Financial Planning

I remember in first year med school I was studying the extrinsic and intrinsic pathways of clotting. The pathways first year are taught as part of cascade reactions in the biochemistry course. I decided to learn a little more so I checked out a 2500 page 20 pound text book on Hematology from the reference desk at the library. The book was so dense it took me half an hour just to find the cascades. Once I did I found there was a lot more to know. It was that experience that taught me the level of knowledge I was up against.

Medical school was about learning 10 things, and you were tested on those 10 things. The “neurosurgeons to be” learned their 10 things perfectly. Some others learned less completely, we all learned enough, but here in my hands was a book that contained nearly all there was to know about Hematology at the time of its publication. My 10 things weren’t even in the index. You learn more than 10 things as you progress and more than thousands of thing as you pass through residency to become attending, It starts with 10 but hardly ends there.

I’ve been thinking about CD’s retort that I’m the Socratic Gadfly of FIRE. It is true, but why is it true? Why don’t I just accept the MMM boiler plate? Why do I think that FIRE movie is propaganda? Why when I read misuse of the Pareto principal does it raise my ire? Why do I care? The essential reason I care is people are basing their futures on what is written. They are basing their futures on learning 10 things. In medicine you learn 10 things, then move onto the clinics and those 10 things are fleshed out into the blood sweat and tears of sick people. If you pay attention the 10 things become more than the cliff notes.

I had a pt once the first day of 4th year on the cancer service at the VA, who came in with extremis. It was the day I learned some people come to the hospital to die. It was also the day I met my wife in a bar as I considered what had happened. The patient came incoherent. I spent a couple hours trying to get an IV in him. I would get into a vein, but no flash. I could advance the catheter but no return and eventually the catheter would “blow”. I would pull out the cath and then it would bleed profusely. I thought WTF? and deduced the PT was in DIC. This was the expression of the cascades in reality. During the course he threw a clot or a wad of cancer from a leg vein to saddle in the pulmonary artery and died. The guy was riddled with metastatic CA and the 4th year resident showed up and cancelled the code. In reality there was nothing to do but that didn’t quench my feeling of inadequacy that I somehow let this guy down. The 4th year knew more than 10 things, way more.

It’s this kind of thing I see in the FIRE movement. I see a lot of people who know their 10 things, but knowing 10 things is woeful. There is a whole 2500 pages to know. I see people spouting those 10 things as if that’s all there is. It’s like a blind man exploring an alligator, not big deal till you find the mouth.

There is a kind of scholastic philosophy called essentialism. It is basically classical education, where you learn rhetoric, English, languages, math history, sciences, philosophy, religion. In studying that body of thought a societal cohesion is formed, and a kind of brotherhood of belonging in a way tat fixes you in space. It’s the education I gave to my children. It’s not just 10 things but it’s the 10 essential things that underpin the truth of shared human experience.

FIRE doesn’t have that. It has no truth. It has millions of opinions expressed for millions of reasons, promoting millions of narratives and agendas. It promotes a mechanism of using index funds to risk money in some simplistic formula, but in the end nobody believes that. It could have truth if it was broken down to the essentials, but as long as it’s every man for himself it does not constitute a body of knowledge. It’s a collection of half truths showcased as the truth, and then marketed as the truth. People are hanging their futures on marketed half truths, while the marketeers clean up. I find that disturbing.

There is a fallacy called the planning fallacy which basically states any plan takes longer to complete than planned. Plans are projection and projections don’t lead necessarily to reality. I break FIR down to 2 parts accumulation and retirement, very different beasts requiring very different plans. Refer to the planning fallacy when considering each

Attaining FI is certainly possible but RE doesn’t necessarily follow. Knowledge of 10 things is not enough knowledge to retire. FI may not actually be FI once you take risk into account. MMM became super frugal, made 1M and retired at 30 on 27K/yr aka WR = 2.7% a far cry from 4%. That plan at 60/40 AA has a good 98.68 chance of lasting 60 years, but what about health care inflation? You move to the alpo diet and hope you don’t wreck and fracture a hip on that bike in the Colorado snow. I guess we missed essential “thing” 11 and 12, yet they are glaringly obvious. It’s 98.68 with the caveat: if nothing goes wrong. What could possibly go wrong?

I guess part of my skepticism comes from not knowing about FIRE narratives in accumulation and reaching retirement financially independent by separate means. First time I heard about FIRE was a year after I quit, so FIRE didn’t bring me to the dance. I didn’t know the 10 things, so I had to manufacture essential things to get here. The MMM narrative is not my narrative and I find it remarkably shallow and self serving, so I don’t buy the soap, sometimes I wish I could.

My goal is not to rain on the FIRE parade but to think about that cliff outside in the cold distance.

No reason to get excited
The thief he kindly spoke
There are many here among us
Who feel that life is but a joke
But you and I, we’ve been through that
And this is not our fate
So let us not talk falsely now
The hour is getting late

Outside in the distance
A wildcat did growl
Two riders were approaching
The wind began to howl

Pareto Principal Malarkey

I read a blog post today abut the topic of how much you need to save. It was a Pareto principal analysis, 20% of the dope gets you 80% of the results. The analysis was a typical FIRE blog analysis which starts at year one (say 30) and ends at year retirement (say 45) and uses the hokey 25 x, or an even safer 30 x. It was 100K/yr and it was decided 2.5M or a safer 3M was enough to get the job done.

Here is the analysis of 3M @ 3% inflation and 5% return a 45 year retirement

A 45 year retirement will cost 9.27M. In this analysis the portfolio fails in year 44 (age 90). The analysis does not include SS with SS it would likely not fail. Let’s see:

This is a guesstimate of SS taken at age 70 and inflation adjusted to age 90, SS=1.1M So you’d wind up with about 700K in the bank at 90.

This is what is wrong with Pareto. This analysis took 10 minutes with explicitly defined assumptions and results. If you Pareto it you end up broke if you work through it you are far clearer in your understanding.

