More On the Concept of Yield Shield and 4 x 25

I’ve been thoroughly enjoying Big ERN’s series on yield shield 29, 30, and 31. In a very even handed way Karsten pretty much demolishes the illusion of SOR “safety” associated with yield based retirements. I think the illusion comes from the way FIRE is sold by the bogglehead crew and others like Mustache. The shockingly simple math is the math of a passbook savings account, not a equity investment account, and given the passbook savings rate even that is far from safe. 1M @ 4% with a 4% WR works fine till the first 4% goes to 3 % or inflation goes to 3.5%.

I was reading another article by a young physician who has 1/2M in the bank and “decided” 3.3M would give him a FI retirement, but now it’s up to 5M. If you actually inflation adjust to just nominal inflation, $150K/yr added to 500K takes 19 yrs to get to 5M. Imagine at high inflation how long it would take. At 3.5% inflation for the same rate of return it now would take 22 years to make that 5M nut and every year after you pulled the trigger your effective WR and “safety” would be less. I’m just playing with shockingly simple 4th grade math here, not calculus or differential equations. Look at these numbers. A cut in the rate of return from 4% to 3%, with a 4% WR wipes you out in 47 years. An increase in inflation from 2% to 3.5% blows you up! These small changes represent SOR. They are what constitute SOR. SOR giveth and SOR taketh away. The yield shield does not take into account SOR because the calculation is based on a constant as in it’s not a variable but life is not based on a constant. SOR by it’s very definition is a variable. It’s a sequence not a constant. Where is the sequence variable in 4 * 25? In 3 * 33? Yet people blindly plan their lives around these variable-less formula and behave as if there is some assurance of success and get all pissed off at Suze O when she dare challenge the illusion.

Lets take the illusion of success and turn it on it’s head using a simple FV calc No fancy Monte Carlo statistics but iterative 4th grade math.

This is a 1M 4% WR 30 year retirement @ 6% return. 2.25% inflation and a 12% tax load. In 30 years your 1M at 6% would generate 2.748M. Taxes, inflation and WR would eat 2.000M. Your have 1.030M of buying power left

Here is the scoop if you make 4% on your 1M instead of 6%. After taxes inflation and WR your 1M has 398K of buying power left.

Here is the scenario at 2% return all else the same. 64K of buying power left. Better hurry up and die! You will notice what we did literally was vary the sequence of return. We turned the constant into a variable, with a pretty dramatic result! THIS is what Suze O knows! She intuitively understands there is a variable in there somewhere to worry about. Ignoring the variable is the face of retirement failure. This retirement is levered to at least 2% rate of return to satisfy the assumptions.

Lets say you get a diagnosis where instead of 40K WR you need 52K WR. For example the drug Repatha costs about $1000/mo

You ran out of money a long time ago. Your Repatha bill killed your portfolio off at 23 years. “Varying” the WR is part of SOR.

Here is a 60 year Mustache retirement. Mustache retired at 30 with shockingly simple math so this calculation takes him to 90.

At 6% Mustache still has 1.8M left in the bank at age 90.

At 4% return he better hurry up and die! Sucka is flat out of dough. 2 variables changed in this scenario SOR and longevity and this portfolio is leveraged to a 4% rate of return for success. This is the problem when you create scenarios like the Yield Shield. If your money is coming from yield your are ignoring growth and growth is your protection against inflation. It’s also the the problem with formula like 4 x 25 where you just pull numbers out of thin air and call it good enough. If Mustache gets a bad diagnosis at 55 or 60, with the above 4% plan the guy is screwed.

Skinning Cats and Fleshing Out Disaster Funding.

I have a well documented plan for post retirement risk management, which includes varied accounts, pre-tax, taxable brokerage, and Roth. My plan is to annuitze the pre-tax accounts through RMD after whittling down their present size through Roth conversion to something that won’t force me into higher tax brackets too quickly. It’s a perverse race between taxes and death. My Roth is primarily disaster money, in case of emergency break glass. The Roth is the most valuable money I own since I own it tax free, while the other two are still taxable, as ordinary income in the case of the pre-tax, and as capital gains in the case of the brokerage.

My pre-tax RMD has included a tax discount because a certain percentage of it was funded with post tax money and the government only taxes you once on pre-tax money. As I was working through my taxes it occurred to me there may be a different format for disaster spending, by spending down the pre-tax money first.

This is a picture of a $600K RMD amortized on the government’s schedule over 45 years @ 3% return. The green is the yearly disbursement and blue the remaining portfolio. It occurred to me after the 7.5% “standard write-off deduction” is met, in the case of a medical emergency you could basically extract extra money from the account tax free, never paying taxes once you meet the threshold. This means a 600K @ 3% pretax (mostly bonds) could provide about 8 years of of catastrophic care @ 85K/yr essentially tax free or at a very low rate. That extra 8 years of growth would be tacked onto the Roth and Brokerage. A 1M Roth would be worth 1.5M if it were risked in a portfolio returning 6% for 8 years with no withdrawal.

Let’s say you make 40K/yr on SS of which 85% or 34K is taxable lets say you generate a $50K bill fighting your cancer diagnosis. The 7.5% threshold is $2,550 so you should be able to pull $47K out of your pre-tax account, tax free to pay your medical bills, and leave the Roth to grow and pay your living expense later if you survive. Your married filing jointly tax bill would be less than $1K/yr on $90K of spendable money You can pull 50K/yr from a 3% 600K portfolio for 15 years before the stream runs dry. In the meantime the Roth grows to 2.3M. How do you spell relief? I spell it “well thought plan”.

