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The ERN Family Early Retirement Capital Preservation Plan

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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:

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

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:

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:

ERN Family Target Portfolio: January 1, 2019. Total: $3,000,000

There are a few features very unique to our family:

The withdrawal plan:

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

The annual expected income should be more than enough to cover the annual ERN family spending!

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!

30% Federal Tax Bracket for Ordinary Income: An Illustration. (From our post last year)

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!

From CBOE: Drawdowns (i.e., loss relative to all-time-high) of Put writing strategies compared to the S&P500. Option writing strategies have lower and shorter-duration drawdowns and should mitigate sequnce of return risk!

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!

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