MD on FI/RE

Oikonomia: Household Management

noun, 

thrifty management; frugality in the expenditure or consumption of money, materials, etc.

an act or means of thrifty saving; a saving:He achieved a small economy by walking to work instead of taking a bus.

the management of the resources of a community, country, etc., especially with a view to its productivity.

the prosperity or earnings of a place:Further inflation would endanger the national economy seriously.

the disposition or regulation of the parts or functions of any organic whole; an organized system or method.

the efficient, sparing, or concise use of something:an economy of effort; an economy of movement.

economy class.Theology.

1. the divine plan for humanity, from creation through redemption to final beatitude.
2. the method of divine administration, as at a particular time or for a particular race.

Obsolete. the management of household affairs.

FIRE is in fact defined by the obsolete definition of economy. All of the books, bogglehead rants, WCI’s Robbin and Collins of the world are subsumed in the normative definition this ONE NOUN. It boils down to frugal or parsimonious expenditure, and the efficient productive use of excess. The more efficient and the more parsimonious the more productive the system becomes. It’s really quite useful to have a one word understanding. Intimately understanding that one word gives you the arrow needed to point at the target and hit the bulls eye.

David over at FIPhysician wrote a provocative article claiming there is no such thing as market risk. With regard to retirement there is some truth to that. If you own a portfolio, what you own is portfolio risk. If your portfolio is 100% passive equities, say VT or VTI you own 100% market risk. Market risk and portfolio risk are identical. If you own 100% 3 month T-bills you own 0% market risk. 3 month T-bills are considered “the risk free asset”. Davids point is you don’t control market risk. The market does what it will.

The Market is a pricing mechanism. In accumulation it converts work into property. You are born with your maximum human capital, the amount of time you have to be productive. You can’t get any more human capital you only spend human capital. You CAN modify the value of your human capital. You can spend some human capital and multiply the value of your human capital through education and experience. You possess less human capital but it’s more valuable and its value is also set by a market. A cardiac surgeon’s human capital is worth more than a nurse practitioners. The parsimony and productivity aka the economy of that is obvious at least in the present market. If a NP’s wages rise and a Surgeon’s wage falls at some point the excess cost of training and practice costs (malpractice etc) will overtake the benefit of being in the workforce an additional 10 years and bearing none of the excess costs. It’s a market driven economy on the value of human capital. Even the cash value of your time is based on a complex analysis of cost and efficiency.

Yea, yea, but what about the damn portfolio! You don’t control market risk but you do control how much risk you own. The market is a pricing mechanism. When you enter the market you convert risk free assets into risky property. Today I added to my BTC position. I took some cash and bought some property. I put the cash “at risk”. BTC is up 3.19% today compared to when I bought so I “made some return” for my trouble. I made some return but what I bought is risk. Given the volatility of BTC I could as easily be down 3% and may be by morning. I don’t own BTC to make money I own BTC to not loose money. It turns out BTC and VTI (the market) are non correlated so it reduces my risk. I also own EDV which is not correlated with BTC and is negatively correlated with VTI. Gold is also not well correlated with any of the other 3. So owning this quartet reduces my risk and the amount of risk I own is all I can control. I don’t control my return. The market controls my return. Owning the quartet does mean I make the same relative return for less risk. This is a parsimonious, frugal and productive use of capital, aka it’s economic, i.e. possess he quality of economy. Here are the correlations

I’ve decided maybe 3 – 3.5% in BTC might be useful, but be very clear BTC is making a bet, but then buying and owning any risk asset is making a bet. 4 x 25 is making a bet.

Back to the portfolio. Retirement portfolio’s have a job. Their job is to pay for your expenses when you quit working. When you quit working you relinquish your remaining human capital. If you retire normally age wise, typically your human capital has all been consumed anyway. Your productivity and efficiency tends to decrease, and you get tired or develop medical issues. The society’s social systems are designed around “normal” retirement. It’s actually a great boom to the younger generation. In times past it was the families job to bear the cost of the elderly parent. In China it’s still the case. Sons are expected to step up and pay. This is why the one child policy generated so many sons in excess of daughters. China does not have SS. No son no old age income. In america we are more communistic we pool the risk and let everybody’s sons and daughters pay for everybody’s parents. This dramatically reduces the families out of pocket expense. If you kvetch about SS you should consider the cost if it wasn’t there. It dramatically reduces your risk. SS therefore reduces your risk to a relatively capped fixed cost while you are accumulating and reduces your risk in retirement because it covers part of your retirement expense. Medicare is there to reduce your cost as well. The “government” aka you pays a discounted amount to cover your parents when they are most likely to get sick. Imagine if it was up to you to cover that expense! At age 65 you don’t have that long to live so the expenses are relatively capped. It’s a societal bet that you run out of breath before the corporate cost of your living becomes uneconomic. Be very glad you pay SS and Medicare you would hate paying full the load as opposed to the discounted pooled load.