A nice strategy to have up your sleeve if the time comes.

Yield Shield Schmield

There is a raging little argument going on over at Millennial Revolution. It’s over living off yield vs living off growth. Wanderer loves his “yield shield” and “cash cushion” and Big ERN is a growther through and through and claims living off yield is a mirage. I’m with ERN on the yield argument but I think there is merit to a tweaked cash cushion approach as well. My cushion tweak is to use an efficient frontier tangent portfolio instead of cash, so it grows in growth years efficiently but does it’s job in down years of protecting the portfolio against early SORR. My tweak also is once the tangent is out of money do not refill it just move to start living off the higher risk portfolio.

Here is 30 years of S&P 500 returns starting in 1988, 5.1% plus 2.245% yield for a net reinvested inflation adjusted 7.35% annualized return!

Here is 20 years of S&P starting in 1998 1.7% growth, 1.9% yield for a total of 3.626/yr total return.

here is a 2008 to 2018 look see, 9.366 growth and 2.281% yield for a whopping 10 year reinvested growth of 11.647% Reinvested yield is a supercharger! $1,000,000 at 11.647 becomes OVER $3,000,000 in 10 years. $1,000,000 at 9.366 becomes $2,440,000 in 10 years plus
281K of compounded dividend interest for a net 2,721,000. If you lived off the yield you would have on the average 28K/yr to live on. If you lived off the growth 3M-2.4M = 600K over 10 years = 60K/yr. Both portfolios after 10 years would be 2.4M

In the 20 year case 1M would grow to 2.04M over 20 years @ 3.636. If you lived off the yield you would live on 23,000/yr and the end portfolio value would be 1.18M. If the reinvest guy winds up with a 1.18M portfolio after spending some WR he could could live on 43K/yr. Both portfolio’s after 20 years are worth 1.18M . If the reinvest guy lived on 23K/yr he would have a portfolio worth 1.38M , 200 grand more than the yield living dude.

It is what it is. Reinvesting the yield is like a dollar cost averaging a yearly cash infusion. The good thing about yield is it tends to be non correlated with S&P growth, so you DCA pretty much the same amount each year whether the S&P is high or low, so some years you buy low, some high but you’re always buying and allowing that dividend money to be exposed to growth. On really good years your growth on the dividend way out performs your WR so only some % of the dividend is extracted and the rest just continues to grow, and grow and grow. In the down year you would prefer not to sell so have some low risk tangent frontier portfolio around to sell instead. I once was enamored with dividend stock scenarios till I did the math. You can goose yourself into using “high dividend stocks” but those can be dangerous and tend to be in concentrated sectors. GE paid a good yield till it didn’t. In the meantime it lost nearly ALL of it’s value. A yield shield doesn’t shield anything of the company goes into negative growth.

I’m with Big ERN except I include the ability to use tangent funds on years the market is down (YTD less than zero) to live on, and still reinvest the dividends when the stock price is low. Do that for a few down years especially in the first half of retirement an u gone b a winner!

I Took The Plunge

I’ve been sitting in quite a bit of cash for a year, largely in my brokerage account. I have 3 brokerages all 3 pay bupkus on the money market accounts. I think it how they generate those “free” mutual funds. They shave points off the money market returns to pay for the mutual funds. Individual investors are notorious fo leaving money un-invested and therefore un-risked and all that un-invested money just keeps the light on plus a tidy profit for the brokerage. With the FED taking it’s boot off the banks you can actually get a tiny bit of interest income these days. I considered putting the dough into a CD ladder but CD ladders tie up the money and create taxes. I did put the money in a short term muni bond fund which “should” have paid me a little tax free while waiting to spend down the balance over the next 4 years, but with interest rates backing up the Muni fund went down and I promptly lost 5K so I decided to take the loss and make another plan.

I could ladder a CD for about 3% average yearly return having trounces of the ladder come due across the period in time to pay for hamburgers and taxes, but the non-liquidity about that plan bugged me. It tied up the money in a way that would generate a penalty if I needed some cash fast for some reason. It turns out there is now online banking which pays pretty high interest, compounded daily, perfectly liquid, FDIC insured to 250K. So I decided to stuff that money into a couple high interest savings accounts. The account yields 2.45% annually, compounded daily paid monthly. The interest is taxable, so given my Roth conversion at the 24% bracket for every dollar of interest I make I have to send Sam 24 cents, but keeping 76 cents ain’t such a bad deal seeing as how presently I’m making 0.1%. If I had a CD ladder I would have a similar tax drag.

The logistics were easy. I have my accounts linked so I merely validated the internal and external accounts and started transferring money. Accounting for the transfer was virtually over night but I’m sure setting the account will take a couple days. The savings account does not have checking or any other “features”. It houses money, compounds money and allows transfer in and out. Unlimited transfer, limited transfer out is limited to 6 electronic transfers per period, or by check PRN. I generally transfer twice a year, enough to cover hamburgers and taxes and pay bills through a checking account. Should generate enough over the next 4 years for 3 free trips to Europe or maybe 2 to Asia, after taxes.

