Tag: simulations

Asset Location: Do Bonds Really Belong in Retirement Accounts? – SWR Series Part 35

Welcome back to another installment of the Safe Withdrawal Rate Series. This one is about taxes. Amazing, how after 30+ installments in the series, I have written conspicuously little about taxes. Sure, I’ve done some Case Studies where, among many other issues, I delved into the tax planning, most recently in the Case Study for Becky and Stephen. But I’ve never written much about taxes and tax planning in the context of the Series.

There are two reasons why I kept the tax discussion on such a low burner: First, my background: If I had an accounting Ph.D. and CPA instead of an economics Ph.D. and a CFA charter, I would have written a whole lot more about taxes! Second, pinning down the Safe Withdrawal strategy and the safe withdrawal rate is my main concern. Most (early) retirees will have extremely low tax liabilities as I outlined in a post last year. You’d have to try pretty hard to pay more than a 5% federal effective tax rate in retirement. So, as long as you stay away from anything clearly irresponsible on the tax planning side, you’re fine. Don’t stress out over taxes in retirement unless you have a really, really large nest egg and taxable income deep into the six-figures during retirement.

But you don’t want to leave any money on the table either. So, I still want to write about taxes if I encounter something that captures my attention. And I came across a topic that’s most definitely interesting from a withdrawal strategy perspective: Asset Location (as opposed to Asset Allocation).

Imagine you target a particular asset allocation, say 60% stocks and 40% bonds. Or 70/30, or 80/20, or whatever suits your needs the best. How should we allocate that across the different account types? If we put all the different accounts into three major buckets…

  1. Taxable, i.e., your standard taxable brokerage account: Interest, dividends and realized capital gains are taxable every year they show up on your 1099 tax form. But you don’t have to pay taxes on capital gains until you realize them.
  2. Tax-deferred, i.e., your 401(k) or your Traditional IRA. Your account grows tax-free until you actually withdraw the money (or roll it over to a Roth). So, so can realize as much in interest income, dividends, capital gains along the way, as long as you keep the money inside the account.
  3. Tax-free, i.e., your Roth IRA or your HSA. The money grows tax-free and you can withdraw tax-free as well.

… then where do we put our bonds and where do we put our stocks? It would be easy, though likely not optimal to simply keep that same asset allocation in all three types of accounts. But is there a better way to allocate your stock vs. bond allocation?

Sure, there is! One of the oldest pieces of “conventional wisdom” investment advice I can remember is this:

“Keep stocks in a taxable account and bonds in your tax-advantaged accounts.”

Or more generally:

“Keep the relatively tax-efficient investments in a taxable account and relatively tax-inefficient investments in a tax-advantaged account.”

Most stocks would be considered more tax-efficient than bonds because a) dividends and capital gains are taxed at a lower rate than interest income and b) you can defer capital gains until you actually withdraw your money, which is a huge tax-advantage (more on that later).

So, it appears that we should ideally load up the taxable account with stocks and the tax-advantaged accounts with bonds. Hmmm, but that doesn’t sound quite right, does it? Why would I want to “waste” the limited shelf space I have in my tax-advantaged accounts with low-return bonds while I expose my high-return stocks to dividend and capital gains taxes? So, it would be completely rational to be skeptical about this common-sense advice!

So who’s right? Conventional wisdom or the skeptics? Long story short: they’re both wrong! You can easily construct examples where either conventional wisdom or the skeptics prevail. So neither side should claim that their recommendation is universally applicable. The asset location decision depends on…

  1. Your expected rates of return,
  2. Your expected tax rates,
  3. Your investment horizon. Yup, you heard that right, it’s possible that you want to go either one way or the other depending on the horizon. Though, this is not really a separate case but really only a result of asset allocation drift. Accounting for that, we’re back to the two cases, but more on that later!

