Tag: investing

Low-Cost Leverage: The “Box Spread” Trade

December 9, 2021 – Last month, I published Part 49 of my Safe Withdrawal Rate Series, dealing with leverage in retirement. In that post, I surmised that the cheapest form of leverage likely comes in the form of a margin loan in an Interactive Brokers (IB) account. If you have the IB Pro account you have access to loan rates tied to the Federal Funds Rate plus a tiered spread ranging from 0.3% to 1.5%. Though, the really low rates don’t start until your loan reaches at least $3,000,000. For more manageable loan amounts that the average retail investor would use, we’re looking at a higher spread: 1.50% spread for the first $100,000 and 1.00% over the Fed Funds Rate for the next $900k. With the current effective Fed Funds Rate at around between 0.08% and 0.10%, that’s a very competitive rate. Certainly better than a Home Equity Line Of Credit (HELOC).

In the comments section, though, a reader brought up an idea for an even lower-cost method for borrowing against your assets: an exotic options trade called a “box spread”. I had heard of this trade before but never put much thought into it. And I certainly didn’t put any money into that idea. But just for fun, I researched this trade some more and even initiated one box spread trade on Monday, essentially issuing a synthetic $20,000 zero-coupon bond maturing in December 2026 at a very competitive interest rate, significantly lower what you’d get from IB.

So, in today’s post, I like to go through the basics of the Box Spread, how to implement it and how this trade could in fact give us a cheaper form of leverage than even the rock-bottom rates from IB. Let’s take a look at the details…

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Using Leverage in Retirement – SWR Series Part 49

November 16, 2021 – My Safe Withdrawal Series has grown to almost 50 parts. After nearly 5 years of researching this topic and writing and speaking about it, a comprehensive solution to Sequence Risk is still elusive. So today I like to write about another potential “fix” of Sequence Risk headache: Instead of selling assets in retirement, why not simply borrow against your portfolio? And pay back the loan when the market eventually recovers, 30 years down the road! You see, if Sequence Risk is the result of selling assets at depressed values during an extended bear market, then leverage could be the potential solution because you delay the liquidation of assets until you find a more opportune time. And since the market has always gone up over a long enough investing window (e.g., 30+ years), you might be able to avoid running out of money. Sweet!

Using margin loans to fund your cash flow needs certainly sounds scary, but it’s quite common among high-net-worth households. In July, the Wall Street Journal featured this widely-cited article: Buy, Borrow, Die: How Rich Americans Live Off Their Paper Wealth. It details how high-net-worth folks borrow against their highly appreciated assets. This approach has tax and estate-planning benefits; you defer capital gains taxes and potentially even eliminate them altogether by either deferring the tax event indefinitely or by using the step-up basis when your heirs inherit the assets. Sweet!

So, is leverage a panacea then? Using leverage cautiously and sparingly, you may indeed hedge a portion of your Sequence Risk and thus increase your safe withdrawal rate. But too much leverage might backfire and will even exacerbate Sequence Risk. Let’s take a look at the details…

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Retirement Bucket Strategies: Cheap Gimmick or the Solution to Sequence Risk? – SWR Series Part 48

September 14, 2021 – Welcome to a new installment of the Safe Withdrawal Rate Series, dealing with Bucket Strategies. This is one approach that’s often considered a viable solution to the dreaded Sequence Risk Problem. Simply keep buckets of assets with different risk characteristics designated to cover expenses during different time windows of your retirement. Specifically, keep one or more buckets with low-risk assets to hedge the first few years of retirement. And – poof – Sequence Risk evaporates, just like that! Sounds too good to be true, right? And it likely is. Long story short, while there are certain parts of the bucket strategy that can indeed partially alleviate the risk of retirement bust, bucket strategies are by no means a solution to Sequence Risk. Let’s take a look at the details…

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When to Worry, When to Wing It: Withdrawal Rate Case Studies – SWR Series Part 47

August 18, 2021 – In my post two weeks ago I outlined my approach to retirement planning: In light of significant uncertainty in retirement, I like to do a more careful, robust, and scientific analysis. Not because I could ever undo any of the existing uncertainties but because I don’t want to add even more uncertainties through “winging it” in retirement.

But how much detail is really required? I can already hear objections like “you can never know your future spending month-by-month, so why go through all this careful analysis with a monthly withdrawal frequency?” To which I like to answer: Well, maybe that’s the part where you can indeed use the “wing it” approach! So, today I want to go through a few case studies and learn how much of a difference it would make in my safe withdrawal strategy simulations if we a) carefully model the whole shebang in great detail, or b) just wing it and use a rough average estimate for the spending path. For example…

  • Does the intra-year distribution of withdrawals matter? In other words, how much of a difference does the withdrawal frequency make: monthly vs. quarterly vs. annual?
  • What if there are fluctuations in my annual withdrawals around the baseline average budget, due to home repairs, health expenses, etc.?
  • What if those fluctuations have an upward bias?
  • What if there is a slow (upward) creep in withdrawals?
  • What about nursing home expenses later in retirement?