In “early” retirement You create a bigger burden on society. You sop paying your fair share and start consuming. You also throw away large chunks of your human capital and productivity. Your “need” will be considerably greater than your cohort who works later so in effect you are stealing some of his productivity and then turn around and call him a dope for not retiring early. If everybody 4 x 25’d it the economy would collapse. So be damn glad and not smug that your neighbor doesn’t retire early and throw away his human capital and productivity. In a low productivity economy, FI becomes AFU.

W hen you buy a portfolio to take over for your job, you need a set amount of money. That’s what 4 x 25 means. In it’s main you save 25 times, and if it was all in inflation adjusted cash aka a risk free asset you could live 25 years. Standard retirement allows you to lever up your 25x principal using risk assets to pay for 30 years of retirement. You expect to gain 5 extra years of retirement for free because you bought the risk. This scheme, and it is a scheme is a bet. It is no less of a bet than BTC is a bet. And just because buckets of digital ink have been consumed extolling it’s safety it’s a bet. The problem with the bet is that it can turn your expected 30 years of money into only 20 years of money. Risk giveth and risk taketh away. All you can control is risk since that is what you buy when you buy risk assets. Buy more risk and maybe you’ll reap bigger return, maybe not. Maybe much smaller return.

David’s article was about mitigating risk over 3 epochs of portfolio life accumulation transition and deflation. Peak risk is the year of retirement. It’s a bet. You retire because you hit your “number” which likely means the market has been going up and your risk has been paying reward. Lets say your FI number is 3M and you retire in 2019 after the longest bull market in history and you own market risk i.e 100% stocks. The market drops the value of your property in half, aka 1.5M. You are no longer FI according to your definition. You presume the market recovers but what if it doesn’t? To stay solvent for say 30 years you have to cut consumption in half. That’s the bet you make with a levered retirement.

If you retire early you get to cut consumption by 2/3 because you have a lot more years to cover. In addition you are far away age wise form “normal” conditions like SS and medicare. Smugness turns to uggness. Therea re means to limit your risk on the journey. Since risk is highest at retirement 10 years before retirement you can sell some risk. Get out of some stocks and get into some bonds. Hold the reduced risk for at least 15 years AFTER retirement slowly ratcheting up over time like a glide path, that’s what David recommends. I’ve seen alternative recommendations of 5 years before and 10 years after retirement. That would constitute 15 years out of a 35 year period or you should reduce risk about 40% of the time. If you’re going to do that you should probably save a bigger pile to start since owning a bigger pile is a means to reduce risk. There are all kinds of variations of risk reducing strategies, peri-retirement, my favorite is the 2 portfolio different risks. One large more risky portfolio to use when times are good, one small low risk portfolio to use when the market drops in half.

It’s all about creating true economy out of granularity. If you think 4 x 25 is safe don’t ever criticize me for buying BTC. I have only a tiny bit at risk.

When I awoke, the dire wolf
Six hundred pounds of sin
Was grinning at my window
All I said was, “Come on in”

Don’t murder me
I beg of you, don’t murder me
Please don’t murder me

Dire Wolf Grateful Dead

My wife and I went to my first local Choose-FI meeting this afternoon in the Orlando area. Nice venue, super friendly and knowledgeable people. Fellow pilgrims on the road. Then out to dinner. Good times! If you have a Choose-FI near you I recommend!

In Sept 2007, I was talking to a friend out California way and she asked me “what about this market” in a “how ’bout them Cubs” kind of way. That question crystallized my trepidation that had been growing over what I saw as a looming debt crisis. I was long the market quietly trying to recover from the dot.com bust and rebuild my portfolio, By 2007 I had a pretty balanced portfolio in things like S&P 500 & S&P 400 and VOO and cash and bonds. I had studied modern portfolio theory and was on board. It was before all the calculators came online so my portfolio was kind of guesstimated but it wasn’t horrible like my portfolio was in 1999. I told my friend I was scared to death. The debt bubble was obvious, and the coming crash was obvious, I just didn’t know how to play that. I had read some books based in the “men are men and the sheep run scared” mentality of never sell and take your lumps, you chicken shit. I see that bravado on display today in the FIRE community. All I can say is whip it out someone gonna cut it off.

Soon enough I had lost my second million dollars in 8 years playing the stand tough game. I recovered the lost million by dollar cost averaging into the market. after selling the debacle in 2000. In 2000 many things actually went to zero or nearly zero. In other words some of my holding never could or would recover. An example is GE. It peaked around 70 I sold at 20 and today it’s 8. So I managed to have some cash left to reinvest. In 2003 we were headed into war with Iraq and the market had bottomed. I asked my self do you bet with or against the US? Being a Navy Vet I decided WITH and plowed 1M into the market at it’s lowest point in 2003. This paid off and due to the credit bubble. I had made back my lost million plus some.