Would you be temped to quit @ age 45 with 2.5M in the bank? Remember this does not account for end of life issues, increasing taxes (note the last year you are in the 32% bracket) or SORR. 2.5M is dicey

Even with SS the portfolio fails in year 35 (age 80). 100,000K x 25 = 2.5M to start. This is why I think it is necessary to plan not from the year of retirement but from the year of presumed death. You can also see the effect of working more years on portfolio longevity and the effect of everything like SS.

Here is a 35 year retirement 2.5M @ 5% and 3% inflation, beginning at age 55 and ending at 90. Notice how the portfolio still fails at age 88 but the longer SS leaves you with 900K in the bank

Would you quit @ 55 with 2.5M in the bank? I’ll leave the consideration up to you but clearly making 25x last 35 years much less 45 years without the safety of SS is nuts. I must admit Pareto got you 80% there BUT 80% WASN’T A GOOD ENOUGH ANALYSIS.

Stochastic Portfolios

In my guest article at ERN, Karsten compared some of my data to his WR spreadsheet. The numbers are very different from my FIREcalc comparison to Monte Carlo in a good way. I think the Sharpe’s adjustment helps. I thought about what Sharpe’s really is and I concluded it’s a risk modifier. If your portfolio has some long term risk, the Sharpe’s modifies that risk because it’s magnified for the period of time when Sharpe’s is high and relaxed when Sharpe’s is low. It’s a very clever cheap and dirty modification that I think improves WR predictability. Cheap and dirty because Sharpe’s is free for the using.

In thinking about this I decided there is a well known physical equivalent. In the general chemistry analysis of solutions, every solution has it’s own equilibrium constant the caveat is “for weak solutions”. To get a more complete picture of solutions there is an alternative P-Chem analysis that involves multipliers. This means P-Chem analysis of solutions turns from a kind of linear analysis A + B = AB to a non linear second order process xA + yB = zAB and the coefficients are determined in various ways. The xyz are called activity constants and are variable depending on certain defined properties for a given solution.

What this means physically is chemicals don’t act with 1:1 correspondence but in concentrated solutions act as clumps of molecules and the molecules clump because of the way molecules act locally in solution. The stochastic looks at macro solution behavior, but the activity looks at deviation of solution behavior from the predicted stochastic. The idea is to develop a model that actually predicts how a solution will behave.

I think Karsten’s modification is like this, and it uses the “clumping” of excessive local risk in times of high Sharpe’s and relaxing of local risk in times of low Sharpe’s as a way to tease out non linear behavior in the risk model based on particular periods of time. I think it’s a cool idea to view the economy as a stochastic model (a marco model, like FIREcalc does) and then further modify the model to gain insight into local economic behavior.

Playing With FIRE

I went to see this movie on Wednesday with my wife. It was in Tampa 2 1/2 hours distant. I had a second ulterior motive. Tampa is now home to a recently opened Hot Dog chain from Chicago. Obviously someone retired from the Chicago chain to Tampa and built a couple stores as a side gig. It’s named Portillo’s and my wife LOVES Portillo’s Italian Beef sammy’s, on a croissant, with sweet roasted pepper, French Fries and Root Beer. We used to go when I was a resident in Chi but her experience predates our meeting so it’s a long part of her history. t was so fun to spring that on her on the way over and then watch her light up at the experience. That alone was worth the trip. I like me some Portillo’s too.

The movie was a disappointment and pretty disturbing. It was pitched at “retire by 30” and was a cross between Tony Robbins, Crossfit culture, Amway and a time share sales pitch.

The story was about a couple and their absolutely adorable baby living in a San Diego beach community in a 1.4M crib with Beemers, a $2000/mo food budget bla bla bla. One of the shots is the guy in his speed boat fishing in some San Diego bay with a gorgeous sunset caught on drone footage. The guy makes video and the wife telecommutes and they haul like $150K/yr, already something doesn’t compute. The guy catches wiff of FIRE on TV and gets a hard on. He badgers his wife into ripping up their life and they leave SoCal to go stay on their parents couches “to save money” first the wife’s parents then the husbands parents. The husband is from IA so they are living in rural IA fishing in creeks and such “saving money”. Still fishing no boat. (should have bought a rural IA crib for 25K and saved some real money)

The wife is paying the bills with her telecommuter job working 8 hours a day. Her goal is to spend time with her baby but that becomes Grandma’s job. Hubby is supposed to have some kind of “remote job” never spelled out so pretty much he’s a dead beat with big ideas, while his wife pulls the train and the parents foot the rent and babysit.

Eventually he starts flying around visiting (and filming) FIRE types and flying to conferences and goes to FIRE camp where they sit around the campfire and squawk about being retired by 30, and the FIRE types are quite happy to pitch him. All the luminaries are there, but wait there’s more! He goes to see MMM and get’s video of him riding his bike “to save money”. ALL of these FIRE types are running huge media empires to supplement the 4 x 25. He has a lot of drone video of Vicki Robbins palatial estate on a Washington State island with the caption “retired by 26”. It’s such BS. It’s like saying Dave Ramsey is “retired”.

Eventually they wear out their welcome at the ‘rents place and fly to HI with the kid for a vaca sleeping on their friend’s couch. There’s a typhoon or something and the place floods and they have a “bad time”. Man what a gyp! They go house hunting and wind up in Bend Oregon, a well known destination for Cali ex pats, and buy a new crib. Downsizing to these people is buying a half a million crib in Bend and trading the Beemer for a perfectly functional Honda. The guy buys a bike and a trailer so he can ride 2 blocks to the piggly wiggly to shop and “save money” and returns to his mortgaged half mil crib and they make a months worth of breakfast burritos and freeze them “to save money”. Oh the Pathos!