Where can I safely wing it? And which are the ones I should worry about? Let’s take a look…

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The Need for Precision in an Uncertain World – SWR Series Part 46

August 5, 2021 – Welcome back to another post in the Safe Withdrawal Rate Series. For a quick intro and a summary of the series, please refer to the new landing page.

People in the FIRE and personal finance blogging community – readers and fellow bloggers alike – often tell me that while they enjoy my writings here, they wonder if I haven’t gone a little too far into the rabbit hole of quantitative analysis. Why measure safe withdrawal rates down to multiple significant digits? Why do all of this careful analysis if there’s so much uncertainty? Market uncertainty, policy uncertainty, personal uncertainty, model uncertainty! Why not just wing it? I always try to give a short reply to defend my quantitative approach and out of the many different mental and written notes I’ve taken over the years I created this post for your enjoyment and for my convenience to refer to if I get this question again next week.

Specifically, I want to propose at least three reasons for being diligent and precise not despite, but precisely because of retirement uncertainties. And, by the way, I will keep today’s post relatively lean in terms of simulations and calculations, and rather try to make this more of a philosophical exercise. So, if you’re one of the quant-skeptics I hope you keep reading because I can promise you that we don’t have to get too deep into the (quant) weeds. So, let’s take a look at my top three reasons to get the math right…

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A Retirement Tax-Planning Case Study (and Excel Toolkit!) – SWR Series Part 45

April 28, 2021 – Welcome back to another installment of the Safe Withdrawal Rate Series. In the previous installment, Part 44, I went through a number of general tax planning ideas, and I promised another post to introduce an Excel Sheet, I created to help me with my tax planning. There were numerous reader requests a long time ago when I ran the withdrawal strategy case studies (2017-2018) to publish not just the Safe Withdrawal Rate calculations but also the tax planning Excel Sheet. Well, I never published those Excel sheets because a) they were custom-tailored to those particular case studies, b) they potentially included personal information of the case study volunteers and c) they were created “for my eyes only” so I couldn’t really publish them without a massive effort to explain and document what exactly I’m doing there.

But now (with a three-year delay!) I’ve finally come around to creating something from scratch I feel comfortable publishing for a broader audience. It’s not a Google Sheet, but an MS Excel Sheet, more on that later. It’s probably still not a universally applicable tool.  And most importantly, it’s a tool that still requires a lot of Excel Spreadsheet mastery. It will not spit out “the” optimal tax strategy, it will only help me (and maybe you) find that optimal tax strategy. A lot of handiwork is still necessary! Much more handiwork than with Safe Withdrawal Sheet (and even that is already a handful!).

So, I like to go through a simple case study to show how this sheet works and showcase how you can “hack” your withdrawal tax optimization strategy in that one specific case. Even aside from tax optimization, the sheet helps me gauge what’s the average effective tax rate throughout retirement, to help me figure out how much of a gross-up I have to apply to translate a net-of-tax retirement budget into a pre-tax withdrawal percentage.

I can’t foresee what exact tax challenges you might face, but with my tool, I would have been able to handle what came across my desk so far, both in my personal finances and the case studies I’ve done so far.

So, let’s take a look…

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Principles of Retirement Tax-Planning – SWR Series Part 44

March 22, 2021 – It’s tax season in the U.S. right now! Even though that deadline has just been pushed back to May 17, taxes are on everybody’s mind, so this is a good time to write about the topic in the context of the Safe Withdrawal Rate Series. Until now, I haven’t written all that much about taxes and the main reasons are:

  1. While I do have a combined 6 letters behind my name (Ph.D. & CFA), I’m missing the three letters “CPA” to write anything truly authoritative about the topic.
  2. My primary focus is on getting the Safe Withdrawal Rate right. It’s the first issue everyone should worry about. I did some case studies years ago for early retirees and some of them could actually raise their SWR to more than 5% if they do their accounting for future cash flows right. That’s 25% better than the naïve 4% Rule. If you start with a tax plan that’s already somewhat OK and close to optimal, I doubt that you can squeeze out another 25% in after-tax withdrawals through a truly “optimal” tax plan. Hence my approach: get your SWR right and factor in the tax optimization plan afterward to make sure you squeeze maybe another percent or two in the after-tax numbers!   (And likewise, if you have a 60-year horizon and not much in the way of supplemental cash flows and you’re looking at a 3.25%, maybe a 3.5% withdrawal rate, you’re not going to “tax-hack” yourself to a 4% withdrawal rate either!)
  3. Taxes are very personal and it’s difficult to give any generalized advice. As much as I would like to create a spreadsheet like the Google Sheet to simulate safe withdrawal rates (See Part 28 for the details) where you plug in your numbers and the sheet spits out a detailed plan, it’s not so trivial. Very likely, the tax analysis would have to be more custom-tailored!  And just to be sure, my Google SWR simulation sheet isn’t trivial either! 🙂

But of course, even if you first do your SWR analysis in before-tax terms, you will want to know how much of a haircut you need to apply to calculate your after-tax retirement budget. Some retirees can indeed make over $110,000 a year and don’t owe any federal tax as I showed in my post in 2019 (“How much can we earn in retirement without paying federal income taxes?“). And in the same post, I showed that to get to a 5% average tax you’ll likely need a $150k annual retirement budget. So, it’s a fair assumption that most of us in the FIRE community will likely get away paying less than 5% of our retirement budget in federal taxes. Add another 0-5% or so for most state tax formulas, and you will likely stay below 10% effective/average tax rate.