Progressive Tax Code




Here is a little graphic representation of the first 4 tax brackets. The taxes you pay are the area under the curve. Blue is 10% 10% ends where Green or 12% starts at about 20K. I extended each graph to show the progression. 12% is from 20K to about 80K so it’s progression ends when Red starts and it’s 3 times bigger than 10%, but it’s slope increases only a little bit. This is the middle class. Red is 22%. It extends to about 160K 80 to 160K is as long as from 0 to 80K but notice the slope virtually doubles. I put a little black piece at the end to give a feeling of what 24% looks like, 24% extends to about 320K or double again from 0 to 160K. A progressively increasing slope up to 37% plus the 3.8% surtax. This is why it pays to Roth convert a big TIRA. The top of the 12% including standard married deductions extends to about 104K/year and every dollar after that is sloped up as the government eats an extra dime from every additional dollar. If you can avoid the green to red transition the tax saving soon enough becomes NON TRIVIAL. You avoid that by cleaning out the TIRA to a point where it takes a long time for RMD to push you past the green to red transition.

It’s interesting to note once past 600K the graph is no longer progressive but becomes linear at a 37% slope plus the sur tax. What that means is if you are pulling 4% WR in ordinary income on 15M dollars you pay the same “tax rate” as someone who is 4% on 30M or 300M.

Toward a Quantitative Understanding of Retirement

I’m going to define retirement as age 65. If you want to call it something else be my guest but that’s my definition. The society is defined around age 65 retirement in terms of social services. The problem with FIRE is there is no definition and you can’t “quantitative” a non definition, you can just blubber about simple math and bullet points. How you get to 65 is your business. How you fund beyond 65 is your business. Understanding the post 65 landscape however greatly informs how to get to 65, so MY analysis starts aimed at the end not aimed at the middle like most FIRE mumbo jumbo. Once you have a clear working model of what happens after 65 then you can start screwing around with the precedents. Included in the model are typical retirement amounts one might acquire by 65 in the upper middle class married brackets. I chose the numbers because they point out places of optimization. Whether and how you optimize is your business. I’m interested in an understanding and not a precise how to guide, but enough detail that you can make choices.

Roth Conversion

My choice is to Roth convert at least some of my TIRA money. There are several cliffs in the tax code as well as progressiveness in the tax code and they are on goingly cliffy and progressive. In addition everybody dies. It’s a known known. When you die is a specific expression of your genetic phenotype and is a known unknown and that introduces the risk of longevity, since you need enough money and a well controlled enough burn rate that your money will out live you. Forget about dying the richest person in the cemetery. Richest, poorest, the point is to die with the security and dignity money buys you and not forced to live a substandard life. This model is about the relationships of portfolio survival not about the fantasy of yacht ownership. Since we have a known unknown you should insure that unknown. Some people buy SPIA which I think is a waste, you wind up paying the insurance company for what you can do yourself. In my analysis the Roth provides that insurance against a high risk and catastrophic situation, as well as some buffer to ongoing unforeseen WR issues as well as some tax relief in the long term and a divorce from the government from control of your retirement accounts, since Roth’s don’t RMD. To own a Roth you have to fund a Roth and funding a Roth can be expensive but there are means to optimize that funding.

I chose a TIRA value at 65 of 1.4M and I analyzed what is the “best” ongoing outcome post conversion. A common maneuver would be to convert to the top of the 24% tax bracket which would virtually eliminate the TIRA. This maximizes future tax relief at the expense of high early cost of conversion. A 340K “top of the 24%” conversion will cost you 65K in taxes per conversion year. A conversion of 250K will cost about 35K so for 90K more conversion you pay nearly twice as much in taxes. In addition income passed 250K for marrieds starts to pile up excess penalties like a 3.8% tax surcharge and double or triple Medicare costs beyond the excessive taxation, it truly is about soak the rich. My conclusion was media via, middle way. For a 1.4M TIRA a plan aimed at 4x 250K conversion was about most efficient in my estimation. You could go to more years but each year has considerable expense on it’s own that needs to be funded. I further analyzed the best conversion time is likely between 65 and 70 because of Medicare eligibility which is likely cheaper than the commercial alternative. You also don’t have to convert equally, so you could convert biggly early and smaller later, but it’s good to convert the most earliest to get the tax free compounding going.

The Cost of Conversion

The cost of conversion is determined by the cost of living plus the excess taxes. The cost of living is not different that non conversion cost of living so if you live on $9000 a month your 4 year cost of living is $432,000 the taxes on 4 years of equal conversion is about 140,000 for a total of $572000. The taxes on the 432,000 cost of living over 4 years for the non converted life, if you are married is 40,000. So in the end your conversion costs an additional 100K in taxes over and above just the cost of living. If you convert 1M, you basically pay a dime in taxes per dollar and you are done with taxes on that money forever. If you convert to the top of the 24% you convert 1.36M and you pay 256,000 for the privileged or a net of 216,000 in extra taxes for an average tax rate of 15 cents on the dollar. You go AH HA I could convert less and save even more! While true the point is to pay the taxes now while living on cash not later when you have other income streams like SS and RMD generating taxes. Also the point is to get at least about 60% out of the TIRA to reduce the RMD and it’s tax burden to a better level. This is how to do the analysis, I’m not telling you what to do. This is what I did. I made a spread sheet to explain conversion. Using 4% growth and 2% to adjust for inflation as the constraints

My conversion is over 4 years starting at 66. The income stream includes Roth conversion investment income and SS income both gross and taxable. I actually chose 245K since I wasn’t 100% sure of my investment income and Roth now has a rule that you can’t re-characterize the contribution, Once contributed you owe those taxes. SS is tax advantaged in that you pay on only 85% of the benefit. SS is also inflation adjusted but I forgot to include that in the example. More on SS to come. You can see at 4% growth there is still a lot of money left in the TIRA even with conversion. My goal is around 500K-600K in the TIRA at the time of age 70 RMD. More in the TIRA generates a bigger tax bill forever, less in the TIRA generates a bigger tax bill sooner (10 cents v 15 cents). Remember this is a concept piece not a how to guide.