They meet JL Collins who advises put every dollar you can into VSTAX AND NEVER SELL so we get to see them stuffing 3K into a brokerage account and they keep flashing their “emergency fund” balance of $12K and keep flashing how much they are saving and how many years to retirement. The wife is pretty miffed at this nonsense having given up her previous life but eventually comes around to the “frugal life” WINNING! All of it is geared around retire by 30 and even making the movie is an obvious sop to this guy trying to create a payday out of cliche’ (nice alliteration ehh?) It’s all boiler plate. Millennial Revolution hawks their party line (her book was released only the day before I saw the movie, (I’m sure her rags to riches story is ripe for movie picking) MMM hawks his line, JD Roth his line, Mad Fientist, Vicki Robbins (retired at 26 and now lives in a multi million crib in Island WA) hawks her line, and so on and so on and scooby dooby dooby.

The audience was full of kids trying to find out how to retire by 30 so they too can live in Bend Oregon with a half a mil crib and 2 paid cars and a bike. AMWAY!!! AMWAY!!! AMWAY!!! I’m all for people living their dreams and building their futures with their own two hands and creating their own narratives. God knows I did it, but because I did it and I get what’s really involved and I think it does the community harm hawking this nonsense. I wonder how these jokers are going to fund their kid’s college? What about health care? So much risk so little insight. Just once I’d like to read the tales of people who flunked FIRE. Suzy Orman tried to convey some of that in he Pound interview from letters she’d received about failure, but she was shouted down. You’re not allowed to fail and if you do, YOU DID SOMETHING WRONG! Not sure how something like getting cancer is doing something wrong. Not sure how 3K in a brokerage 12K in emergency and a half a million mortgage constitutes FIRE.

Another thing that bothers me is who pays the bills? America and FIRE is predicated on productivity. If America isn’t productive your bank account won’t last 10 years. You are not a tycoon, you are a flea living on the economy’s ass and you go where it goes. If productivity tanks it’s game over. We are the most productive people in history. Were do the taxes come from to pay for the roads and schools and military? The reason we are the reserve currency is because of our military who protects that store of value and the military is dependent on our productivity. The whole pitch was about “I got mine!!!” You only got yours till the government confiscates it. You can watch the Sound of Music for more details.

All in all it was a good time. We had a good time hanging with each other, a too fun meal, a nice trip over and a nice trip home and some interesting discussion dissecting the movie. My wife is not a FIRE type at all this was her first official foray into the topic but she’s naturally parsimonious and she knows BS when she hears it. I tweak the finance she tweaks the budget. I think this over selling and zealotry is why virtually no one pays attention to the FIRE rap. The flaws are too obvious

Compare Historical vs Monte Carlo

Karsten picked up my article and published it over at ERN. I was fun collaborating with him, he’s a very smart cookie. In my recent analysis I thought about comparing FIREcalc, the kind of gold standard for historical based retirement calculators, and Monte Carlo. By comparing you can gain some insight into future variability in your retirement plan from 2 vastly different mathematical points of view. The Trinity study looks at historical return, in 30 year aliquots of time from 1925 to 1995. You can see already the Trinity stud is 25 years out of date. Between 1995 and today we have gone through 2 major recessions. The government is leveraged out the yin yang and they would love to loot your retirement funds to feed that beast.

The Trinity type approach uses a 50/50 portfolio as does Bengen’s earlier 1994 study and a 30 year time frame in the historical analysis. The authors give this caveat:

The word planning is emphasized because of the great uncertainties in the stock and bond markets. Mid-course corrections likely will be required, with the actual dollar amounts withdrawn adjusted downward or upward relative to the plan. The investor needs to keep in mind that selection of a withdrawal rate is not a matter of contract but rather a matter of planning.


FIREcalc is a calculator based on the Trinity methodology. It looks at aliquots of history, the length of the aliquot is set in the calculator as is yearly spending and starting portfolio value. It analyzes data from 1871 with latest data update earlier this year. The question it asks is what would have happened over history if I had the listed portfolio, and how many times historically would I have run out of money. It therefore only looks at the past in a deterministic way and presumes the past will somehow mimic the future

From FIREcalc home page:

How can FIRECalc predict future returns from past performance?

It can’t. And it doesn’t try….

Except for this kind of severe limitation FIREcalc is a very powerful planner. You can adjust all kinds of parameters like inflation and portfolio AA and even a granular portfolio mix like small caps and EM etc. It allows addition of SS income on a given date for both spouses, different spending models. A lot of time went into designing this piece of software. One problem I have is understanding how a portfolio of stocks and bonds starting in 1871 (6 years after the Civil War) provides some rational information about my portfolio ending in 2050. The program is widely used as proof of performance and many FIRE retirements are based on it’s presumptions and calculations. I don’t have a dog in that fight, people can do what ever they like and since I haven’t reached 2050 I don’t know if my presumptions will hold true. So I use FIREcalc for what it’s worth and use Monte Carlo for what it’s worth, and try to divine the tea leaves,

FIREcalc is deterministic not truly probabilistic. It looks at history and ask the question of failure in the past. Monte Carlo is entirely probabilistic but uses some historical parameters to determine the model, things like an averaged historical inflation, how assets performed both in risk and reward over some period, things like that so the model is not entirely divorced from history, but what the model predicts is a distribution of “probable futures” from most likely to least likely on both the down side and the upside. It tells you there is some chance of running out of money (10% line and below) and there is some chance of getting lotto like returns (90% line and above) and then there is the most likely result that lives on the 50% line, so Monte Carlo in some sense forward looking in terms of likelihood but NOT deterministic. Taken together the two calculators give some range of perspective.

I used a 50/50 AA, a 30 year retirement and a 50 year retirement. I used US Stocks and US Bonds in the MonteCarlo and used the asset mix native to FIREcalc except I adjusted the AA to 50/50 equity/fixed. I used 1M and 40K/year withdrawal and whatever the calculator calls historical inflation. Monte Carlo allows SOR stress testing but FIREcalc does not since it only looks at history.

30 years of 4% WR on FIREcalc with historic inflation

FIRECalc looked at the 119 possible 30 year periods in the available data, starting with a portfolio of $1,000,000 and spending your specified amounts each year thereafter.