Let’s look at the details…

Continue reading “Asset Location: Do Bonds Really Belong in Retirement Accounts? – SWR Series Part 35” →

Using Gold as a Hedge against Sequence Risk – SWR Series Part 34

Happy New Year! It’s time for another installment in the Safe Withdrawal Series! Here’s a topic that I’ve thought about for a while and that was also requested dozens, maybe even hundreds of times from commenters: What about gold? Gold has been a safe haven asset for many decades (Centuries? Millenials???) and it should have the potential to hedge against Sequence of Return Risk. And I recently found this article on Yahoo Finance: “The world’s super-rich are hoarding physical gold“. Maybe it’s just click-bait. Yahoo Finance must have lowered its standards substantially because they even (re-)published one of my articles last year. 🙂

But seriously, in light of the recent runup in gold prices, rising interest by the world’s super-rich and the many requests by readers, I’ve finally gotten around to studying this subject in the context of Sequence Risk. Let’s take a look at how useful gold would be as a hedge against running out of money in retirement…
Continue reading “Using Gold as a Hedge against Sequence Risk – SWR Series Part 34” →

How to Calculate Your Safe Withdrawal Rate without using Simulations – SWR Series Part 33

It’s time for a new post in the Safe Withdrawal Rate Series. It’s been a while, I know! This is a post I’ve been mulling over for a long time and a recent suggestion from a reader made me revisit my notes again. Why not calculate sustainable withdrawal based on how accountants or actuaries work. No simulations necessary! Neither historical nor Monte Carlo simulations! And here’s the kicker: you run this SWR calculation with all the data you’re going to assemble to use my Google SWR Sheet already. No extra work necessary! So, what do we have to do? Very simple:

  1. Take stock of all of your asset and liabilities today
  2. Take stock of all of your future expected cash flows: both positive (Social Security, Pensions, etc.) and negative (health expenses, kids’ college expenses, etc.).

This is essentially the information that you’d already need to know when doing a Safe Withdrawal Rate analysis, specifically, the inputs for the Safe Withdrawal Google Sheet, see Part 28 of this series!

So, how do you calculate a safe withdrawal rate without simulating anything? Very simple, use Net Present Value (NPV) calculations to transform all future cash flows (Social Security, Pensions, annuities, etc.) into today’s values, so you will end up with an adjusted net worth that takes into account not just your current assets and liabilities but also all of the future flows. And again, those future flows can be positive (Social Security, pensions) or negative (setting aside money for health expenses, nursing homes, etc.)

Once we have this “adjusted net worth” we can simply do a “reverse NPV calculation” to determine what retirement budget will exactly match our net worth. And that’s a sustainable retirement budget the way an actuary or an accountant would likely compute it.

Before everybody gets too excited, though, let me state the obvious: I would not recommend relying exclusively on this one approach and you’ll need to rely on simulations after all – more on the disadvantages below. But I certainly like the simplicity and some of the information we can gather from this approach!

Let’s take a look…
Continue reading “How to Calculate Your Safe Withdrawal Rate without using Simulations – SWR Series Part 33” →

A Safe Withdrawal Rate Case Study for Becky and Stephen

What? A new case study? I know, I had promised myself to wind down the Case Study Series I ran in 2017/18 after “only” 10 installments. It was a lot of work and a lot of back and forth via email. It takes forever! I mean F-O-R-E-V-E-R! But then again, there’s always a reason to make an exception to the rule! Jonathan and Brad from the ChooseFI Podcast had a very interesting guest on their show this week (episode 152). Becky talked about her experience of a late start in getting her and her husband’s finances in order. They started at around age 50 and became Financially Independent (FI) in their early 60s and retired a year ago. I should also mention that Becky recently started her own blog, appropriately labeled Started At 50, writing about her path to FI and RE so make sure you check that out, too.

In any case, Jonathan and Brad asked me to look at Becky’s numbers because I must be some sort of an expert on Safe Withdrawal Strategies in the FIRE community. I chatted with Jonathan and Brad about my case study results the other day and this conversation should come out as this week’s Friday Roundup episode. Because there’s only so much time we had on the podcast and I didn’t get to talk about everything I had prepared, I thought I should write up my notes and share them here. Heck, with all of that effort already spent, I might as well make a blog post out of it, right? That’s what we have on the menu for today… Continue reading “A Safe Withdrawal Rate Case Study for Becky and Stephen” →

Who’s Afraid of a Bear Market?