History was about to repeat in 2008. I could see the crisis on the horizon, it was obvious. You can’t own 2 new cars a boat a McMansion on a cabbies salary, default was a comin’. But I still stood pat and lost another million. This time I didn’t have to sell because companies did not go to zero. The fed stepped in and did some fancy footwork and made what should have been a flat out depression into a multi year recession. It took 7 years for the market to reach the 2007 peak. I made back my million plus a lot more because I had some risk management on-board in 2008. By then I was on the efficient frontier so my loss was muted because my risk was managed, and I was made whole in 2011, 2 years earlier than the 2013 recovery of the stock mavens. I was already compounding when they were just getting even, so my period of compounding for this expansion has bee from 2011-2019 not 2013 – 2019. I have 2 years more compounding.

In the mean time I’ve retired. Being retired requires even better risk management because you are not adding more W2 money to the pile anymore. You instead are spending portfolio money to stay alive. I’ve been listening to videos by some damn smart finance people and not one of them is bullish. They are either neutral aka don’t have a clear conviction or they are all the way to 100% we are headed toward OR ARE ALREADY IN a recession. Dalio thinks we are replaying 1929 . 2008 was the once in a lifetime event just as 1929 was the once in a lifetime event of that century. What followed ’29 was ’37. He thinks were are headed to our version of ’37. Every expert I listened to was either about collapsing risk to the long side (reducing equity exposure) or actually getting ready to short equities (increasing risk to the down side).

In 2007 there weren’t really good ways to buy downside risk against credit swaps, at least I didn’t know how to short that, but today there are plenty of short and levered short ETF’s available so you can trade a crash, but I’m not doing that because I have no W2 to take up the slack if I’m wrong.

Neither am I stupid enough to just stand there and take it because I no longer have a W2 as a backup. So what I did was sell some equities at the top of the longest economic expansion in history. In my case I was able to sell tax free since I have tax efficiency built into my portfolio. Given the impending corporate debt crisis and pension debt crisis and the baby boom underfunded retirement picture and the fact the rest of the world is already in recession I bought long bonds. Germany just today issued 30 years with a negative interest rate. World wide banks have PE’s of about 8. US banks are at 12. That difference has to arbitrage and if Germany is issuing negative debt on all their paper all the way to the 30 year Bund, German banks are sunk and can’t rally, meaning US banks must fall. The FED must therefore cut rates or increase QE or both forcing US 30 years lower, so my 30’s will appreciate. If the US goes negative my 30’s will appreciate a lot. I also bought GLD which tends to rally when it hits the fan. Selling stocks reduces my risk. I sold enough to reduce my risk by 12% and with the other moves may see no change or even positive in my return. My other advantage is I’m living off cash so even though I changed the risk profile the portfolio is closed to SORR, I improved my sequence risk with no SORR risk at least till my cash runs out. SS kicks in 2.5 years from now further improving my cash flow.

What did I give up? The market will probably rally some in the short term and become more volatile. I’ll miss out on some of that rally but also more of the volatility. I calculated my loss of return:loss of volatility ratio to be 0.4:1 meaning for every 10 bucks I lose if the market crashes I only lose 4 bucks of return since my return is not strictly dependent on the market but diversified. If the diversity was a good bet I may loose nothing in return as the alternatives (30 yr and GLD) pay off. It’s very non bogglehead approach, to sell some but I did not cash out only managed my AA to a lower risk. I moved to a AA I can afford to hold for the long term which is a bit different than market timing risk on risk off. I own cash but I didn’t add to cash so my portfolio is still risked, just less risked. I have enough money and a short enough retirement horizon and a small enough WR, I can easily afford to live with less risk.

Ray Dalio is a true Maven. He uses a template to analyze his deals and the economy. You make money by buying low selling high and Dalio uses the template to analyze what’s going low or high.

He created a YOUTUBE video explaining the economy as a machine. I came to a similar understanding in my own investing career but not as well thought out as this video. Especially pay attention to the long term credit cycle. It’s been about 90 years since 1929.

In the last post Existential Doc posed the question what to do? I went through how I would analyze it but a more formal presentation might be useful.

What would happen to survivability if the stock market dropped in half permanently? How does AA affect this? Lets start with the good old bogglehead triple fund. The triple is a 80% stocks 20% bonds fund of US stocks Global stocks and total bonds and if you used it as your retirement portfolio for 30 years and a 4% WR the probabilities would look like this:

82% survival for 30 years. I’m going to treat this as an 80/20 portfolio socks to bonds. Let’s say stocks fall in half. A 1M portfolio now becomes 200K in bonds and 400K in stocks so the portfolio is worth 600K and the AA is 67/34. Lets monte carlo that 67/34 portfolio using the same ratios and WR on the 600K principal

43% survive at 40K/yr WR. If you knock the WR down to 28K we are at 82% survival once again. So to survive a 50% equity hair cut using an 80/20 bogglehead at equal levels of survival and a 1M start you’re 40K/yr WR must drop to 28K/yr or a 30% cut. That’s almost 2500/mo. What about a 60/40 Stocks v bonds at 4% WR and 30 year horizon?