“Here is how your portfolio would have fared in each of the 119 cycles. The lowest and highest portfolio balance at the end of your retirement was $-223,952 to $4,145,063, with an average at the end of $1,146,780. (Note: this is looking at all the possible periods; values are in terms of the dollars as of the beginning of the retirement period for each cycle.)

For our purposes, failure means the portfolio was depleted before the end of the 30 years. FIRECalc found that 6 cycles failed, for a success rate of 95.0%.”

The first failure seems around year 25.

The Monte Carlo predicts 97.98 success and

Year 16 start to fail. Interesting data..

A 50 year retirement:

“FIRECalc looked at the 99 possible 50 year periods in the available data, starting with a portfolio of $1,000,000 and spending your specified amounts each year thereafter.

Here is how your portfolio would have fared in each of the 99 cycles. The lowest and highest portfolio balance at the end of your retirement was $-1,641,644 to $7,055,125, with an average at the end of $1,022,915. (Note: this is looking at all the possible periods; values are in terms of the dollars as of the beginning of the retirement period for each cycle.)

For our purposes, failure means the portfolio was depleted before the end of the 50 years. FIRECalc found that 40 cycles failed, for a success rate of 59.6%.”

Monte Carlo 50/50 AA at 50 years:

59% success vs 91% predicted difference between the 2 calculations. Amazing!

80% AA at 50 years

“FIRECalc looked at the 99 possible 50 year periods in the available data, starting with a portfolio of $1,000,000 and spending your specified amounts each year thereafter.

Here is how your portfolio would have fared in each of the 99 cycles. The lowest and highest portfolio balance at the end of your retirement was $-2,339,116 to $20,646,899, with an average at the end of $4,071,620. (Note: this is looking at all the possible periods; values are in terms of the dollars as of the beginning of the retirement period for each cycle.)

For our purposes, failure means the portfolio was depleted before the end of the 50 years. FIRECalc found that 20 cycles failed, for a success rate of 79.8%.”

Monte Carlo at 80/20 and 50 years

80% vs 88% success rate. Note how increasing the AA to 80/20 made longevity worse for MC and better for FIREcalc on a 50 year retirement. This may be why FIREcalc-ers tend toward high AA, because the calculator predicts a better outcome and why Monte Caro-ists tend toward more stodgy allocations. The two calculators predict different futures that’s for sure! Personally I think much deviation is accounted for in the method of projection. All FIRE is based on projection and projection is deviant. It does not actually predict what it portends to predict. It’s like shooting a bullet at a distant target using Kentucky wind-age in a truly accurate gun, a tad to the left you miss the target by a mile but to the left. A tad to the right the opposite occurs. Both shots miss the target, but both misses give you information about where the target actually is. There is nothing says you can’t improve your aim. In fact that is what you do. Come a downturn you may well reduce your WR and change the calculus. You may use a mechanical re-balancing technique as risk management and come a downturn you may re-balance and super charge your post recession returns. The models tend to be static, life is dynamic . Another issue is these models project withdrawal and most people are unfamiliar with withdrawal but are used to accumulation. When you start withdrawal your risk profile is very different than when accumulating.

Secure Act in More Depth

My financial adviser is retirement expert Phil DeMuth PhD author of about 12 books on finance and a contributor to Forbes. Every quarter he dutifully pens a letter keeping the troops under his tutelage informed of developments. I wrote a piece on the secure act last month, but this letter’s content is far more extensive. Be afraid, be very afraid

The SECURE Act: Implications for your Retirement

Accounts and Estate Planning: Sometimes a piece of legislation is so terrible that both parties immediately fall in love with it, and this is the case with the Secure Act. It passed the House with an overwhelming majority and is widely expected to pass the Senate soon. The Secure Act covers all the main retirement vehicles: Traditional IRAs, Roth IRAs, SEP IRAs, Simple IRAs, 401(k)s, 403(b), and 457 plans. The legislation is so important that I want to discuss it in detail. I hope it does not pass, but if it does, you will want to be thinking about how it affects you and how to respond.

Background: The main sponsor of the Secure Act is the insurance industry. They are lobbying hard and have our representatives on speed dial. Why? The Secure Act mandates that an annuity payout be offered as an option in all retirement plans. Insurance companies sold $230,000,000,000 worth of annuities in 2018, and their goal is to sell even more.

Annuitizing your retirement plan assets is a bad idea unless:

 You need all the cash for living expenses (you have no bequest motives)

 You can find an annuity that indexed to CPI-E, the inflation rate facing senior citizens that includes their increasingly expensive medical care

 It is indexed to our rising standard of living

 It has the lowest possible default risk

 It is low-cost

Unfortunately, such an annuity doesn’t exist. Congress eyes your retirement accounts as a giant piggy bank. The mandatory offer of an annuity is a slippery slope that could lead to the mandatory annuitization of all retirement accounts in the future. This would shoehorn the distributions into higher tax brackets, raise revenues, and eliminate the “problem” of the inherited IRA. Best of all, politicians would get to accomplish this without “raising taxes.” But that is a problem for another day.

The issue before us is that the Secure Act would be an estate planning catastrophe for people with large IRAs. It takes the sensible planning done up until now and stands it on its head. What is the problem? The Secure Act eliminates the stretch IRA. The stretch IRA let you leave your retirement accounts to your children or grandchildren or other heirs, who then parcel out the required minimum distributions (RMDs)over their actuarial lifetimes. The payout might be small for a child but would grow over the decades until the inherited IRA would comfortably provide for the child’s retirement. A parent could die with the knowledge that, whatever vicissitudes their children might experience in life, they would have freedom from want in old age. What a wonderful legacy. Congress wants to kill it. In exchange, they plan to let you postpone taking your first required minimum distribution for a year and a half – until age 72.

