Hedging Against Inflation and Monetary Policy Risk

July 5, 2022

Over the last few decades, we’ve become accustomed to a negative correlation between stocks and U.S. Treasury bonds. Bonds used to serve as a great diversifier against macroeconomic risk. Specifically, the last four downturns in 1991, 2001, 2007-2009, and 2020 were all so-called “demand-side” recessions where the drop in GDP went hand-in-hand with lower inflation because a drop in demand also lowered price pressures. The Federal Reserve then lowered interest rates, which lifted bonds. This helped tremendously with hedging against the sharp declines in your stock portfolio. And in the last two recessions, central banks even deployed asset purchase programs to further bolster the returns of long-duration nominal government bonds. Sweet!

Well, just when people start treating a statistical artifact as the next Law of Thermodynamics, the whole correlation collapses. Bonds got hammered in 2022, right around the time when stocks dropped! At one point, intermediate (10Y) Treasury bonds had a worse drawdown than even the S&P 500 index. So much for diversification!

So, is the worst over now for bonds? Maybe not. The future for nominal bonds looks uncertain. We are supposed to believe that with relatively modest rate hikes, to 3.4% by the end of this year and 3.8% by the end of 2023, as predicted by the median FOMC member at the June 14/15, 2022 meeting, inflation will miraculously come under control. As I wrote in my last post, that doesn’t quite pass the smell test because it violates the Taylor Principle. The Wall Street Journal quipped “The Cost of Wishful Thinking on Inflation Is Going Up Too“. I’m not saying that it’s impossible for inflation to easily subside, but at least we should be prepared for some significant upside risk on inflation and interest rates. Watch out for the July 13 CPI release, everybody!

So, trying to avoid nominal bonds, how do we accomplish derisking and diversification? Here are ten suggestions…

Continue reading “Hedging Against Inflation and Monetary Policy Risk”

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…

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

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…

Continue reading “Low-Cost Leverage: The “Box Spread” Trade”

Our Three-Year FIRE Anniversary

July 1, 2021

Time flies! I can’t believe I already had my 3-year FIRE anniversary last month! Time to reflect and think back on the first three years of early retirement: travel, moving, “market timing”, dealing with the shutdown, and some other exciting news in the ERN retirement life. Let’s take a look…

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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…

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

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…

Continue reading “Principles of Retirement Tax-Planning – SWR Series Part 44”

What’s wrong with Target Date Funds?

November 9, 2020

Amazingly, after 4+ years of blogging and 200 posts, I haven’t written anything about Target Date Funds (TDFs). For some folks, they are certainly a neat tool. Your fund provider automatically allocates your regular retirement contributions to a portfolio that they deem appropriate for your age and/or the number of years you’re away from your retirement date. It’s a hands-off approach for people who don’t want to think about their asset allocation and simply outsource that task to a fund manager.

But I think not all is well in the TDF world. People planning for FIRE should stay away from TDFs. But even for traditional retirees, there are some unpleasant features. Let’s take a look…

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Is an Employee Stock Purchase Plan (ESPP) better than a Retirement Account?

September 23, 2020

In last week’s post, I showed that if you have access to an Employee Stock Purchase Plans (ESPP) offering the full 15% maximum discount you can justify prioritizing the ESPP over an index fund investment in a taxable account, despite the higher risk. But I didn’t answer another important question: would you want to prioritize your ESPP even over retirement savings accounts? 

If your company match is 50% or even 100%, well, then you get a quick guaranteed 50% or 100% return, much higher than any ESPP discount you can expect. The retirement plan with such a high matching percentage easily mops the floor with that puny 15% ESPP discount. But what about the 401(k) contributions after the match? Should we forego those and invest in the ESPP instead? Is the ESPP better than a Roth IRA?

Well, it all depends on your personal situation, specifically, your tax and benefit parameters. So, that’s the question for today: How do we determine priorities across the different savings vehicles? Under what conditions would we forego the 401(k) contributions beyond the company match and invest in the ESPP instead?

Let’s take a closer look: Continue reading “Is an Employee Stock Purchase Plan (ESPP) better than a Retirement Account?”

Is an Employee Stock Purchase Plan (ESPP) Worth the Risk?

September 16, 2020

One question I’ve gotten from readers a few times over the years is whether the participation in a so-called Employee Stock Purchase Plan (ESPP) is worthwhile.

A little bit of background: some corporations offer their employees to buy stocks of their company at a discount of up to 15%. There are some strings attached, though. For example, there are often minimum holding periods, anywhere between a few months and up to two years. The discount is also taxed as ordinary income, though the subsequent capital gains may qualify for treatment as long-term gains.

If you can liquidate the stocks right away and pocket the discount, then participating is likely a no-brainer. Take the money out of the ESPP and invest it in a low-cost index fund. It’s a nice boost to your contributions in your taxable account after you’ve maxed out all your other tax-advantaged options. 15% adjusted by your marginal income tax rate – federal and state. That would still be more than 10% for most people! Pretty sweet!

But what should you do if there’s a minimum holding period? During that time, part of your portfolio is now concentrated in one single corporation. The opposite of diversification. So, it’s a tradeoff: You get the discount but you also take on additional risk. Is it still worthwhile? This is an inherently quantitative question. Without putting hard numbers behind this we can talk about this until the cows come home. The only way to answer this question is through a quantitative exercise. And it turns out, the numbers look like it’s indeed worthwhile to participate in an ESPP, especially if you can get the full 15% discount, the maximum allowed under federal law.

Let’s take a closer look…

Continue reading “Is an Employee Stock Purchase Plan (ESPP) Worth the Risk?”

The Ultimate Tax Hack: We Are Moving To Monaco! (No we’re not! Happy April Fool’s Day!)

April 1, 2020

Despite the postponement of the deadline this year, April is still tax season for us! Oh, how much I dread this part of the year! And it’s not even the paperwork! If I could do twice the paperwork to cut my taxes in half, I’d gladly do so. So, certainly, for me, the problem is not the filing of my taxes! The discomfort of tax season is 100% due to paying income taxes. Sure, we moved to Washington State to eliminate the state income tax – a big plus compared to California – but that still leaves that pesky federal tax. Last year, we still ended up in the 22% federal tax bracket for ordinary income and 15% for long-term capital gains and qualified dividends. I still don’t the final, final tally yet but it looks like our total federal tax bill will be about $23,000. That hurts! And it hurts more having to pay taxes for the blockbuster year 2019, right around the time the market is melting down this year!

So we developed the ultimate tax hack! Move to a location without any(!!!) income taxes! At all! That location is Monaco, a tiny sovereign nation on the Mediterranean coast surrounded by Southern France. It has no income tax, no capital gains tax and no property tax, how awesome is that?

We did a reconnaissance visit to the Cote d’Azur last year, including Monaco, and we absolutely fell in love with the place! I mean, where else in the world can you watch a Formula One race looking out of your apartment window?

Monaco-HairPinCurve
Yup, that’s the hairpin curve you’ve seen in the Formula One races!

It’s sunny and warm year-round and the food and wine are outstanding.

Let’s look at the numbers in more detail… Continue reading “The Ultimate Tax Hack: We Are Moving To Monaco! (No we’re not! Happy April Fool’s Day!)”