Just by changing the AA to 60 /40 and getting rid of foreign survivability goes to 96%. What happens if we loose 50% of the equities? on a 1M portfolio the bonds are 400K and the stocks are 300K, so you immediately start with an extra 100K in the bank compared to the BH3 example. The AA of that 700K is 43/57 stocks v bonds so lets MC that sucker 700K, 40K WR and a 43/57 AA

so a 40K WR on 700K drops survival to 70% What if we re-balance back to 60/40?

74% It helps a little, so let’s keep 60/40 and try reducing WR to 30K/yr

We see a 94% success at 30K/yr nearly the same as the original 96%.

So what does all this mean? It’s how you plan. What do you do if you loose 1/3 of your money? What do you do before you loose your money? We saw what happened to a typical 80/20 portfolio not on the efficient frontier. WE saw what happened to a safer 60/40 portfolio on the efficient frontier, and we saw the survival rates. To get the bogglehead 3 to 92% survival required dropping the WR from 40K/yr to 19K/yr after the disastrous loss.

The other thing that matters is when SS kicks in. If you are close to SS when the disaster hits you are largely immunized. If you are far away from SS because you retired early…

I’ve been watching youtube video and have discovered Raul Pal and Real Vision Finance (Also). He is talking about in a clearer way my concerns. In my opinion he is right on. We are heading into deflation, not growth, not recession. Recession is about the business cycle. It’s a temporary downturn that later reverts to an upturn. In America we expect the down turn 30% of the time and the upturn 70% of the time. As long as that happens we grow. Growth has been spurred by consumption. The FIRE movement turns its nose up at consumption, as if “those people” are lepers the Jones keeper uppers. It’s the Jones keeper uppers that support the business cycle so when you are turning up your nose at these folks you are turning up your nose at economic growth and economic growth is how you expect to pay for your hamburgers in retirement. The Jones are the golden goose.

The boomers are retiring and one thing happens when boomers retire consumption plummets. The reason unemployment is low is boomers are quitting more than the economy is booming. It is the reason we ave low unemployment AND low inflation. People leaving the workforce explains that. People own a ton of equities. Equities are directly tied to consumption, and equities have been leveraged by corporations buying back shares using debt. There is a corporate debt bomb out there of greater impact than the 2008 consumer debt bomb. so expect a huge crash aka a huge reversion to the mean as the leverage gets un-levered. What this means if the market is riding 90% above the mean, when it reverts literally 45% of the dough especially equity dough is going away permanently. You can expect a 45% permanent (or possibly decades long) hair cut on your portfolio. With permanently curtailed consumption the motor that drives growth will no longer pull the train. It’s happened in both Europe and Japan. If it happens here China is also hosed.

I retired normally at 65, so I have less time to live, and I have a pretty large portfolio and a small WR of under 2%. If my assets permanently fall in half my WR only goes to 4% and I have only about 20 years for my portfolio’s survival. I have further reduced my equity risk into other non correlated assets like gold bonds and cash and some BTC so my exposure to the leverage in equities is muted. Imagine if you are 45, heavily invested in equities and retired and have a 45 year horizon and only half the money and still have kids to send through school, or not because no one will be able to afford it. Imagine you’re sitting on a 1M property or a 1M apartment building and can only rent for 1/3 of the break even or sell for 250K. That’s what could happen with permanent deflation. People will dump their homes and move into cars and trailers. This happened in 2008. Excess leverage will eat your lunch. The problem with deflation is it’s near impossible to re-ignite inflation aka growth. This is a graph of the Nikkei, Once 45,000 now hovers around 10,000

Watch this video and consider deeply the consequences. If you are FI, are you still FI with a 50% hair cut? If you are FIRE can you survive twice the time on half the money? I find this guys argument entirely credible.

I’ve been spending some time looking at retirement sites written by people who dream about retiring. There are many ways to get there some more effective than others. Investment vehicles and techniques have changed over time. The Motley Fools are a media organization started by a couple brothers and not that much different from financial blogs today

Back in the 90’s the funds they touted were not index funds. Portfolios were sets of managed funds often that addressed specific sectors like tech based or hot fund managers who were thought to be the golden children of investing. By the time you paid the fees and the loads and transaction costs it was damn hard to make any money. But you could make money publishing “articles” touting fund runners magic powers. It was a common theme in those days and was often driven by advertising. The Fools are all about the media and media sales. They are also into systems like versions of Dogs of the Dow all of this is about “beating the market”.

