Timing Leverage in Retirement – SWR Series Part 52

March 21, 2022

Last year in Part 49 of the Safe Withdrawal Series, I wrote a post about using leverage in retirement, and in today’s post, I like to explore some additional issues. 

A quick recap, the appeal of using leverage in retirement is that we would borrow against the portfolio instead of liquidating assets. Nice! That might help with Sequence Risk if we avoid liquidating assets at temporarily depressed prices. There could also be a tax advantage in that we keep deferring the realization of taxable capital gains, potentially until we bequeath our assets to our daughter who can then use the “step-up basis” for complete forgiveness of all of our accumulated capital gains. That’s the famous “buy, borrow, die” approach popular with high-net-worth folks.

The gist of the post last year: Not so fast! Leverage could potentially even exacerbate Sequence Risk if you are unlucky and retire right before a bad market event that’s deep enough (like the Great Depression) or long enough (like the 1965-1982 stagflation episode) to compromise the portfolio so badly that the margin loan becomes unsustainable relative to the underwater portfolio.

One solution proposed by several readers: instead of always borrowing against the portfolio, maybe we should carefully time when we use leverage. For example, borrow only when the stock market is down “far enough” and use withdrawals from the portfolio otherwise. And if the market is doing well again, potentially pay back the loan again! Sounds like a reasonable and intuitive plan. But I want to put that to the test with some real simulations. Let’s take a look at the details… 

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Retirement in a High-Inflation Environment – SWR Series Part 51

February 28, 2022

What a difference a year makes! In late 2020, only about 16 months ago, I felt the urge to comment on the then-fashionable discussion of how low inflation would impact retirees. See Part 41 – Can we raise our Safe Withdrawal Rate when inflation is low? of my SWR Series. Feels like a lifetime ago, doesn’t it?

The takeaway back then: don’t get distracted by high-frequency economic fluctuations. Low inflation doesn’t necessarily mean we can all raise our safe withdrawal rates. Certainly not one-for-one. There is neither empirical nor theoretical economic backing for materially changing your retirement strategy.

Only a little more than a year later the tide has turned. We’re now facing the highest inflation readings in about 40 years. 7.5% CPI and potentially 8% year-over-year once the BLS releases the February figure in mid-March. So, people asked me if my inflation views are symmetric, i.e., high inflation is also a non-event? As I signaled in my inflation post last month, I’m not too worried. Here’s why…

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Ten things the “Makers” of the FIRE movement don’t want you to know – SWR Series Part 50

January 3, 2022

Happy New Year, everybody. I hope you had a relaxing and healthy Christmas and a good start to the New Year!

Last month was the 5th anniversary of the Safe Withdrawal Rate Series! In December 2016, I published the first part of that series. I had material for maybe four or five parts but one thing led to another and with new ideas, most of them due to reader feedback, the series took off. It’s been running for 5 years and I obviously opened a bottle of bubbly last month to celebrate.

So, what’s the deal with the title then? Very simple: Blogging 101. You need a catchy title! I might have called the post “What I’ve learned in 5 years and 50 posts” or something along those lines. But to shake things up and get everybody’s attention, this is the title I went with. Think of this post as a natural extension of Part 26 “Ten things the “Makers” of the 4% Rule don’t want you to know” or the equally “tongue-in-cheek” posts “How to ‘Lie’ with Personal Finance” – Part 1 and Part 2.

So, after 5 years, 50 posts, what have I learned? What do I think others in the FIRE community are missing? What can you learn from my series that you may not have seen elsewhere? Let’s take a look…

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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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Passive income through option writing: Part 7 – Careful when shorting long-dated options!

May 3, 2021

Welcome back to a new installment of the options series! In the discussion following the previous post (Part 6), a reader suggested the following: In recent history, the index has never lost more than 50% over the span of one year. Then why not simply write (=short) a put option, about one year out with a strike 50+% below today’s index level? Make it extra-safe and use a strike 60% below today’s index!

12-month rolling S&P 500 index returns (price index only, not total returns!).

So, let’s take a look at the following scenario where we short a put option on the S&P 500 index slightly more than a year out and with a strike about 60% below the current index level:

  • Trading date: 4/30/2021
  • Index level at inception: 4,181.17
  • Expiration: 6/16/2022
  • Strike: 1,700 (=59.2% below the index)
  • Option premium: $11.50
  • Multiplier: 100x  (so, we receive $1,150 per short contract, minus about $1.50 in commission)
  • Initial Margin: $4,400, maintenance margin: $4,000

In other words, as a percentage of the initial margin, we can generate about 26% return over about 13.5 months. Annualized that’s still slightly above 23%! Even if we put down $15,000 instead of the bare minimum initial margin, we’re still looking at about 6.8% annualized return. If that’s a truly bulletproof and 100% safe return that’s nothing to sneeze at. A 6.8% safe return certainly beats the 0.1% safe return in a money market, right? Does that mean we have solved that pesky Sequence Risk problem?

Here are a few reasons to be skeptical about this strategy…

Continue reading “Passive income through option writing: Part 7 – Careful when shorting long-dated options!”

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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Can we raise our Safe Withdrawal Rate when inflation is low? – SWR Series Part 41

October 26, 2020

A few weeks ago I wrote the post “Do we really have to lower our Safe Withdrawal Rate to 0.5% now?” about the pretty ridiculous claim that the Safe Withdrawal Rate should go all the way down to just 0.5%, in light of today’s ultra-low interest rates. The claim was transparently false and it was great fun to debunk it. But recently I came across another proclamation of the type “We have to rethink the Safe Withdrawal Rate” – this time proposing to raise it all the way up to 5% and even 5.5%! Well, count me a skeptic on this one, too. Though I’d have to tread a bit more cautiously here because the 5.5% SWR claim doesn’t come from some random internet troll but from the “Father of the 4% Rule” himself, Bill Bengen. He’s been doing the rounds recently advocating for a 5% and even 5.5% Safe Withdrawal Rate:

  • In September in a piece he wrote for FA-mag with a recommendation to raise the SWR to 5%.
  • On October 1, the same article, reprinted almost verbatim under a different title in the same magazine: “Choosing The Highest Safe Withdrawal Rate At Retirement”
  • On October 13 on Michael Kitces’ podcast, Bengen made another explicit SWR recommendation: “[I]n a very low inflation environment like we have now, if we had modest stocks, I wouldn’t be recommending 4.5%, I’d probably be recommending 5.25%, 5.5%” It’s not clear what made him raise the SWR by another 0.25-0.50%, though.

And the whole discussion was quickly picked up in the personal finance  and FIRE community:

The main rationale for increasing the SWR: inflation has been really tame recently and will stay subdued over the coming years and even decades. That’s his forecast, not mine! Hence, Bengen makes the case that we’d have to make smaller “cost-of-living adjustments” (COLA) to our withdrawals. Smaller future aggregate withdrawals afford you larger initial withdrawals, according to Bengen. But as you might have guessed, the calculations that justify the significantly higher withdrawal rate don’t appear so convincing once look at the details…

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