How it would work: The Secure Act forces non-spouse beneficiaries to pull out all the money from your IRA over ten years. (The original Senate plan was even worse: 5 years). A surviving spouse can pull the money out over his or her actuarial lifetime (or yours, if preferable). A child can pull it out over his or her actuarial lifetime up to age 21 but then must takeout the remainder over ten years. Only beneficiaries who are disabled or fewer than ten years younger than the account owner are exempt from this ten-year pullout rule. If you skip a generation and leave the IRA to your 5-year-old granddaughter, she must take the money out over ten years. Under the Kiddie Tax, it would be taxed at her parent’s rates. Only your children (not your grandchildren) can use the actuarial payouts up to age 21. Before, the best approach was to leave your IRA to your kids or grand-kids and stretch the payout over decades. Now the longest stretch might be with your surviving spouse – who likely will be paying taxes in the higher “filing single” tax bracket.

The bracket jump a surviving spouse experiences can easily go from 12% to 25% or from 24% to 35%, especially as the mandatory payout ratios automatically increase with age. For example, the RMD for a seventy-year-old is 3.7% of the retirement account balance, but for a ninety-year-old, this rises to 8.8%. In most cases, the IRA will eventually pass to adult children. If a million-dollar IRA ends up in the hands of an attorney/daughter, she will have to add $100,000 of annual income on top of her six-figure salary for a decade. As much as half might be swallowed by taxes. The effect is to make more of your IRA subject to higher taxes sooner, as distributions are forced out in bigger chunks that are subject to higher tax rates under our progressive tax code. This is not what the government promised us when we were making all those contributions, but there it is.

By the way, the Secure Act is also a college planning catastrophe for middle-class parents. The temporary but jumbo, highly taxed mandatory distributions from inherited IRAs will make these families spuriously appear high-income on the Free Application for Federal Student Aid, ruining their prospects for need-based financial aid. The ten-year mandatory IRA payout will look like a Christmas goose to colleges. The result is the opposite of what the grandparents intended. The Secure Act lowers the value of retirement plans – perhaps not for the half of the population who pay no Federal income tax – but very possibly for you. Our estate planning options for them have become much more unwieldy.

Using a Trust In the past, many estate attorneys would cut and paste the boilerplate from Natalie Choate’s IRA book to establish trusts that could stretch the IRA distributions, rather than having the IRAs pass directly to human beneficiaries. One appropriate use for a trust might be if you had beneficiaries who were young and you didn’t want, say, your 8-year-old grandson to get unfettered access to a million dollar IRA when he turned 18. What happens under the Secure Act? Since there are no longer any “Required Minimum Distributions,” the trust receives nothing for the first nine years. Then year ten, by law, the IRA must pay out everything. Now the kid turns 18, and suddenly he gets $1,000,000. With a decade of additional compound growth, it might be $2,000,000. All delivered in one year, so most of it is taxed at the highest Federal and state brackets. The money that remains is his to spend. Once again, we have the exact situation the grandparents set up the trust to prevent.

Recommendations: Broadly, there are two kinds of trusts that people use here. One is a conduit trust, where the trust passes through all the income to its beneficiaries every year. The other is a discretionary trust, where the trustee decides what gets paid out to each beneficiary every year. In the example above, we saw the conduit trust makes Johnny a millionaire at age 18. If this were a discretionary trust, the trustee could withhold the distribution. But trust tax rates start at 37% on only $12,500 worth of income, and state taxes are on top of that. We can postpone giving the money to Johnny, but the taxes would be severe. If you want to use a conduit trust, take the money out in equal installments over ten years and try to distribute it over as many beneficiaries as possible (kids, grand-kids) so that no one’s taxes are raised unduly. Most kids up to age 24 will be taxed at their parent’s rates due to the Kiddie Tax. If you are going to use a discretionary trust, convert your traditional IRA to a Roth first. That way the distribution to the trust might be postponed for another ten years while it grows untaxed, and then the tax-free distribution can stay in the trust until the trustee parcels it out. The only further taxes would be on the earnings within the trust until it was distributed to its beneficiaries. These can be mitigated by the use of zero dividend stocks like Berkshire Hathaway. But – if you are considering this Roth IRA approach, then the question arises whether you would be better off taking the money earmarked to pay the taxes on the Roth conversion and using it to buy a universal life insurance policy inside an Irrevocable Life Insurance Trust (ILIT) for the beneficiaries instead. That money is out of your estate no matter what happens to the current $11.4 million estate tax exemption and the proceeds from this ILIT would go tax-free to your heirs, distributed on terms that you set. You can model it both ways – Roth vs. ILIT – to see which seems most economically advantageous.

Using a Charitable Remainder Unit Trust Families with large IRAs and some measure of charitable intent could make a Charitable Remainder Unit Trust (CRUT) the beneficiary of a traditional IRA. This maneuver reconstructs the stretch provisions of the inherited IRA that the Secure Act abolishes. The CRUT needs to file a tax return every year but offers you the flexibility to set it up and invest it yourself. There is no reason why the final charity couldn’t be your family’s donor-advised fund if you so choose (although not your private family foundation). The CRUT sells the IRA assets but does not pay taxes. Your estate receives the amount that will eventually go to charity – 10% at a minimum – as a tax deduction. Meanwhile, the beneficiaries receive, say, 10% of the account balance per year for twenty years. They pay taxes on that as ordinary income. If the CRUT is invested successfully, beneficiaries could even burn through the initial contribution and eventually receive distributions taxed as capital gains. As one attorney told me who is doing this with his own estate, there are plenty of ways to screw it up. There are rules to be carefully followed. Talk it through in advance with your custodian and trustee to make sure everything is in good order – especially the beneficiary forms – so the IRA flows seamlessly to the new CRUT. It will probably work best where the IRA and the CRUT have the same custodian. If you don’t want all this trouble, big charities are happy to let you use the CRUTs they manage if you are willing to leave the remainder to them.