As a professional stock picker you can beat the market but you have to be a lot closer to the information than some source like the Fools can provide. If you’re not a professional speculator, it’s very unlikely you can beat the market because your competition is deadly. smart and exquisitely informed. The point being buying Fools books and systems is unlikely to make you rich, it just makes them rich.

The boggleehad approach has some advantages. It forces you to right size your life in a way that discourages debt and living in or close to the edge of debt. As a high wage earner living toward the mean gives you the ability to reliably invest excess money every month. The investment vehicle of the bogglehead approach are index funds. The system is designed to pay off over a long time as long as the market over decades continues to go up. Companies in America are well managed and we have good rule of law, a stable currency and some control over inflation so the likelihood of going up more than going down is good, so the likelihood of index funds paying off is good. Your investing return is not dependent on you, it is dependent on the people in the C suites of the corporations making the correct decisions. You are basically along for the ride.

Your return will be AT BEST the market return and If you don’t do it right AT WORST you won’t do very well or may loose money. So what do you need to do? First create a plan based on index funds, the simplest being a US total bond fund and a US total stock fund. The 2 fund approach puts your portfolio on the line of the most efficient portfolios, returning the most return for the least risk. Adding more funds unless done correctly tends to have lower returns for greater risk both undesirable.

The next thing to do is put all the money you want to invest in those funds and add to those every month or even week as you acquire more cash to invest. Do not mess around trying to market time. You don’t make a thing until the money is invested so sneaking up on it merely means you’re making less because you’re not invested. You need to choose an asset allocation, how much of every dollar to put in the bond fund and how much to put in stocks. The more stocks you own the more risk you own, and the more risk you own the worse you do in a downturn. I’ve read papers that say 70/30 or 75/25 over time are most efficient. Higher than that you own too much risk, lower you give up some return. During accumulation I ran my portfolio at 75/25. In retirement I own less risk so I’m about 57/43 including cash.

The next thing is re-balancing. Stocks tend to outperform bonds so the ratio will become unbalanced so once in a while if stocks get heavy sell some and buy some bonds with the proceeds on the way up. It’s a means of selling high and stashing some of that value in bonds. This manages your risk because 75/25 has lower risk than say 80/20 or 85/15. When the crash comes you re-balance the other way you pull some money out of bonds and buy stocks cheap so you are constantly cycling sell high and buy low, mechanically controlled by the asset allocation, which takes human guess work out of the equation. The human brain is not wired to make smart decisions in a crisis unless trained.

The last thing is NEVER SELL. When the crash comes NEVER SELL, just re-balance. When you buy stocks and bonds you are buying property. The more property you own the richer you are, so the whole point is to keep buying property. The value of your property is variable and set by a market. If the market crashes you own the same amount of property it’s just temporarily worth less. Relative to other property owners if you have a lot of property whether the market is low or high the one who owns the most property is always the wealthiest. If you sell low you are giving your property away, stupid move. If the market is down your purchasing power will go farther so buy more property for the same dollars and get even richer. Buy low Sell High is the mantra.

Over decades the price of your property will appreciate and the property you bought first will appreciate the most so buy soon and often. If you are 30 and you die at 90 your property has 60 years to grow, and with a bogglehead approach it’s those 60 years that pay the rent since the best you can expect is market return. With this approach YOU CAN”T BEAT THE MARKET so don’t even try. You’ll only goof it up, with hair brained schemes so sit back tend to the knitting of property purchase and enjoy the ride. I’m a fan of investing in 3 types of accounts Brokerage. Roth and IRA like accounts all the numbered accounts) and maybe HSA if its available but don’t overdo the HSA. (I think a big HSA is a likely target for means testing)

The reason to own 3 accounts is when you go to spend down in retirement the government has some tax surprises in store for you and owning 3 account types improves your ability to tax plan in retirement because the 3 types are treated differently when it comes to taxes. I’m not a fan of retirement formulas like 4×25 or 3 x 33. There is no reason not to sit down and plan a yearly retirement budget with some granularity. You are surrounded by old people, patients and relatives so use their experiences to inform you about likelihoods. You need to plan for expenses but also disaster and end of life and if you’re married 2 disasters and 2 ends of life. Disaster would include things like a CA diagnosis Alzheimer 24/7 memory care for 15 years, stroke, high inflation, bad sequence of return on investments and the increased tax burden of the surviving spouse when one spouse dies. None of that is considered by the typical bogglehead, but rest assure that train is coming down your track and when you’re 80 it’s too late to do anything about it. It’s only 50 lines on a spreadsheet to plan 50 years. I have my retirement planned and 25 years will cost 2.7M inflation adjusted in basic living expense. I have quite a bit more than that available for living expense and a spare million tucked away in a Roth which doesn’t get touched as a disaster fund that grows unmolested. Million bucks growing at 7% buys a lot of inflation protection, bad SOR or end of life care (given the inflation rate of healthcare and the likelihood of the government turning medicine into the one size fits all of the VA). I don’t need any side gigs or excessive leverage because my plan covers all the bases. Since I have a plan beyond something like 4 x 25 I have something specific to track and can readily make adjustments based on the economy.

