Then do a Roth conversion on all the Traditional IRAs.
• Mrs. ERN also has a Traditional IRA that requires a Roth conversion.

Stage 2: The first quarter of 2018:

Big ERN is still working and waiting for the nice big annual bonus to roll in during the first quarter in 2018. While waiting for that there are a few more things to attend to:

• Early in 2018, we’ll get our apartment ready to be sold. Fortunately, it’s in great shape (considering we have a toddler running around) and there will be only minor repairs and touch-ups. We will have to chat with the realtor on whether we list it while we’re still living there (never a pleasant experience) or whether it’s best to first move out and then professionally “stage” the unit.
• Front-load the before-tax 401k contributions so that we exhaust the entire $18,000 annual pre-tax maximum (might increase to $18,500 by 2018!) all in the first 3 months.
• Increase the post-tax contributions to pretty much max out each paycheck, leaving only enough money to pay for taxes, health insurance, transportation benefits etc.
• In light of the previous two items, we’ll be living on borrowed money from our HELOC for a few paychecks until the bonus money arrives. A scary thought for the faint-hearted but remember the ERN family is not afraid of debt and leverage if used for a good purpose!
• Look for a place to rent in our new location. Yup, you heard that right! We’ll be renters for a while because we don’t want to rush the house buying process in the new location! Especially if we don’t have a feel for the new state/town/neighborhood.

Stage 3: The rest of 2018

There isn’t really much of a drawdown/capital preservation strategy because we’ll simply set aside the living expenses for the remainder of the year from the proceeds of the apartment sale.

Stage 4: 2019 and onward

We now finally retired from our sky-high marginal tax rates (currently 40%+ combined for federal and state!!!) as well. Now the actual capital preservation (the un-drawdown!) magic should happen. Our portfolio should look as follows; a projection using some pretty conservative estimates for the bonus and market returns:

There are a few features very unique to our family:

• We have a relatively high consumption target. We shoot for around $80,000-90,000 p.a. but could go as high as $105,000 (=3.5% out of a $3m portfolio). We like the safety margin to allow for potentially 20,000+ in annual health care spending, further contributions into Little Mrs. ERN’s college savings, and especially room to lower consumption in adverse market conditions. Also, notice that we’ll have a bit of a cash flow crunch early on when we have to rent a place. If and when we purchase a home again we’d have around $250,000 to $300,000 less in investable assets but also much lower annual expenses.
• Almost 2/3 of our net worth is in taxable accounts. What’s more, the cost basis of our taxable investments is relatively high. Only the taxable equity account has sizable capital gains (some tax lots from way back in March 2009!!!). The rest, especially the $1m+ options trading account, is all (!) cost basis. That’s because previous gains have already been taxed: Section 1256 contracts are marked to market every day (but still taxed at 60% Long-term gains and 40% Short-term gains). And almost half of the options trading account will consist of the proceeds from the home sale and other accounts (deferred bonuses, net of tax) that are paid out when Big ERN retires. All cost basis.

The withdrawal plan:

• Options Trading and Private Equity: Withdraw the gains, but keep the principal in place.
• Taxable Equity: Withdraw only the dividends, and keep the principal in place.
• Retirement Accounts: leave untouched for now. We might tap the tax-deferred money at age 59.5 and we have to take the RMDs at age 70.5. But we try not to touch the Roth.

How much would we generate in annual income? See table below:

• I assume a 2% dividend yield for the publicly traded equity portfolio. Again, we will let this account grow and not touch the capital gains. Of course, if you believe Jack Bogle with his 4% expected return for equities for the next 10 years, we won’t get much more than the 2% dividend yield in real terms. The remaining 2% will merely compensate for inflation! But I’m personally a bit more optimistic about equities and would assume a 3-3.5% additional nominal price return.
• 8% return from the Real Estate Private Equity funds. Also, we assume that the PE income is distributed 60%/20%/20% into ordinary income, long-term capital gains and tax-free income (some funds have tax-advantaged housing investments).
• A roughly 7.4% return from the options trading account. We detailed the strategy in two posts last year (see part 1 and part 2). In retirement, of course, we will run this strategy with a lot less risk budget but the idea is the same: Invest a large chunk of the margin cash in Muni bonds (tax-free interest!) and Preferred Shares (high dividend yield, partially qualifying dividends!) and then trade put options on S&P500 futures on margin. If this sounds scary, it can be and has been, so don’t try this at home until you practiced with a smaller account size for a few years!

With the return assumptions above we should generate around $126k in annual income. There will be a very small federal tax bill: The ordinary income will stretch all the way into the 15% bracket, assuming about $25,000 in tax-free income from deductions and personal exemptions and $20,000 for the 10% bracket. In addition, the long-term gains and dividends exhaust their entire 0% bracket and reach into their 15% bracket. So, we will owe roughly $3,000 in federal taxes, but even after paying taxes, we should generate way more than our income needs.