This is the schedule of my conversion the numbers are slightly less because my conversion amount was reduced by SS and investment income, but still nearly 1M is in the Roth by age 70 which was the goal. I had about 15K in my Roth to start. From this point the Roth just grows unmolested unless needed. You have a million bucks in the bank just in case. A spare million IS true financial independence.

SS concerns.

My wife worked early in our careers but then became a SAHM and raised my daughters. We home schooled so I assure you she was employed just uncompensated. Given her earning record at age 62 she is eligible for 800/mo and I am eligible for half of her 800 or 400 for a net 1200/mo or about 14K/yr. An extra 14K pays half the tax cost of conversion for a year and that money is tax advantaged so I can use tax advantaged money to pay for conversion and save my cash for other uses. My SS plus her SS at age 70 will generate 55,000/yr of which 46750 is taxable. Max payout for SS is 59000 for a family. So “our” earning record taken as a whole is 93% of max SS. SS is not a trivial benefit especially because of the tax advantage. Depending on your tax bracket SS essentially pays it’s own taxes up to the 15% average tax rate at which point the marginal rate over takes the advantage. People blow off SS in their analysis but what it allows for is a lower WR early in retirement because it replaces some of the WR burden on the portfolio. This is anti-SORR and desirable for portfolio longevity. SS has therefore more subtle utility on the end game than doing the “bent finger” analysis might suggest.

Budget

I’ll include my budget analysis more as an example of how to think about it than suggestive. When I retired I wasn’t sure what to expect. I read all the dope on “being happy” money and the “80% rule” and bla bla bla. None of it means anything. Your budget has a lower limit and it’s not the same lower limit as your W2 budget. It’s not the same because the W2 budget has part of the actual cost of living subsidized by your employer in the form of benefits. This is not a trivial benefit. It includes insurances, paid vacation, fees, sick days etc as well as retirement benefits and management of your life in terms of filing taxes. Your 100K in W2 terms may be 125K or more in terms of the risk that is paid for. When you quit all that extra risk befalls you. In addition W2 tends to give one a sensation of having “time”. Need a new roof? You got some “time” to cover that with the W2 and shuttle some dough toward the roof. Need a new roof when retired? Get out the check book and you better do it pronto because ignoring it only costs more. I just mention that since while you have the W2 you have some luxury to save up for the know known one off expenses like a roof or A/C or car etc.

In my case I had all of my early retirement “one offs” planned for in a separate account. I settled on 10K/mo as my “target”, did my planning around that and initially it worked out to be a rational choice. After 1 1/2 years 9K is what it averages out to be. That 9K covers all the additional risk of living beside the bottom line cost. I left the estimate at 10K and use that extra 12K/yr as pin money for splurges. The extra 12K pretty much means I never have to say no or feel constrained. I retired with 2 kids in college. One is launching, the other still has 2 years but #1 may go to grad school, such is life. If I need more I’m adequately funded but I like having a plan to use as a governor. In my working life I never budgeted. Once retired I strictly budgeted till I understood the moving parts using Mint. Now I check Mint twice a month and export the month data into a spreadsheet for further analysis.

The Post RMD Plan

Given that I now understand quantitatively and relatively precisely my actual needs and cash flow, I wrote a spread sheet which incorporates the plan including RMD, SS income, investment income, and taxes. By mapping out the plan year by year I get a precise and predictable picture. Notice the analysis has not thus far even engaged “net worth”, only “net need” and “net available cash flow” namely SS, investment income, RMD and self insurance. This analysis is a quantified picture of my future with contingencies in built, not shockingly stupid math.

This is not my exact plan but close. At age 70 SS provides 55K/yr and RMD provides 25,547 of income. I just set investment income as a constant 25K because it’s there but unknowable, a known unknown but over the past decade that’s proven to be a reasonable estimate so it’s better than a guess. You can read through the columns and see what I anticipate including what I anticipate my tax load to be. If the laws change I merely redo the estimated taxes. The RED part is what happens when I die. My wife is younger and her family is long lived. In my family all the men are dead by 80. I could last longer than that but who knows? If I last longer I’ll make a new projection, in the mean time the Roth continues to grow unmolested so I have back up. When I die she goes from married jointly with 2 deductions to less SS (she will take the survivor benefit when I die) and she will have a dramatically larger tax percentage. So the inflation adjusted gross income of 137843 drops to 103069 a 34775 loss in income but the taxes effectively go up a bit. The average tax rate increases at 80 from 19.7% to 37.2% at age 81. So mama is paying more taxes on less income! This needs to be planned for. In addition there is another income drop when SS is scheduled to be cut 25% in 2034. This is another 9825 hit to mama’s income and also needs to be planned for, else mama goes from living a comfortable life style to having to make moves to reduce expenses because you followed some dumb assed simple math and a few bullet points.