But I get the message: because we can’t completely ignore taxes, I wrote today’s post to talk about the general ideas and principles in retirement tax planning. In at least one additional future post (maybe two, maybe three) I will also do a few case studies to see the general principles in action. At that point, I will also include the Excel Sheet I use to perform the tax planning analysis because a lot of readers asked for that tool when I published the Case Studies 3+ years ago! And as I warned before: it’s not as simple as just putting your parameters and Excel automatically spits out your plan. It involves a bit more human input and analysis, stay tuned!

But before we even get to the messy parts, let’s take a look at some general principles…

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Pre-Retirement Glidepaths: How crazy is it to hold 100% equities until retirement? – SWR Series Part 43

March 2, 2021 – A while ago, I wrote about the challenge of designing pre-retirement equity/bond glidepaths (“What’s wrong with Target Date Funds?“). In a nutshell, the main weakness of Target Date Funds (TDFs) for folks planning an early retirement is that if you have a short horizon and a large savings rate then the “industry standard” TDF is probably useless. 10 years before retirement, the TDF has likely shifted too far out of equities, likely below 70%!

The problem is that the traditional glidepaths are calibrated to the traditional retiree (who would have guessed???) with a sizable nest egg ten years away from retirement. In that case, you want to hedge against the possibility of a bear market so close to retirement from which you might have trouble recovering due to the relatively small contributions of “only” 10-15% of your income. But people planning early retirement with a small initial net worth and a massive 50+% savings rates should clearly take more risk to get their portfolio off the ground.

In any case, back then I mentioned that I had some additional material about glidepaths toward retirement for the FIRE community, to be published at a later date, which is today!

Why is this post part of the Safe Withdrawal Rate Series? First, today’s post is a natural extension of the FIRE glidepath posts (Part 19, Part 20) in this series. Moreover, the majority of readers of the series are not necessarily retired yet. Many seek guidance during the last few years before retirement. In fact, one of the most frequent questions I have been getting is that people who are almost retired and still holding 100% equities wonder how they are supposed to transition to a less aggressive allocation, say 75% stocks and 25% bonds at the start of retirement. Should you do a gradual transition? Or keep the allocation at 100% equities and then rapidly (cold-turkey?) shift to a more cautious allocation upon retirement? 

My usual response: It depends on your parameters and constraints. You can certainly maintain your 100% equity allocation much longer than the traditional TDFs would make you believe. If you are “flexible” with your retirement date you can even keep the equity weight at 100% until you retire. If you are really set on a specific date and want to hedge the downside risk, you probably want to gradually shift there over the last few years. So, let’s take a look at my findings…
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The Effect of “One More Year” – SWR Series Part 42

January 13, 2021 – Happy New Year, everyone! And welcome to a new installment of the Safe Withdrawal Rate Series. Today I like to write about the One More Year Syndrome (OMYS) – the fear of retirement and the decision to just work another year. What I find intriguing about OMYS is that procrastination normally works the other way around. You opt for the fun and easy stuff and promise yourself to do the hard work tomorrow. Only to repeat that charade again tomorrow and postpone the unpleasant tasks to the day after tomorrow. And so on. 

But why procrastinate a fun-filled early retirement and keep working? Physician on FIRE and Fritz at The Retirement Manifesto have written about their rationales. The number one reason is that you grow your nest egg and put your retirement finances on a better footing. That was certainly my main rationale, too. I could have retired comfortably in 2017, probably even in 2016 but I delayed that decision until 2018.

So, qualitatively it’s obvious. But can we quantify by how much the OMYS improves your retirement security? Is it worth the additional year in the workforce? How can we incorporate OMYS in the Big ERN Google Safe Withdrawal Simulation Sheet? Is it possible that OMYS will boost your retirement health so substantially that it’s not as irrational as it’s sometimes made? Let’s take a look…

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What to make of that Q3 U.S. GDP number?

October 29, 2020 – Today’s GDP release for the third quarter came in at 33.1%. Not a typo. After the disastrous second-quarter number of -31.4%, the worst quarterly number on record we now got the best quarterly reading on record. What’s going on here? What do I make of that number? Are we out of the woods now? I’m putting on my economist’s hat for today and share my thoughts in a short post. Let’s take a look…

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