My point is the part that is often missed is the follow through, the spend down part. It just gets assigned a number pretty much out of thin air. You can fart around trying to beat the market, I bought BTC at $275, it paid off pretty good, it’s property so I never sold it, but that’s pure speculation not investing. It’s not the kind of thing you need to retire on. The Motley Fools are in fact jokers when it comes to building a sustainable money machine.

There were a couple videos posted in the PoF Facebook group which I found very illuminating, They were the tail of 3 brothers each of who retired 3 years apart 1997, 2000, 2003. The videos look at the SOR results, The discussion is by professional money managers and discusses management techniques to avoid failure.

Here is the first video with Mark Cortazzo and Mary Beth Franklin. Cortazzo is one of those dreaded AUM managers, see if his advice sounds dreaded to you! Franklin made her mark as a Social Security expert, who knows how to make SS give up every last dime using various claiming strategies.

In the second video Cortazzo reviews the fate of the brothers in 2018. If you watch video 1 do not miss video 2. It validates all of my mumbo jumbo about risk management.

If you were Mr Retire in 2000 would your plan have had the chops to survive?

Expectancy theory

Description

Expectancy theory proposes that an individual will behave or act in a certain way because they are motivated to select a specific behavior over others due to what they expect the result of that selected behavior will be. Wikipedia

Expectancy is odds making. The human is very keen on odds making. The human brain is sub-cortically wired toward risk avoidance. It is a survival mechanism and it happens without thought, but can be affected by memory and other cortical and subcortical structures. The site of risk analysis seems the Cingulate cortex. It sits next to the center of memory, the Hippocmpus. Other sites are involved like prefrontal cortex but the point is risk aversion happens automatically below the level of thought.

Risk aversion is wired in the human at a level of 4:1 biased in favor of aversion. Given a situation you are 4 time as likely to chose the risk averse outcome. Risk aversion can be modified towards more risk by other sub cortical structures, and is part of the reason an otherwise responsible adult becomes addicted to cocaine, or someone pays 10 grand to go on a Sandel’s vacation to have the time of your life.

So what’s this got to do with expectancy? Humans given rational choices can modify the risk adverse behavior bias towards something more likely to succeed if presented with the right data. The reason people sell in a panic is because of 4:1. If you’re presented with “the data” you close your eyes and hang on. There is a whole huge Social Psychological literature devoted to this kind of game analysis.

David Graham MD wrote recent articles HERE and HERE that looks at the expectancy of keeping or quitting disability insurance at various points in portfolio accumulation. The bet is what is the likelihood of becoming disabled vs what is the cost of insurance with the presumption of “financial independence” (whatever that means) . He uses statistics to game out the statistics of cost vs benefit for keeping vs quitting. The analysis is specific but also global in how to think about risk analysis. I highly recommend the articles. A major conclusion is do not base your decision on sunk cost, the money history of what you have paid. Base your conclusion on the future cost vs the probability of need and the amount of payback.

Part of David’s discussion presumes “financial independence” but as we all know FI is a slippery number. It can be whatever you want to call it up to the very day you retire. When you retire is when the rubber meets the road. The dice will be cast and your future will unfold from there. It’s no more a “slippery” number, it is nailed down and there is no W2 to cover your risk.

My tact will be to look at the outcome on portfolio longevity if you are forced to “retire early” perhaps earlier than you intended with a presumption of “financial independence” People tend to believe they are FI and therefore bullet proof (FU Money) without actually doing the analysis. So I’m going to game out an analysis and see what disability insurance really is, it is not disability insurance at all, it is portfolio protection insurance. Sometimes when you FU you are the one who gets F’d. Earlier retirement (greater portfolio longevity) and early SORR are killers to future wealth and success in retirement. So let’s add a little earlier retirement and SORR to the analysis.

I’m going to use a BH3 portfolio, a common portfolio used by accumulators. I’m going to use 4% WR a common WR used by the presumed FI crowd and I’m going to vary the nest egg size based on a retirement earlier than expected, and I’m going to include medical expenses since permanent disability often includes considerable medical expense and the expense occurs up front. That is the actual scenario of someone forced to go out on disability say 5 years early or 10 years early and tap their FU money before expected. I’ll use Monte Carlo to do the statistical analysis. Follow along with the narrative!