Action Item: A rule of thumb is that you use a trust when you don’t trust. If your beneficiaries can be people (responsible adults who unlikely to be sued) that is always easiest and cheapest since you avoid the expenses of drafting trusts, using trustees, and filing trust tax returns every year while paying trust tax rates. We can change beneficiaries easily by submitting a piece of paper to Fidelity. If your retirement accounts currently name a trust as the beneficiary, you should contact your attorney if/when the Secure Act passes to determine whether the trust as written still achieves your objectives. One red flag would be any mention of “required minimum distributions” or other actuarial-based withdrawals from the IRA in the trust documents. Your trust would have to work with the new ten-year withdrawal rule.

Superb analysis IMHO!

Will Passive Investing Cause an Avalanche?

I read an article about passive investing over taking 60% of the market, and an additional 20% being traded by robots. Nobody knows what this means. It’s a brand new phenomenon. The market index funds are up 39B while the active funds are bleeding to death down 90B.

Index funds are not index funds. They are index tracking funds. Total Stock Market does not hold all the stocks in the market. Last time I looked it held 180 stocks which are weight adjusted to track the market. I’m not sure what it holds today. Passive investing is built on the idea you buy and hold, and sell a little dab once in a while to buy hamburgers, or live off the dividends or some combo of that. Passive funds are owned by relatively inexperienced investors who bought in a time of sustained growth out of proportion to the norm. Market averages are thought to be 90% higher than the trends predict, so people are used to the good life. It is absolutely unclear what would happen if the market crashed. Would people violate “Buy and Hold”?

In addition the funds are not the index but a small fraction of the index, adjusted. When the sell orders come funds are selling those few stocks in the tracking fund, not the index which will accelerate the volatility in those particular shares and distort the funds price compared to the actual index likely a distortion to the downside. If suddenly your VTI is trading below par what you gonna do? The market will regress to the mean at some point, we can only hope the regression is orderly and covered by rational sustained growth and not all at once.

The robots follow trends and are algorithms tuned to maximize profit. As trend followers they will go long OR short. It’s buy low sell high OR Sell high buy low, that’s how they make money and they are agnostic to which pair of profit makers to employ. So in the up trend they are your ally tending to add to up momentum, but in the down your enemy if your a buy and hold type since their position becomes anti-momentum to your position. Shorting the market increases volatility and 20% is a pretty big short compared to 60% buy and hold. In addition the regular speculative traders will tend to follow the trend aka don’t fight the tape, so suddenly 40% of the market is aligned against you, where as 40% prior was aligned with you.

I read several Bogel books and articles and he was worried about this when indexing was only 20% of the market. If someone as smart and plugged in as Jack was worried who am I to blow that off?

What to do, what to do? First off consider your risk profile. A 80/20 has lot more to loose in this kind of crash than a 50/50. Don’t presume “it will come back” as that is unclear to me. The market is already something like 90% over valued. If 60% get burned it’s very unclear 60% will return, and I think many will cut and run at any price adding to the volatility.

Own stuff less likely to sell. I own DFA funds through an adviser. You can only own those through an adviser, and a good adviser can stand in the way of your panic. The best antidote for volatility is owning the VIX unfortunately nobody can afford the VIX but professionals, long term because of the carry charges and the ETF are not a good stand in. The don’t really track the VIX very well. Own some GLD. GLD’s volatility tends to be in the opposite direction from stocks in a crash so the net is a reduction in volatility. Own some cash equivalent like a tangent portfolio. The tangent is mostly bonds so it’s volatility in a crash is very low and it gives you something to spend while waiting for the dust to settle. It’s like a security blanket.

One thing to remember is owning stocks is owning property. They are NOT cash. The more property you own the richer you are, so it’s a good time to buy some property when it’s on sale if you can stomach it. It’s also time to tax loss harvest, a different way to make hay while the sun shines. To tax loss harvest you need brokerage stocks so a brokerage account would be a good thing to own. May take a while to pay off but it’s always done so in the past.

That 60% passive index + 20% robots freaks me out.

A Different Way to Plan Retirement

Karsten at ERN suggested I write a post for his site so I’m giving it a test drive here. If he picks it up I’ll probably delete it since it’s old hat to my readers. If he likes it I’m hoping we can somehow cut and paste it

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

What’s the problem you say? The problem is volatility. The problem is the market can not guarantee 6% and 2% inflation. Return is all over the map as is inflation. One year you may make 12%, the next year loose 20%. One year inflation maybe 2% and 5 years later 13% (1979). If your lucky it’ll work out you tell yourself, probably will work out, I read it on the internet! So what’s the probability?

This graph is generated by a Monte Carlo engine at Portfolio Visualizer a free to use financial tool kit. The analyzer works like this. It creates a model from a given portfolio (in this case 50% US total stocks and 50% US total bonds) and then runs it through 10,000 sequences from -3 to +3 Standard deviation where 0 is the mean. It mixes in inflation and a standard sequence of return risk, and spits out a Gaussian plot of the 10,000 probable futures from most likely to least likely. The most likely is the mean and is the 50% line the least likely graphed probability is the 10% line and the 90% line. The are successes below 10% but at some point there are failures. the 10% line represents 30 years of overall poor returns, but when all is said and done you still have 561K in the bank at 30 years with poor returns. Another calculator in the suite the efficient frontier calculator calculates the nominal rates of risk (as SD) and return for the 50/50 portfolio described above with data going back to 1987.

with a 50/50 you can expect on the average 8.56% return, 2.56% above your 6% limit. These are quantitatively calculated statistical values not just guesstimates, useful and more granular knowledge than guesstimates.

In the above example over 30 years of normative sequence out of 10,000 simulations 9838 succeeded to make 30 years the rest failed before 30 years. When did the failures start?

by year 18, 3 people had failed, year 17 nobody failed. Quite a bit of information on a simple 2 fund 50/50 portfolio. Useful information in planning your future, since this is a future looking calculator.

What happens at 80/20 AA?

9504/10,000 succeed the rest fail

The first failure is year 11 out of a 30 year retirement.