We made it through October, without much volatility this time – what a change compared to last year! We even got to a new all-time high in the S&P 500 in the last few days. When you reach new records, the pessimists come out of the woodworks and declare that “this is the top” and the next bear market must be right around the corner! It’s like clockwork! And if you go to the popular forums and Facebook Groups in the FIRE community, you’ll see people poking fun at the perma-pessimists. Quite appropriately, I think!

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Even if we’re at a top, we’ll have another top before too long! Source: Twitter.com, StockCharts.com

But why are people still a bit nervous about corrections and bear markets and market crashes? Being retired now, I have to admit I feel at least a little bit uneasy right now. Why’s that? If I wanted to quantify how afraid I am of something I’d do so as follows: Fear depends on both the probability and the magnitude of something scary happening:     FEAR = The probability of something scary  TIMES  the magnitude of something scary

In my recent post My thoughts on the “Upcoming Recession” I wrote about the probability part. I personally don’t think that the economy is at the brink of a major slowdown (yet) and with the economic growth trend, still intact the stock market will likely chug along. This all looks like a mid-cycle, temporary soft spot.

What makes me nervous about the bear market prospect, though, is the magnitude part; the fact that IF a bear market were to occur (however unlikely that may be) we’d most definitely go through some anxiety for a while. That’s true for all retirees and even folks close to retirement. Probably not so much for everybody just starting out in their accumulation phase, see the post “How can a drop in the stock market possibly be good for investors?” from earlier this year.

Quite intriguingly, though, if you look around in the FIRE community I get the sense that people minimize how scary a bear market will be if it were to start today. And the thought process is:

  1. The market will always recover (see the chart above)
  2. Most bear markets last only about one to two years

It sounds like the bear has really lost its teeth! So, why am I not convinced? There are multiple problems with that line of thinking. That 1-2 years estimate wildly underestimates how long it takes to recover from a bear market.  If you do the math right a bear market will appear a lot scarier than it’s commonly portrayed. Let’s see why…

Continue reading “Who’s Afraid of a Bear Market?” →

You are a Pension Fund of One (or Two) – SWR Series Part 32

Before we get to the business part of today’s post, again, let me thank everybody who nominated my blog for this year’s Plutus Awards! We got into the final five in two categories: “Best Financial Independence/Early Retirement Blog” and “Best Series: Blog, Podcast, or Video.” We’ll find out at FinCon next week on Friday who will win! But let’s not forget that there’s also the People’s Choice Award. I never even actively encouraged anyone to vote for me yet – I never thought I’d have a chance anyway. But it looks like the ERN blog is among the top 10 contenders as of August 28, see screenshot below! How awesome is that? If you haven’t cast a vote yet, please consider heading over to the Plutus Award page…

https://www.plutusawards.com/nominate/?pc=earlyretirementnow.com

… to nominate the ERN blog for that category. All you need is to enter your name and email address. The blog URL is already pre-filled! 🙂

SWR-Part32-PlutusAward01
Source: PlutusFoundation.org

But let’s get to the really important business. Safe Withdrawal Strategy business! The other day I was browsing on Amazon to look for the book “The Simple Path to Running a Pension Fund” and couldn’t find anything. Maybe Jim Collins is working on that right now? Or Mr. Money Mustache might have a blog post on the “simple math” or wait, I mean the “shockingly simple math” of running a pension fund? Duh’uh! Of course, there is no such simple path/simple math! Because it’s no simple task. Lots of people are involved in running a pension fund. And we’re not just talking about the operational people; customer service reps, lawyers, etc. There would also be a bunch of highly-trained investment professionals taking care of the portfolio. When I worked in the asset management industry I talked to them frequently because a lot of our clients were indeed pension funds. 