Scenario 1 Drop the disability and save 6K/yr

We have a 60 yo WM Physician in good health who expects to retire at age 65. At 65 he expects to have 2.5M in the bank in a BH3 portfolio and he intends to spend 100K/yr in retirement, the typical 4 x 25 and claim SS at FRA. That’s his plan. He goes skiing the back country of Telluride and destroys is right leg and hip to the extent he will require extensive and multiple surgeries and rehab. He is forced to retire but he let his disability insurance lapse because he believes he has “FU money”. He read it on a blog.

Since he expects 2.5M at 65 he has 1.6M in his portfolio now, and adds 65K/YR which will equal 2.5M at 65, so he’s not really Fat FI but thinks of himself as FI. He is expecting Medicare to pick up his health care risk, and he could claim SS at 65 as a backup plan. He is forced to retire early which means his portfolio must cover a longer period. His portion of the out of pocket medical expense in the first year is 100K and 50K the second year and he has an ongoing 25K/yr ACA plan plus a 10K deductible each year.

I’m going to model the upfront cost as a bad initial SORR for 2 years on the portfolio since that is what the medical cost represents bad SORR and I’m going to keep his 100K living expense outlay constant to start (6.25% WR).

YIKES no scenario survives unscathed. Even at 90% best return, 80% of the money is gone at 35 years.

Lets readjust to 4% of 1.6m. He now lives on 64k/yr (a 36%reduction in life style) and can just qualify for ACA subsidy.

Only 57% of the portfolios last 35 years and remember the ACA, he barely meets the subsidy.

He decides to take SS at 62. His SS at FRA is 35K. His age 62 SS is 80% of FRA SS, or 28K /yr. We add 28K + 64K he now makes 92K/yr but he is still running out of money before he reaches 33 more years, 43% of the time! So he further reduces his WR to 55K/yr

He barely makes 30 years on 55K/yr WR in the worst case. If you include SS plus his 55K retirement income at age 62 he lives on 55K +28K or 83K/yr. His portfolio has a 90% chance of survival. Not a terrible life but he’s not swimming in the dough either. It’s definitely a downgraded future but he does have a future. He still has the ACA insurance costs to pay from his 83K, until medicare kicks in. So much for FU money.

Scenario 2 Disability intact

Our skier has a 10K/mo policy which kicks in till 65. So he will receive 600K tax free over the next 5 years. He still starts with 1.6M in the bank and the 100K and 50K year 1 and 2 medical expense and the ACA cost of 25K and 10K deductible. He scales his living expense back to 80K/yr (a 20% reduction in life style). His first year cost is 100K + 25K + 80K = 205K. His income is 120K from insurance so he has to tap his nest egg for 85K. His nest egg remains constant at 1,600,000 that year despite the 85K tap. Not advancing, but holding even despite the bad SOR (medical expense)

The next year he has a 50K medical expense so his cost is 50K + 25K + 80K= 155K and his income is 120K so he needs to tap his retirement for 35K and his nest egg grows to 1,672,000 in the second year. The next 3 years his medical expense plummets but he is left disabled and continues to receive 120K tax free. He stays at 80K/yr living expense plus 25K ACA but his medical expense is way down so his cost of living is 105K and he puts the extra 15K in his portfolio to grow, because he knows the gravy train is going to end and he is now acutely aware of whatit means to own your own risk and not offload it on an employer or insurance company.

At 65 his portfolio is worth 2M. He retires at 65 on 2M and takes medicare which drops his medical expense to 260/mo or 3120/yr. He continues to live on 4% of 2M or 80K/yr for 2 more years until FRA. At FRA (67) he takes his 35K/yr SS, so his income becomes 115K/yr. He adjusts his living to 100,000/yr of which 35000 is SS so his portfolio WR drops to 65K/yr or 3.25%. His portfolio Monte Carlo’s to:

His portfolio success is now 96%. He lives on his anticipated 100K/yr. He no longer skis. He walks with a cane, but his brain is intact. He writes a financial blog about what it means to be FI. He can reach in his accounts and snatch out 25K for his daughters wedding and he will hobble her down the aisle. His disability costs was $6000/yr. As you can see his disability insurance was really portfolio insurance because it protected his portfolio. It is true he may never have injured himself and wasted an extra 30K on unused insurance. That means he would have wasted an extra 30K to protect the portfolio’s growth to 65. That unused 30K would have guaranteed the extra 500K at full retirement. (2M vs 2.5M)

You can draw your own conclusions regarding FU money and the value of disability to protect your portfolio. Your subcortical structures have already analyzed the reality and the 4:1 risk management bias is kicking in. Do not under estimate your vulnerability with your heady belief in your invincibility. The numbers will humble you in a heart beat.