What about inflation?

The equity holdings in the taxable and retirement accounts should provide their own inflation protection probably 2-3 times over because we don’t withdraw any principal early on. Once our spending target of $80-90k is inflated up to the net income of around $120k (after about 20 years) we already have access to the tax-deferred accounts so we don’t really worry too much about inflation eroding our portfolio.

Notably absent from the ERN family plan: The Roth Conversion Ladder

One cornerstone of the FIRE community you will notice is missing from our plan right now is the Roth Conversion Ladder (see some great summaries/examples at Mad Fientist, Retire by 40, Root of Good). Why is that? Four reasons:

1. Taxes
2. Low expected equity returns
3. Sequence Risk
4. Our Options Trading account is already a “Synthetic Roth IRA”

1. Taxes: Looking at the income composition above we exhaust all of the 0% federal tax bracket (~$25k) and likely even the entire 10% federal bracket (~$19-20k). So, the completely tax-free Roth conversion ladder will not work for us.

What’s worse, any dollar we move from the Rollover IRA into the Roth will be taxed at a 30% (!) marginal rate, compliments of a little-known quirk in the tax code we wrote about last year: Our ordinary income reaches into the 15% brackets and LTG/Dividends reach into their 15% bracket. Then every dollar of additional income (say, through side gigs or Roth Rollovers) is taxed first at 15% but also pushes another dollar of previously untaxed LTG/Dividend income into the 15% bracket. A combined 30% marginal tax! Sneaky!

2. Low Expected Equity Returns: We could, of course, simply forget about the whole option trading and private equity investments and put all that money in an equity index fund. We’d generate essentially zero ordinary income, which would open up the room to perform the Roth Conversion. We would likely even max out the 10% bracket with Roth conversions. But we think that the expected returns from the options (7.4%) and real estate investments (8%) will beat those from the equity market (4% according to Jack Bogle, about 5.75%, according to Big ERN’s recent forecast).  We may certainly revive the Roth Conversion Ladder in the future (if it still exists), especially after equities go through their next correction. When that happens and the CAPE is around 20 again and expected returns for equities are higher again we will be game! But until then we prefer return maximization over tax optimization.

3. Sequence Risk: In addition to better returns, the options trading and real estate also have less sequence risk. With real estate, you generate relatively stable rental income so it’s much easier to delay selling assets until values have recovered. Quite intriguingly, the same is true for the put writing strategy as well. In past recessions, this strategy had more shallow and shorter drawdown events than the equity market, see chart below. That sounds really counter-intuitive because the idea of the put writing strategy is to take on downside risk while foregoing the upside beyond the option premium. But during periods of market stress, investors tend to overpay for downside protection. That helps cushion the fall and creates a more rapid recovery! So, we are willing to forego a little bit of tax-efficiency 30 years down the road for the peace of mind of less sequence risk today!

4. Our Options Trading Account is already a “Synthetic Roth IRA”: We wrote a post about the Synthetic Roth last year. It takes two ingredients:

1. a margin account with cost basis = portfolio value. Check! That’s our Options Trading Account.
2. Trade a risky asset through leveraged futures (or futures options) exposure to exactly overcome the marginal tax rate. Example: If our marginal tax rate on Section 1256 contracts is 20%, then trade with 1.25x margin: 1.25x(1-0.2)=1.00, so we get the same return as in a Roth IRA.

So, during our retirement, we’d have effectively a Roth IRA worth about $1.3m. We can withdraw the principal tax-free and the income is scaled up through margin to exactly match our after-tax expected return target. If marginal tax rates go up? We simply scale up the leverage.

For full disclosure: There are a few limitations and pitfalls and we wrote about them in that post last year. Before anyone tries this at home, please make sure you know what you’re doing! Also, please read our Disclaimers!

Conclusion

Accumulating assets was simple. But living off your money gets more complicated! There is no one-size-fits-all solution. Everybody’s situation is different because everybody has different preferences, constraints, risk aversion attitudes, etc. For example, the safe withdrawal rate changes over time depending on equity valuations and the safe withdrawal rate can be vastly different depending on your age and expectations about Social Security, see two case studies I did recently at ChooseFI and last week here on our blog. That’s probably the main reason this “chain gang” of FIRE planning is so useful: Everybody can see the whole spectrum of different opinions and approaches. Thanks to our friend Fritz at The Retirement Manifesto for starting this project and keeping track of the new posts! If you’d like to join the chain, then share your strategy via Twitter: #DrawdownStrategy. 

We hope you enjoyed today’s post. Please share your comments and thoughts below!