The 10% guy at 80/20 only has 396K left in his account compared to 561K for the 10% 50/50 guy. Quite a bit more information

What about bad SORR? You can adjust the SORR by putting the bad SOR in the first years of the model. So if youretired in 1972 you had about 3 years of bad SOR plus very high inflation, It happens. Here is a nominal 3 year bad SOR scenario with a 80/20 AA

Only 6722/10,100 survive the rest fail

The first failures are at year 9 and the 10% line is out of money at year 16 AND the 25% line is out of money at year 23. This is with a 30 year retirement. What about 50 years of 80/20 AA 3 bad years of SOR first?

Only 3508 survive and 10% 25% AND 50% are out of money before 50 years

The first failure is year 8

So that’s what you’re messing with with a leveraged future. Remember this is the nominal 4% x25 retirement plan everybody quotes. Sober you right up doesn’t it?

Rick Ferri Podcast

I was over on my friend CD’s site and that suckah likes to stir the pot. The topic is interesting enough to warrant a post, but it’s ground I’ve trodden before. Never the less I may have a little better conceptual model than squawking about mean square variance and variable risk. By the way I’m in no way knocking Rick Ferri. I was an investor in the dark ages and in the land of the blind he had one eye. The podcast is here and I recommend!

My conception is a portfolio lives on a plane and has a shape on that plane. It has a center, and the assets fan out from the center in lines like the spokes of a wheel. The shape and area of portfolio on the plane represents portfolio’s total risk, and the spokes individual asset risk and asset correlation.

A square is a more inefficient plane from a risk perspective compared to a circle

The circle represents the efficient frontier. It is the plane where the assets and their correlations come together and form the least risk. The surface area is a measure of portfolio risk, so clearly the circular portfolio holds less risk than the square. Here is the square which holds the assets:

This is not to scale, just a picture of assets as spokes and their relative correlations with each other. The spokes represent individual asset risk and the length of the spoke is adjusted by the assets volatility and it’s percentage in the makeup of the AA. EM is very risky compared to US, 22.73% SD vs 16.67% SD, but if you own only a dab it tends to tone down the risk in the portfolio on a weight adjusted basis. Note bonds form a near perfect right axis with stocks. The correlation between bonds and stock is nearly zero, meaning as stocks gyrate their values wildly due to their risk, bonds don’t budge and are virtually impervious to that gyration. Here is a snapshot of correlations to US stocks

In the diagram the angle between spokes is equal to the correlation. Gold is NOT to scale but gold has a property in a crash I want to talk about later.

The most efficient portfolio is a circle. It is the portfolio of least surface area and therefore least risk. If the radius = 1 the area of a square is 4 and the area of a circle is 3.14, a 27% reduction in area corresponding to a 27% reduction in risk. Again I don’t want to emphasize absolute values but just to give a visual of how to think about portfolio risk. In accumulation the key attribute of a portfolio is return, risk be damned. In accumulation the risk is managed by the W2. You just work more or longer. The calculus changes in retirement once the portfolio is open to withdrawal and SOR and risk becomes paramount, and minimizing risk is a good strategy for portfolio longevity. You want to make the surface area (risk profile) of your portfolio small and circular if you can.

Look at the square and it’s contained assets. Notice how US, Global, and EM all go in pretty much the same direction. Their contribution to surface area is out sized in the vertical dimension. They add a lot to the height not much to the breadth. Bonds add to the breadth. This is why IMHO it’s important to own bonds. They are built in risk management. Bonds further act as a storehouse of value, like a bank, but bonds don’t grow much either. So they add stability but not much return. Re-balancing means you use a little of stocks growth to sock away some value in the bank. You sell a little of the stocks when they are high and stuff that value in the bonds (bank) for later when things aren’t so groovy. It’s a natural thing for a indexer to do, economize and save and invest don’t speculate, reduce the risk, that’s the indexer’s motto. The whole reason to own an index is because of the diversity it provides and diversity to a point improves risk. Diversity is way over done however. Diversity in a given asset class like stocks is asymptotic meaning after a certain point is reached there is barely anymore advantage to be had, and piling higher and deeper PhD just buys you complexity and portfolio drag. A large cap fund becomes diverse with as little as 30 stocks spread across 10 sectors. The DJIA is diverse.

Look at EM US and Global. Are they diverse? NO. They all go in the same direction. They add a little to spreading out the perimeter on the way up. On the way down they all collapse together, and the ones with the greatest risk collapse far more than the ones with smaller risk. So on the way up a dab of diversity, on the way down nightmare. I analyzed EM’s performance in the 2008 crash and if US stocks dipped 50% EM went down 70-75%. If you go down 50% it takes 100% to get even. If you go down 75%, 150% to get even. The thing that gets you even is growth. The relative growth of US stocks is 10.89% the relative growth of EM is 8.66%. How long do you think its going to take for something down 150% to recover at 8.66% growth compared to 100% at 10.89% growth? YEARS is the correct answer yet everybody insists EM needs to be in the portfolio. Quantitatively a stupid idea IMHO.

People criticize factor investing because it may take decades for small cap value to pay off, but blindly put EM in their portfolios which may take centuries to pay off based on some half assed explanation of increased diversity. If the arrows point in the same direction it ain’t diverse. Bonds diversity is called non correlated diversity because it’s correlation is zero. Gold is like that too, non correlated, as is cash (lets say 3 month T-bills = cash). Those are your store houses of wealth, the bank against SOR-Risk if you will. Stocks are the engines of growth. That’s how a portfolio works.

Gold is a special case IMHO. Gold doesn’t return anything it just stores value. It is a commodity not an investment per se’. So why own it?

Behavior of GLD in 2008 crash

Notice how GLD soared while stocks crashed and recall correlations. This is a strong negative correlation in the face of a crash. Soaring gold gives you something to “sell high” when everything else is going to hell and all the stock arrows are pointing into the ground. You want some hamburgers? Sell some GLD when the S&P is in the toilet. It’s a hedge against SORR. What about GLD today?

It’s time to buy a little GLD (buy low) to get ready to hedge. This is still a strong negative correlation but more approaching zero correlation. Gold gets quiet when stocks go up and becomes quite volatile when they go down. So you can trade some GLD volatility for that stock volatility and reduce the over all volatility. That’s why I own some GLD. Not for return but as a volatility hedge.