The plan of course is to have enough! Now we get to the portfolio aspect

This is a schedule of what it costs to generate 9000/mo inflation adjusted, given the proceeding RMD SS investment income and taxes burden. In this plan mama still get’s her inflation adjusted 9K/mo. I didn’t run this out 30 years since that’s your job. After tax income is compared to inflation adjusted spending and a deficit signal is generated. The deficit IS the portfolio WR. In this example SS is treated as an annuity, RMD is likewise treated as annuity. In my case I reinvest my investment income yearly. That dollar cost averages money into the portfolio yearly and I (or mama) extracts money late after it’s had time to compound. Notice the deficit is small for the first decade. Maybe 18K. If my investment income is 25K that’s a net positive dollar cost average of 7K into the portfolio. At my death the WR changes dramatically, but by then the size of the portfolio has grown also. The changes also include the 2034 cut to SS. Not to worry however! The burn rate is mostly covered by the post tax portfolio but note it’s starting to decline, which is fine. Mama is now 80 and there is plenty of money left in the portfolio. At her age 80 the TIRA still has 450K left in the account. I set the TIRA to a conservative 3% which pretty well assures its longevity as an annuity and controls the tax bite. RMD is considered separately therefore from WR. If absolutely necessary you can extract more than RMD from the TIRA whenever you want. RMD is required minimum. The taxable continues to provide hamburgers and is the real source of WR since that deficit is what you need to withdraw. How foreign to the usual boggle head boiler plate an actual variable WR FREAK OUT! If you need some money look at what’s sitting next to post tax money why it’s old Mr Roth! Mr Roth is there in case mama starts to run short or has the big whammy like a cancer diagnosis or something.

HOW MUCH?

The point of all this is to consider how much you need. At age 65 in this scenario you need 1M post tax, you need 1.4M TIRA, you need about 600K in cash to do the conversion. Which is 3M AT 65 for a 30 year retirement taking mama to about 95. Judiciously executed you have well over age 95 money available. I Monte Carlo’d the stuff as best I could and got about a 98% probability of success with these assumptions. What you do to survive prior to age 65 is a separate problem. If you borrow from the 3M portfolio to survive before age 65, it’s like taking out a second mortgage on your house, and the bigger the second mortgage the greater the chance of loss. You can retire at 65 with less than 3M or you can quit and screw up your % max of SS or you can fail to optimize taxes and pay a bunch when you are old. You can “max out your retirement accounts” and then wind up with no post tax account. Tons of alternate futures to play with This in my opinion is the proper way of thinking about FI and RE. When you quit you are taking out a loan on your future. If it’s a big high interest loan the odds are worse than if it’s a cheap small low interest loan. Oh I forgot you’re an investor not a speculator. The boggleheads told you so!

HR Block and the New Tax Code Rocks

I’ve had 49 W2’s over the years or the self employed equivalent. Over that time, once I entered medicine I started using tax accounting software DOS based on a floppy to start my journey. The software was TaxCut, which evolved to Kiplinger and finally was assumed by HR Block. I just stayed with the same package since filling in last years data was automatic and ongoing totals like 8606 post tax money in the IRA was preserved. This turned out to be a boon to me this year since I did my first IRA withdrawals for my Roth conversions. Because of the post tax basis in the IRA, I was able to reduce my taxes paid on the conversion, by 33% in my wife’s case and by 6% in my case. Her IRA’s are now completely converted. Mine are ongoing and my small IRA RMD withdrawal will last decades. The pro-rata rule will mean for every TIRA withdrawal I make I will get a 6% tax break till kingdom come. It’s not really a break as I already paid those taxes once, but it does reduce my AGI from what I will RMD when I’m 70, so my TIRA and my SS will have an ongoing tax adjustment for the better.

The software acting as a track keeper really helped. I kept the shoebox (actually bankers boxes) of old paper and sifted through to pull out the 8606’s from years gone by but some were missed and I completely missed my and my wife’s SEP IRA pro-rata contribution but the software didn’t miss any of it. When I finally got to those screens my pro-rata was filled in and significantly more than what I anticipated aka if found me some free money. The interview process made working through the Roth conversion and 1099-R info a breeze as well. I was kind of dreading that whole process.

The software now allows one to download account data directly from the brokerage server which saved hours and hours of sometimes confusing data entry. 1099-B was not implemented correctly so I had to enter that data by hand but I only had a dozen transactions last year so it only took about half an hour to enter and check. 1009-INT and 1099-DIV import worked fine. All three brokerages I use coughed up the goods but I had to enter the 1099 from my bank by hand. I was not able to get a 1099-INT directly into the program All of this data is also available in downloadable PDF format as well. I opened up the PDF for each account in it’s own browser tab and put that in the left monitor while I entered and massaged data in the right.

The new tax law knocks the hell out of deductions. You can wheedle the deductions all you want but unless your charitable is truly huge and you spent the year generating cancer treatment kinds of medical bills, it’s going to be hard as a retiree to beat the standard deduction. My plan worked perfectly. I underestimated my conversion a little because I wasn’t exactly sure of my revenue and cap gains distributions on my taxable accounts by my assumptions were almost exactly on point. I wrote off the cap gain with some Tax Loss Harvest from a 2018 harvest plus from some previous years. The TLH should hold through all of Roth conversion, keeping the tax bill low till my ordinary income returns to 12% bracket levels when I RMD and take SS. I did overpay my estimated but since I Roth converted late last year and I will be Roth converting in the next week or so for 2019 I decided to shmush the 2 years together applying the excess from 2018 to 2019 to try and avoid any penalties. I was able to dodge the 3.8% surtax by making a smaller conversion and through the pro-rata breaks.