Disability Insurance in this case is like owning a 5 year alternative 600K portfolio at the cost of 6K/yr. It protects the main portfolio when the main portfolio is at it’s most vulnerable. Portfolios take a long time to disintegrate, typically decades and a wrong move early, like thinking you are more financially independent than you really are, can be devastating despite all the blogoland noise about the joy and power of being FI. The Disability Insurance protected against SORR, for this is also a study of SORR and it’s dangers. The DI also re-indexes the main portfolio to a more sustainable state before withdrawal begins in earnest. The portfolio begins to be emptied at 65 instead of 60 except for a little dab up front for medical expense. In effect the DI is the equivalent to my “fuse portfolio”I’ve written about before. an extra $17,000/yr (1500/mo) makes a lot of difference in the relative luxury of a given retirement.

This post still looks at expectancy. It compares 2 scenarios and the cost of each scenario and the payout of each scenario statically using a Monte Carlo engine. The thing about retirement is it lasts a long time and the effects needs to be analyzed to the end not just to the middle.

The end of July effectively marks my the completion of my second year of retirement. I retired having some idea of where I was going but no finely thought out plan. I knew the size of my portfolio, the risk of my portfolio, the expected reward. I really didn’t know my cost of living, so I started with an assumption of 10K/mo, about half of what my portfolio supposedly would support. It was a pretty good estimate but actually a little generous. My actual spending came in at about 9K/mo on the average.

I devised a method using Mint to accurately track my expenses. I also stress tested my budget to find out what tightening my belt actually felt like. Armed with real budget data and real variability data, I could then project what my need would be in full retirement. I look at my retirement in terms of epochs. Each epoch has it’s job to fulfill in my financial life. Prior to retirement was accumulation split into 2 sub epochs pretax savings and brokerage account savings. I maxed out my pretax to about age 50 and then realized what I was doing was maxing out my tax bill in old age. I had a brokerage and began aggressively funding the brokerage. I knew I had to move some money from TIRA to Roth to save myself from progressive taxation and living off brokerage money turned into cash was just he ticket. I also was fortunate to Tax Loss Harvest which helped my tax bill come Roth conversion time.

Epoch 2 was to retire. I completed my last SS payments, rustled up some health insurance, I was on Medicare the family on Liberty Healthshare, and said goodbye to my medical career. Epoch 3 was to map out a plan for Roth conversion, with the goal of converting the most TIRA at the least taxes. Epoch 4 was coming to understand how to optimize my portfolio. As I worked through the Roth conversions. I came to see partial Roth conversion was a more efficient model. In this epoch I subdivided my portfolio according to what I expected from each account type in retirement. I owned Brokerage, TIRA, Roth, Cash, Tax Loss Harvest and at age 70 I will claim SS. Each of these had their own tax treatment so I optimized along tax guidelines to minimize taxes as time passes in epoch 4 and this will further extend to epochs 5 and 6.

The brokerage mixed with tax loss harvest is the source of cash to live on while Roth converting and the money to pay the taxes of conversion. The TIRA provides funds to convert into the Roth. I discovered that leaving myself a small TIRA (500K) was most efficient. The small TIRA will contain money in stocks and bonds in a 20/80 ratio, which will have slow steady and controlled growth. I will let it go to RMD and the TIRA will act like an inflation adjusted annuity, throwing off a couple K/mo basically forever (at least till I’m dead and my wife is dead). My second source of income will be SS, first my wife will claim, then I will claim we will use it together and then upon my death she will claim survivor benefits. Topping of my income will be a little from the brokerage about a 2% WR or less. This setup will keep me in the 12% bracket for 15-20 years. The Roth provides insurance. It will remain closed to grow unmolested until there is an emergency. In an emergency it will fund the emergency without decimating the rest of the portfolio. Each account has it’s job protecting my future.

I analyzed how much I was going to need to live for the 20 years post full retirement using an inflation adjusted amount from my budget, which should be a fairly true estimate and it’s 2.7M inflation adjusted over 20 years. This is an important step because it ties need to reality in epoch 5. I have more than 2.7M so I have no need to over risk my portfolio. Less risk means a better chance of success. Living out those 20 years is epoch 5.

Epoch 6 happens when I die leaving my wife to fend for herself. When a spouse dies taxes can go up 2 brackets in addition to a loss of 1 deduction and part of SS income. Here is an instance where one might open the Roth. Also in the case of chronic debilitating disease the Roth serves it’s purpose as a money source. It took the better part of 2 years to make and implement this plan. This plan has a 99% chance of success despite its moving parts

Otherwise my life is full. My children fare well, my wife and I are closer than ever. I was dealt a little medical set back but am getting along in my recovery. My time is my own and there are a billion interesting things to do, including getting 8 hours sleep per day. The plan is unfolding precisely as planned. I picked a good time to retire. The economy is up as is my portfolio. The county is stable despite the news media’s insistence we are blowing up. I’m enjoying opining on his blog and others… I wouldn’t go back to work on a bet! Once optimized there’s nothing left to do but live a good life. Despite all my missives, hi jinx, conversions, tax payments and 2 years of spend down, I have more today than when I retired.

Life’s been good to me so far! We’ll see what the next year holds.