And I realize that – strictly speaking – I’m actually running a pension fund right now. For a married couple like us, it has only two beneficiaries, my wife and myself. I could count our daughter as beneficiary #3 because she’ll get some money for the first two decades or her life, but strictly speaking, she’s more of a “residual claimant” who’s going to get most of the “leftovers” when Mrs. ERN and I are gone. All of us in the FIRE community are running our own little one-person or two-person pension funds. And of course, in a lot of ways, running these small-potato pension funds is a lot easier than what the big guys (and gals) are doing. We don’t need fancy buildings, lawyers, customer reps, etc. But that’s the bureaucracy side. How about the mathematical and financial aspects? I’ve obviously written about how decumulating assets in retirement is clearly more complicated than accumulating assets while working (see Part 27 of this series – Why is Retirement Harder than Saving for Retirement?) but I was surprised how my DIY pension fund faces math/finance challenges greater than even a large pension fund. So, here are seven reasons why I think my personal pension fund is a heck of a lot more challenging than a corporate or public pension fund…

Continue reading “You are a Pension Fund of One (or Two) – SWR Series Part 32” →

Can a Rising Equity Glidepath Save the 4% Safe Withdrawal Rate Over a 60 Year Retirement? (Guest Post by Dr. David Graham)

Welcome back to another guest post. Dr. David Graham, over at FIPhysician has been on a roll. His spike in productivity has been the perfect “hedge” against my drop in productivity while traveling this summer, so when he offered me to write a follow-up on his very well-received guest post a few weeks ago, I was all for it. This current post is about adding a “glidepath” to your retirement portfolio and how and why this would change the success prospects over a 60-year retirement horizon. Over to you, Dr. Graham…

In my last post, I show a 4% Safe Withdrawal Rate (SWR) is actually NOT safe over 60-years (assumptions, assumptions). A more conservative 3.25% SWR does ok. On the other hand, if the asset allocation is increased from 60/40 to 90/10 stock to bond ratio, a 4% SWR thrives again. ERN advises, however, that a 90/10 portfolio sets you up for even more Sequence of Return Risk (SORR). SORR describes the long-term detrimental effects initial negative market returns have on overall portfolio success. Even if the stock market eventually recovers, selling part of your equity portfolio at rock-bottom prices can lead to premature failure of the withdrawal strategy.

What protects from SORR yet permits a higher SWR? A rising equity glidepath is one possibility. Let’s look at the details…

Continue reading “Can a Rising Equity Glidepath Save the 4% Safe Withdrawal Rate Over a 60 Year Retirement? (Guest Post by Dr. David Graham)” →

A Different Way to Plan Retirement – Guest Post on “Monte Carlo” Simulations by “Gasem”

Today we have another guest post, this time by our long-time reader “Gasem.” I’m sure most of you who have looked through the comments section here and at a number of other blogs would have noticed his comments. They are always highly insightful. He’s also a prolific writer on his own blog MD on FIRE, which I highly recommend. And if you’re not a Gasem-fan yet, I suggest you check out the What’s Up Next? podcast episode earlier this year where he was featured together with Susan from FIIdeas and VagabondMD. 

In any case, we had a discussion about using Monte Carlo Simulations to gauge safe withdrawal rates following David Graham’s guest post two weeks ago. And Gasem volunteered to write a guest post here detailing his approach measuring retirement risks. So without further ado, Dr. “Gasem,” please take over…

David Graham recently wrote a great post on this site regarding the 4% rule. What is the 4% rule really? You save 25x your yearly need and put it at some risk in a portfolio and then try to extract 30 years of value from the portfolio by extracting 4%/yr. 25x is the target (initial) principal. You have to inflation-adjust the withdrawal, and then you risk the principal at some interest rate above inflation. Let’s say you have 1M, you pull out 4% above inflation (and SORR doesn’t eat your lunch) you will preserve your capital and thus still have 1M 25 years later. You can re-retire for another 25 years on that 1M (capital preservation!) and still pull out 4%. So if inflation is 2% you need to make 6% on your money to run this money machine. 6% is the leverage on your future, That’s the “math” behind the 4% projection.