I consider this a dry run since the whole 1099-R thing is new to me, but my tax life has simplified considerably with the incorporation of online data importing, well designed software with good longevity built in, and the whole code being streamlined. The bracket breaks don’t hurt either. I converted well into the 24% bracket but paid under 16% average. I’ll take it! My taxes were about 2 thousand below what I anticipated, nice surprise. some of that will go away next year as a child tax credit for my oldest will evaporate but by March I will have over half of my Roth conversion completed and safely tucked away growing tax free forever. The software double checked and triple checked and forced me to fill in a little missing data like Vanguard’s zip code on the my wife’s 1099-R. About 10 of those typo kind of mistakes to correct plus an analysis of low probability of audit and I was good to go.

I was all happy as I submitted online owing zero dollars and in a couple hours got the notification I was REJECTED! Not my problem but a goofed up form on HR Block’s end and a fix due out by the 22nd. It’s all right, I’ve moved on! Now I’m scheming on what to transfer for 2019. Usually taxes for me was a three day immersion experience, this year more like 3 hours . Now that I know what I’m doing with a pretty much guaranteed standard deduction next year should be more like an hour. The year after that my wife will claim SS and I will claim spousal benefits so I’ll get to learn about that and a few years after that I’ll pull the trigger on my SS and start RMD.

Why Paying Off Your Student Loan Early is Like Buying a BMW.

All you read is how people have paid off their student loans early. They beam with pride at their financial prowess. They write books about it! Dave Ramsey is their god!!! Let’s think about this. You take a student loan for a reason. The reason is to multiply your prospective lifetime income potential. You go to college and you decide to major in biology. You’re not that great at math but OK, and chemistry is hard, and physics fergitaboutit. You come out of college basically qualified to be a bio high school teacher @ 50K/yr or something. Not a bad job, union, benefits, pension after 30 years, you’re 22 that means retirement at 52, summers off. You meet Miss Cathcart who teaches computer coding at the same high school same 50K and terms. You get married and live a great life. Out of that 100K you saved 20K/yr and over 30 years your 60/40 returned 6% on the average and you have 1.6M in the bank and a pension. You retire at 100K/yr the pension pays half and the portfolio pays the other half. You die at 92 40 years in the future having spent 4.2M from your pension/portfolio combination. Your total earnings need for your life therefore (not counting taxes) is 100K x 30 yrs (3M) plus 4.2M or 7.2M. How did you manage such a feat on 100K/yr x 30 yrs? The answer is leverage. Instead of spending money you bought property also known as stocks. The market went up over 30 years and you levered that property a from 20K x 30 yr principal donation (600K) into a 4.2M lifetime bonanza. Such is the power of capitalism and risk (another name for leverage). This future is just how it worked out, it could have gone the other way where a long bad SOR early in the 40 years of retirement and the risk could have eaten part of your 40 year nest egg or killed it altogether.

You have bigger plans. You manage to get into med school with your bio degree signing up for an additional 10 years of schooling, going into debt for 200K . So now you’re 32, 200K in debt but you have a job that pays 300K/yr. 300K however has a lot of extra taxes etc associated (soak the rich) so you really make 225K. During the course of 10 years guy 1 bought a house, has a kid, has been contributing to a college fund. His portfolio is worth 300K and his 15 year house loan is 2/3 paid off.

You have 200K in debt a 225K job no house, no pension, no portfolio, you married a nurse and have a kid but have yet to address college. Dave friggin Ramsey says pay off your loan!! is that wise? Your loan is a known known. It has a term say 10 years, and a payment schedule in 10 years depending on the interest you will pay back 200K plus some interest say 50K for a total of 250K and the payback over each year may be 25K/yr. What is that 25K? It’s the cost of doing business. It’s the cost you pay for multiplying your ability to make 200K/yr instead of 50K per year, but you also lost 10 years of portfolio growth and pension and college funding. What does paying off your debt 5 years early buy you? You will pay a little less interest, you will be 5 years older. You still will not have really started saving enough to catch up with guy 1 or pay for college. You bought too much house, too much car, ’cause you’re a doctor. At 37 can you catch up? At 15 years in guy 1 is just shy of 500K in the portfolio. You now start saving aggressively but you have to aggressively fund college and fund that big damn house as well. If you invest 65K/ yr for 15 years you will almost catch up to guy 1’s portfolio so you are now 52. Wait a minute guy 1 has a pension! That means you need not 1.6M but 3.2M at age 52 to have enough to generate 4.2M you need till you die. Pony up 130K/yr to get even

Instead of putting all your money in the known known of a student loan you would have been far wiser to expose that money you spent paying down the loan early to the long term risk necessary to support you to age 92. The loan is a strictly defined nuisance in terms of your life long risk and any extra money you put into paying that off early is money you do NOT put toward a potential 60 years of growth you could have had. But it’s not even a nuisance since it is the tool you used to buy your way into your career. You would be the first one to criticize someone for buying a depreciating asset like a BMW but a loan is just a depreciating fixed term liability wasting too much assets on that is just as dumb as buying a BMW. OH but I saved 20K in interest!! At 32 you have 60 years left and at 37 you have 55 years left that 20K you “saved” could have become 659K in 60 years instead it became 493K without those extra 5 years of growth. That 20K and the “good feeling” of not being in debt you bought with it at age 32 cost you 150K over the course. Notice what occurred, what drove you. It was a feeling and a narrative somebody sold you. You hate debt!!! you say self righteously! Debt doesn’t hate you, neither dose it love you. It’s a tool. A known known. Something you can completely plan for and optimize relative to the other features of your financial life. It’s leverage, a force multiplier.

