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 Captial 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

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:

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

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 as 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 net 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!
ERN Family Target Income 2019
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!

Diagram for 30pc Fed Tax Bracket
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!

CBOE Put strategy drawdown plot
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. Heck, J. Collins wrote a book about how simple it is. 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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44 thoughts on “The ERN Family Early Retirement Capital Preservation Plan

  1. Big ERN,
    I am amazed that you continue to produce such high quality impactful work!

    The personalization aspect of a post-FIRE plan is so spot on. Been struggling with this for a while trying to chart a course for my family and you have provided me with a few new ideas and different ways of looking at the challenge. Asset allocation, taxes, family situations, relocation, and a whole host other variables provide opportunities and limitations.

    Your comments about about being prepared to do Roth conversions if/when conditions in the future warrant the conversions are particularly helpful for me. Same thing goes for your intentional delay on buying another house. We have limited ability to peer into the future–stuff happens and things change. When change happens that could/should affect a post-FIRE plan, then having a solid understanding of the available options and their consequences is extraordinarily valuable. Stated somewhat differently, military strategist Helmuth von Moltke noted, “No battle plan survives contact with the enemy.” When your plan meets reality, reality wins–every time! Having some strategic flexible in a post-FIRE plan is a must.

    Liked by 1 person

  2. Welcome to the “chain gang”! It’s great having your perspective and well thought out plan to compare to. The options trading is a very unique circumstance, but given how comfortable you are with the prospect of solid returns and still maintaining a minimal tax impact, it is hard to argue with. Would you begin to curtail this once the RMDs begin rolling in to reduce the ordinary income? Or would you plans change in any other fashion to reduce the tax impact of those RMDs?

    Thanks for sharing your perspective!

    Liked by 1 person

    • Haha, never thought I’d be in a chain gang, but I enjoy the company!
      You are right: Once I reach age 70 we’d have the perfect storm of ordinary income: Social Security (I hope) which is 85% taxable, and the RMD. At that time I’d certainly have to shift more toward generating long-term capital gains and dividends.

      Like

  3. As always, a completely different flavor. Looks like a terrific strategy unless the earth is hit by a meteor the size of Texas. If you get those haters coming to your site, they will be armed with cries of “Voodoo! Trickery! What is this financial witchcraft nonsense!?”. Seriously, your disclaimer to even savvy FIRE readers to tread carefully with options trading should be taken, well, very seriously.

    Interesting approach on the house sale viz-a-viz leaving/staging versus selling it while you live there. We will battle the “selling it while we live in it” and also share your concerns on the hassles that will bring. I suspect a lot of gnashing of teeth and Twitter ranting from the PIE’s after March next year when we put our primary home on the market.

    Have you narrowed down your search for a new ERN pad to a particular location?

    Our SWR of 2.5% is based, in part, to the expected low equity returns predicted by Bogle. If you are right and he is wrong,we of course will be delighted. Like you, we have buffer baked in to account for supplementing the college funds stash as well as teenage years expenses (Hello orthodontist work, car insurance and the like……)

    Again, fine reading and a wonderful addition to the Chain Gang.

    Like

    • Haha, that options trading strategy is not for everybody. Bogelheads will get a bogle, uhm, heart attack.
      That’s my concern too: kids will become more expensive. I see my daughter’s teeth and see big expenses in the future, haha. Always good to have a significant cushion!

      We have narrowed down the future ERN home state to about 3, tax-fiendly states. More details will follow! 🙂

      Like

  4. You are in great shape for a comfortable early retirement, or as they call it on Reddit, FatFIRE.

    That sneaky 30% marginal tax on additional ordinary income is incredible. My setup is a bit different than yours, of course, but I could find myself in that same tax situation. And we’ll tack state tax onto that. I thought I was going to be done with these high marginal tax brackets!

    Thanks for participating in the series. I’ll be adding your post to the list in the addendum to my “anchor post.”