What’s the problem you say? The problem is volatility. The problem is the market can not guarantee 6% return and 2% inflation. Return is all over the map as is inflation. One year you may make 12%, the next year lose 20%. One year inflation maybe 2% and 5 years later 13% (1979). If you’re lucky it’ll work out you tell yourself, probably will work out, I read it on the internet! So what’s the probability? That’s where “Monte Carlo Simulations” come in. Let’s take a look… Continue reading “A Different Way to Plan Retirement – Guest Post on “Monte Carlo” Simulations by “Gasem”” →

Does A 4% Withdrawal Rate Survive a 60-Year Retirement? (Guest Post by Dr. David Graham)

You might have noticed that I haven’t published any guest posts for a while. I even explicitly state on my contact page that I’m no longer interested in publishing any guest posts. But every once in a while you make an exception to the rule. David Graham, actually, Dr. David Graham (FIPhysician), has been on a roll with a bunch of top-notch guest posts on other personal finance blogs; first writing for the White Coat Investor blog on Roth Conversions, then two guest posts on Physician on FIRE, first on Asset Location in Retirement, and then on Buffer Stock and Bucket Strategies to alleviate Sequence Risk in retirement. All really important topics! And after sending a few emails back and forth with the good Dr. Graham we agreed on a topic for him to publish a guest post here on the ERN blog, Instead of using backward-looking historical return windows, as I would normally do in my SWR Series, why not check the sustainability of the 4% Rule with forward-looking return projections? Vanguard and a lot of financial companies publish those every year. Sounds like an interesting exercise! So, without further ado, please take over Dr. Graham…

As we all know, ERN is the man when it comes to Safe Withdrawal Rate (SWR) and FIRE. Reading between the lines, he has a different opinion on SWRs for a 60-year retirement vs. a more traditional 30-year plan. Obviously, using only historical data, it is more difficult to study SWR with rolling 60-year stock and bond returns than 30-year periods. Nevertheless, FIRE often subscribes to the 4% rule despite a prolonged period of income demands on the accumulated nest egg. In order to further understanding of the 4% rule over a longer than usual planned retirement, let’s visualize the 4% rule over a 60-year period and see what we can learn. Continue reading “Does A 4% Withdrawal Rate Survive a 60-Year Retirement? (Guest Post by Dr. David Graham)” →

How To “Lie” With Personal Finance

“Lies, damned lies and statistics” (Mark Twain)

“Do not trust any statistic you did not fake yourself” (Winston Churchill)

There is a classic book called “How to lie with Statistics” that I read many, many years ago (actually decades ago!) as a college student. If you’re ever looking for an inexpensive but fun and impactful present for a young student/graduate with the hidden agenda of getting that person interested in math and statistics, this is the one! The book taught me to take with a grain of salt pretty much anything and everything number-related. Anywhere! Whether it’s in the news or in the Personal Finance blogging world and even (particularly?!) in academia. I’m not sure if I was already a severely suspicious (paranoid?) person before reading this or the book turned me into the person I’m today. So, inspired by that book, I thought it would be a nice idea to write a blog post about the different ways numbers are misrepresented in the FIRE/Personal Finance arena. And just to be sure, this post is not to be understood as a manual for fudging numbers, but – in the spirit of the “How to Lie With Statistics” classic – serves as a manual on how to spot the personal finance “lies” out there!

And there’s a lot of material! Probably enough for at least one more followup post, so for today’s post, I look at just four different way of how quantitative financial issues are frequently fudged in the personal finance world. And a side note about the slightly attention-grabbing title I used here: Well, I put the word “Lie” in quotation marks to show to the faint-hearted that this is a bit tongue-in-cheek. I could have written, “fudge the numbers” or “Enron-accounting” or “How we delude ourselves in personal finance,” or something like that. Also, Hanlon’s Razor (“don’t attribute to malice what can be explained by incompetence”) comes to mind here, but I’m not sure if those faint-hearted folks feel that incompetence is a significantly more benign explanation than malice.

So, let’s look at some of my favorite examples of how people lie to themselves (and others) in the realm of personal finance…

Continue reading “How To “Lie” With Personal Finance” →