When I retired Obama was president and Clinton was running. The government had a program to take out some money from house equity, and as a Navy vet I could extract some big dough from my equity and put it in the market. You had to do it while you had a W2 happening. I considered it and decided against because the economy was doing less than 2%. Too much risk. The economy was a wreck, like a one lung COPDer with cor pulmonale and a peg leg. That guy ain’t climbing any stairs despite what CNN says. The pathology is too obvious to ignore. The program expired and so did my W2. Trump won, I shoulda!

DCA! DCA!

I recently read a post by a so called FIRE investing hot shot. I’m growing increasingly disillusioned with FIRE narratives. In the post a reader asked a question about how to invest something like $100K sitting in the bank in cash. The blogger went into this long explanation about dollar cost averaging over 3 to 6 months, bla, bla, bla! Lets think about that advice in the face of what we actually own when we own a retirement portfolio. The misunderstanding comes from the mistaken belief stock portfolios compound interest. THEY DO NOT! Bond portfolios can be setup to compound interest and there is a class of bonds called zero coupon bonds that automatically do this. You buy a zero coup at a discount and some number of years later the bond pays you what you would have had, had you reinvested the coupon yearly for that number of years. Interest compounding means you take a principle and multiply it by the interest (the coupon) and add that back to the principle so the next year both the principal AND interest get a new dab of interest. This is the actual “magic of compounding”. In fact the magic of compounding is what lead Leonhard Euler to discover the number e. e is an irrational number and is the base of the natural logarithmic system like 10 is the base of the base 10 logarithmic system. If you’ve seen a log equation using the notation ln() instead of log(), ln refers to the log base e. It turns out if you have compounding going on you can divide the interest payment into periods, once a year, twice a year, quarterly etc, and it turns out because of the interest being added back to the principal the more often you add interest the better the investment. Euler studied what happens to the magic if the interest is taken to the limit of continuous compounding. That limit turns out to be a number called e and is about 2.718. You might call e MAX MAGIC! Note in tax law interest is taxed as ordinary income which tends to define it’s asset class. Interest is not converted to cash IT IS CASH. Compounding therefore is not a variable, it is a constant and best compounding is defined by the number e. The money you make compounding is strictly defined by the length of time, the interest rate and the period of payment back into the principal. Interest is covered by 4th grade math. There is a bond market where you can buy and sell bonds but it’s the 4th grade math that sets the value of one bond compared to another, so the bond market is secondary. If you hold a bond to maturity it will pay you exactly what the contract specifies (assuming the bonding agency is still solvent) This is why bonds tend to be lower risk because you own a contract to pay you cash, and your risk is related to failure not variability. Good bonds low risk of failure, bad bonds high risk. Good bonds tend to pay low interest because the risk is small, junk must pay high interest because the risk is high. In addition you get paid a premium for how long your willing to tie up the money. There is more but these features are what is salient.

Stocks on the other hand are not cash, not cash at all. Stocks are property, and a stock’s return is entirely variable and set by a market action. Let’s buy some IBM! We see IBM is $100/share and we decide to buy 1000 shares and pony up $100K. We now own some property! The very next day IBM pays a dividend, enough to purchase another 100 shares because we checked the box “reinvest dividends” so we now own 1100 shares of IBM and on this day after the dust settles IBM goes up to $105 and our 100K investment is worth 115,500 wow! Notice we had something like compounding occur in that the company paid out some money and reinvested that for us by buying more property but the company determined what was paid out, if and when. There was no contractual payout like with a bond. The payout is a variable. In addition the value of our property was set by the market response to the divided. People decided IBM property this week was worth 5 bux more compared to last week, so that entire improvement in value was due to variables and not constant as defined by a contract. This makes owning IBM risky, volatile and variable. The next month IBM gets a 10B lawsuit and the stock drops to $90 You still own 1100 shares but the value is now 99K and you’re under water! HOW CAN THIS SEQUENCE REPRESENT COMPOUNDING? In fact it does not represent compounding. Instead of a linear predictable return, the “return” is all over the map or shall we say all over the risk reward plane. IBM is 2 dimensional, it has a risk and a reward and the risk and reward are set by market speculation and business activity.