So what about re-balancing? If you put some money in the bond (bank) on the way up, you have some money to spend when the crash comes. If you own GLD or maybe a cash equivalent (more later) you have something to buy hamburgers with, so take some money out of the bond bank and buy stocks LOW. The rule is buy low sell high, or sell high buy low. People say “you can’t time the market” but they’d be wrong. If you look at growth after a recession it tends to explode to the upside and buying low is exactly the “right time” to buy. The feature of this kind of risk management is it’s automatic, no human intervention required except to do the mechanics of re-balancing year in and year out. Look at the 2009 chart above the right time to buy was Jan 2009 and if you re-balanced in Jan 2009 you hit a home run. That’s called market timing, it’s mechanical and that part is critical. It takes the dumb assed human who’s constantly trying to maximize profit out of the loop. Dumb assed humans can’t time the market but a mechanical system can capture at least some extra growth.

What about cash equivalents? I consider a tangent portfolio a cash equivalent. What is a tangent portfolio?

The tangent portfolio is the roundest portfolio. It is a portfolio of stocks and bonds that has the most return for the least risk and the least risk is the roundest area. If you look at this portfolio it’s expected return is 6% but it’s risk only 3%. It’s mostly bonds with a dab of stock so if bonds are horizontal it’s just enough stock to turn the bond line into a circle from a risk perspective. If you own 12% stock and the market drops in half you now own 6% stock barely a budge on the net portfolio value. It drops 6%. If you’ve been re-balancing on the way up you’ve stored extra value in the bonds anyway, so a few years in you could loose 6% and still be money ahead. If you wan’t to store some equivalent to cash for a rainy day this is a pretty good way to do it. Lets say you store 2 years of WR (say 200K) in a tangent for 5 years and the crash comes.

lets say you can tighten your belt to 85K/yr.

You have about 3.5 years of money to live on without touching the main portfolio. This is a strong hedge against SORR since you leave the main portfolio alone while using the tangent to buy hamburgers. I did an analysis and burning this fuse portfolio needs only happen once to change the trajectory of SORR in a bad crash to something sustainable. You don’t need to keep refilling this bucket if you have it full to start. It just changes the probability of success to the good in a very Bayesian way. The cost? 2 more years of work. A little GLD and a little Tangent = a lot of horse power when it comes to combating SORR. If you never use it good deal. Just die richer or blow it on a Bentley at 85. Again GLD (non correlated) and a tangent (relatively non correlated since its mostly bonds) reduce the risk.

The last portfolio risk rounder is the Roth. Getting some dough in a Roth is insurance because your retirement is NOT going to happen as you think it is and you can be woefully underfunded.

A mere 200K in a Roth 20 years later is 650K and that buys a lot of end of life care. Remember if you’re married you have to fund 2 end of life plans. You don’t get to suck up all the dough and leave your wife hanging. In your death she will have higher taxes and a reduction in SS income and if you don’t plan for that it will bite her in her ass, no thanks to you Mr bogglehead tycoon. 650K is a nice back up portfolio and virtually eliminates SORR from your life and her life. Notice that 69% of the backup portfolio is accrued interest aka free money when it sits in a Roth.

You further reduce risk by proper tax planning but that’s another post. CD’s post was on complexity and kind of addressed the complexity in a single portfolio. Portfolios can be analyzed simply on the efficient frontier plane to reduce complexity.

Here is a 5 fund portfolio of 3 kinds of stock funds, bonds and GLD

It expects a 7.5% return at 12% risk

Here is a portfolio with the same return but half the risk

You tell me which one you want to own in retirement. This is not complex. The efficient frontier calculator is effectively a square rounder. You feed it some assets and it will tell you the assets and allocations of the best circle. You may feed it 10 assets in may only choose 3 to give you the best circle. The tangent is the best circle. It will then create a line of “better circles” for various risk/reward pairs, and you just pick off what you like. It will also analyze your particular asset allocations you fed it and give you the overall risk and reward of that portfolio.

What is complex, is planning for the unknown SORR and the the hedges described above do that with minimum muss and fuss, but you don’t get to retire at 29. The complexity also comes from trying to win against an arcane tax code designed to separate you from your wealth. You only get to spend what they don’t take,

Price Transparency in Medicine

Oh Baby Oh Baby Trump just stuck a shiv in the MBA top heavy medical industry by ordering price transparency in Medicine especially the drug biz. It’s the day the universe changed.

I went to Med school in 1981, it was a heady time of 17% interest rates on student loans. When I was accepted my med school cost 6800/yr and I sold my house and had saved enough to cover 4 years. By the time I walked through the doors 6 mos later it was 8600. The next year was 12,000 and the 3rd year… I ran out of money and I wasn’t going into debt at 17% interest, which started accruing immediately. So I marched down to the NAS Glenview, in Chicago raised my right hand, swore to defend the constitution and the peeps and it was anchors aweigh for this pilgrim. It was actually a great deal they pay 2 years, I pay back 2 years after I complete my residency. They get a fully trained anesthesiologist for LT’s pay which was 36K/yr.

When I got to med school it was the time of the first HMO. My buddy and I looked at each other and said “OH NO! It’s going to be the $39.95 gall bag operation”, because it was dead clear he MBA’s meant to pierce the profit in private practice medicine and hoover it up for themselves and it’s been down hill ever since.

When I started the physician commanded 12 cents of the medical buck and soon enough it was 6 cents then 3 cents. Where did the dough go? Strait into MBA’s pockets. MBA’s and middle men. You can’t run a competitive business unless you know the cost and if you break your wrist what gets paid is who knows? It’s what ever the contract says you get paid plus the slippage of denials.

Transparency is going to change that as he says BIGGLY. A wrist can’t get set without a Doc but it sure as hell can get set without a MBA sucking off the profit or a screw company charging 10K a screw. United health, CVS, all them jokers are heading down. Should be an interesting ride.