    Cheers!
    -PoF

    Like

  5. This is a really interesting and detailed plan, thank you. Recently, I’ve been doing a lot of research into options trading as from what I’ve read, I feel that may be good for my circumstances at the moment. Right now I’m really just trying to plan for the future, what would you suggest is the best way to get started?

    Liked by 1 person

  6. You’re not late! You made it to the first ten links in the chain. Many more to come. And I’m glad to see a plan that’s based on higher expenses. Many a John Q Public will discount FIRE and say it’s only achievable by those who spend super frugally.

    It’s easier to show a property when you no longer live there. But I wonder whether, if buyers are aware the seller moved out, they expect the seller to be more “motivated”. Do they lowball an offer based on that? It’s something I consider for our next move.

    Liked by 1 person

    • Thanks! THat’s a good way to look at it. Nobody is late. here will be tons more posts on this topic!

      Good point on the real estate. There is no easy way out. Given how much money is involved this is clearly one area that needs some optimization.

      Like

  7. […] 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: Drawdown vs. Wealth Preservation in Early Retirement Link 4:   Freedom Is Groovy: The Groovy Drawdown Strategy Link 5:   The Green Swan:  The Nastiest, Hardest Problem In Finance:  Decumulation 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 Early Retirement Withdrawal Strategy Link 10: Early Retirement Now:  The ERN Family Early Retirement Capital Preservation Plan […]

    Like

  8. Welcome to the “Chain Gang”. I enjoyed reading your #DrawdownStrategy. Like you, our goal is to not draw it down to zero. We want to continue to grow our portfolio while we are living off of it. Thanks for sharing about your options strategy. I would like to learn more about that strategy.

    Liked by 1 person

  9. Your plan and the “chain gang” initiative are both commendable. I’m especially interested in reading what older professionals like you and the good doctor are saying and doing about FI and retirement. That’s more credible than advice from some young dude with a cubicle that he hates, a blog that he writes, and $100K in an IRA. (Clearly there is an audience for the latter, but it might be limited to millennials who don’t like their jobs.)

    My observation about your FIRE plan is that it is less about retirement than about a shift to part-time work in finance. Nothing wrong with that. On the contrary, it’s the kind of transition that a finance professional is best-suited for. If I can go part-time in so-called Big Law (and that’s hard to do), then I will do the equivalent thing. I view this as down-sizing within one’s chosen career.

    I also view your real estate play as a classic move (and one that I’ve made, too): Sell out of a high-priced market and migrate into a lower-priced one. Housing arbitrage. Adding state tax arbitrage makes it even better.

    If only I had the options trading experience that you have, I might be doing exactly as you are planning for yourself. Please keep teaching us about it. Meanwhile, be happy that you chose your career wisely. It set you up with more options (pun intended) than others have.

    Liked by 1 person

    • Haha, good point! I can’t hate my job in finance too much because I’m writing about (personal) finance in my spare time!
      I will promise to write more options (pun intended, too) and write more about options trading as well! 🙂
      Cheers!

      Like

  10. Thanks for sharing this. I’m wondering, having read through most of your SWR series, if you have seen any of William Sharpe’s work on this general subject. I don’t have the technical ability to sort through his materials to see if or how it could be applied to early retirement but I bet you do.

    http://web.stanford.edu/~wfsharpe/RISMAT/

    Coverage from last month: https://www.bloomberg.com/view/articles/2017-06-05/tackling-the-nastiest-hardest-problem-in-finance

    Liked by 1 person

  11. Ah, the chain gang continues! Sounds like you’ve got a good plan. Since leaving work in 2012, I’ve been unable to draw down principal because it HURTS too much. So, my goal is to always try to make more money in order to never have to draw principal, and then donate whatever money is left over when I die. Is that weird?

    I love a good challenge. Keeps me busy in early retirement!

    Sam

    Like

  12. It is nice that you put inflation into consideration in your plan because $100,000 today will not have the same value in 10 years time. I must commend that you have a very robust plan.

    Like

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