This is the key understanding that is missing in the FIRE narrative. What you do when you buy a stock is place some money at risk and hope to God for some return. Underlying that return is the economy, the company and things like rule of law, and a stable currency, and a stable capitalistic society and you make a judgement the reward will be worth the risk. This is why people freeze when investing and why someone ends up with 100K in cash in a bank account. Notice in the above example you were 15K ahead an 1K down in a week, The next month the lawsuit is dismissed and IBM over the next 4 months rises to a steady 136, same 1100 shares of property your 100K is now 150K. Wait a minute your hamburger account is empty and you need some beef! So you sell 10 shares for $1360 and you buy half a steer and freeze it! You now own 1090 shares of IBM up 90 shares from the original 1000 shares, you got a meat locker full of hamburgers, break out the charcoal! 1090 shares are worth 148,240

Note what paid you here. It was not compounding or cash, it was risk. In an equity portfolio you d on’t make the return until you take the risk. In 6 months in this example you were up 50K! Suppose you dollar cost averaged at 20K per month You’d buy 20K of IBM month 1 for 200 shares and get an additional 20 shares from the dividend you own 220 shares and have 22K in stock value and 80K in cash. The next month the stock is 90 and your 20K buys 222 shares so you have 442 shares and the value is 39,780 plus you have 60K in the bank IBM is stable at 136 for the next 3 months of purchase and you buy an additional 441 shares over those 3 months for a total of 883 shares. Month 6 the meat locker is empty and you need to buy some burgers for $1360 bux that’s 10 shares. So at the end of 6 months you have a full meat locker and 873 shares worth 118,728

Wait a minute isn’t dollar cost averaging supposed to pay you??? The FIRE hotshot told me so!!! You only get paid for taking risk. Taking risk is known as buying IBM. If your dough is sitting around in the bank it’s not at risk so you ain’t getting paid! You spent 6 months playing with yourself, pretending to be “smart” because some swinging weenie told you so! When is dollar cost averaging smart? When you invest every month! The whole point is to get the dough at risk ASAP and not sit around accumulating money in the bank. Once you decide on your risk like a 60/40 market risk of 62% just put the damn money in the market at 60/40 ASAP. If you don’t understand these relationships COLD you don’t understand jack. If you’re wasting your time worrying about saving 2bp on your portfolio cost YOU DON’T UNDERSTAND JACK. Sure the sequence could have been written to give the dollar cost average a better outcome but that misses the point that it’s the risk that pays you. Over decades in a rising economy the little piddling around with dollar cost averaging a wad is a waste of time. In a falling economy like Japan post 1990 you’re hosed whether you dollar cost average or not because one of those variables is “the economy” and if the economy is busted DCA doesn’t matter a whit.

If you understand this post you understand 90% of sequence of return risk. Bonds are not correlated with stocks which means even if they don’t make much money, they don’t loose money so they are a ready way to shuttle money into and out of stocks. That’s what the AA sets, the risk and the 2 funds allows for cycling between buy low and sell high. Stocks high? sell a little and stash in bonds do that for a few years since in our economy stocks are down <20% of the time. When stocks crash you re-balance some of that sold high stock money you stored in bonds back into stocks when they are cheap. If you have extra money you add according to the AA and you would buy relatively more bonds when stocks are high with the extra money to also be used to buy stocks when they go low. That’s the juice dollar cost averaging buys you. Recall interest was taxed as ordinary income stocks are taxed as property using capital gains two very different tax treatments for two very different investment classes. If you’re analyzing your stock portfolio by using what is effectively a bond interest calculator you ain’t playing with a full deck. The other thing this post shows is the danger of thinking living off dividends is “safe” Dividends I think provide some diversity but only if reinvested, which then puts that money back at risk by buying more property. Siphoning off the dividend is like siphoning off the risk in an unpredictable way. You want some hamburgers sell some of the portfolio according to the AA if the market is down you will sell more bonds than stocks if up more stocks than bonds. You are always buying low and selling high anyway. This is where my last post really comes into play. If you have a separate small low risk portfolio when stocks go low you can sell from the other portfolio.

It Works

This is the average return for the S&P 500 over the past 20 years and its SOR. It includes 5 down years including the dot com bust, the 2008 recession and 2018. I adjusted the returns by using the % risk of a less risky portfolio namely a 60/40 portfolio. A 60/40 portfolio would expect to be 59% as risky as a 100% S&P portfolio, so I adjusted the returns such that the 1998 28.58% return became an expected 17% in the 60/40 and then generated a SOR for the 20 years risk adjusted. I also took the tangent portfolio which is a 16/84 portfolio and risk adjusted that list of returns. I then generated what each portfolio would return if you started with 1M total and subtracted 4.5%/ yr in both the static 60/40 and low risk/high risk portfolios. This portfolio has a bad early SOR of 3 years in years 3,4,and 5, the dot com bust years. Over 20 years the 1M portfolio delivered 945K total return into my bank account.

I then generated 2 portfolios one with $135K (3 years WR) and generated returns for 20 years in a 16/84 portfolio (low risk). In down years I subtracted the 4.5% WR from the low risk account, and subtracted nothing from the high risk account. In up years I subtracted the 4.5% from the high risk account. The high risk 60/40 account started with 865,000 and the low risk 135,000 for the same 1M start. I extracted the same $945,000 from each account over 20 years. At the end starting with 1M the 60/40 account had generated a total 1,772,226. The dynamic low/high account generated 1,793,801 or an additional 21,500. The low risk account flamed out in 2008. It provided funding for the entire dot com bust plus some for the 2008 recession before all the money was exhausted. The improved rate of return is small but positive and it’s effectively free money generated by the improved non correlated diversity and the efficiency of the tangent portfolio. Note these low/high risk portfolios both reside on the efficient frontier. If you were to compare to a BH3 for example you would generate more free money in the low/high portfolio. It’s not harder than re-balancing a 60/40 to apply the trading rules. It does exactly the opposite of what the “bucket method” does to a portfolio. I might fool with this a little more to see how a higher risk portfolio say 80/20 or 90/10 performs against a low/high with a similar high risk portion.