I’ve been discussing using a Roth as an insurance vehicle over on XRAY’s site It’s a useful way to demonstrate planning using modern portfolio theory and taking risk as well as reward into account. I’m nothing if not a quant A quant is someone who uses computers to analyze investments. It is also a pole used to guide a large barge, from the Greek kontos “boat pole”. If I’m going to guide my barge I want a good chance at being successful and staying off the rocks.
The discussion devolved to how to fund extrinsic risk like medical disaster in retirement. In preparing for retirement you purchase a product called a portfolio which at some point takes over the job of providing you money. It is bounded. If you have 1M you can leverage it but leverage increases the likelihood of failure. What does leverage mean? You can take your 1M, put it in cash, take out $30K/yr at 2% inflation and you’re money will last 25 years. Whoa whoa 25x should be $40K!, but $40K 25 years in the future is only worth $30K @ 2% inflation
How do you combat the loss in value? Leverage my boy/girl leverage. If you make 2% on interest and take out $40K your money lasts 35 years
That % the inflation ate, is returned and then some. GREAT! I want to make 10% OVER INFLATION then (12% not a bit greedy)!!!
Yep 35M that’s the ticket! So what is it? 40K/yr for 35 years and 0 dollars in the bank or 40K for 35 years and 35M in the bank? That’s the power of leverage all things being equal. This never happens. If you have 35M in the bank at least 50K is coming out or 900K or what ever. If you start yanking more less in the bank. How much less? Lets yank 900K
Lawdy Mama I’m 335M in debt! With that kind of debt I think I’ll grow a beard and change my name to Uncle Sam! This is still the power of leverage when leverage goes against you.
To get back your million and live on 900K/year you only need make 90% on your money every year, EVERY YEAR. So a FV calculator is a blunt tool. It gives some quick information but not very deep information. Are you planning your life with such a tool?
Enter Monte Carlo. Monte Carlo calculators take into account the multitude of variables. Still incomplete but more complete. Lets use Monte Carlo to consider the problem of saving for extraordinary risk such as medical disaster in old age. One thing you could do is buy SPIA insurance. Let’s say you get Alzheimer’s at age 70 and you need 30K/yr for nursing home care. The average length of the disease till death is 12 years but can last even 20 years. So you buy SPIA at $500K and it pays you 30K/yr for life. SPIA doesn’t inflate and you don’t have much variability and you pay taxes on the income. You live 12 years, the insurance company wins. You live 20 years the insurance company looses, but does it really loose? Upshot the insurance company didn’t loose even at 20 years. You’re the looser remember those taxes?
Lets Monte Carlo this suckah
Here is $500K in a 50/50 fund at 30K/yr withdrawal inflation adjusted for 20 years. It succeeds 93.7% of the time for 20 years BUT it succeeds 99.96% of the time for 12 years at a very worst case scenario, the 10% SORR line. This means 90% of the time you do better than 93.7% with inflation adjusted tax free worst case scenario money. If the $500K is in a Roth the money comes out tax free. SPIA costs $500K this plan costs $500K. The SPIA plan pays out for a lifetime (say 20 years) 100%. The Roth pays out nearly 94% for 20 years (essentially a lifetime) but an increasing % portfolio survival if you die sooner in a nursing home aka virtually bullet proof.
Stop being the Tool by Using the Tools
Let’s say you are 24 and you put 5500 in a Roth for 10 years to age 34 ($55000 principal) at the end of 10 years you will have about 85K if you get 6.67% on your money in a 2 fund using the tangent portfolio at the best risk/reward ratio which is 18/82. This is epoch 1 of the accumulation. This best portfolio is determined by using the Efficient Frontier
You then just leave the 85K in the Roth and switch to a 50/50 ratio with no added or subtracted money till age 70 (35 years additional or 45 years total growth). This is epoch 2 of accumulation. It has a different risk that epoch 1. The risk in epoch 1 was 4.2% the risk in epoch 2 is 7.8% or half the market risk (15%). Epoch 1 is only 10 years but epoch 2 is 35 years so you have considerable time for the risks/returns to normalize to the mean during epoch 2. This is about as set and forget as you can get and quite safe. It is extremely safe because we plan around the worst case scenario.
At age 70 worst case (10% line) you will have $685K available for your catastrophe, to withdraw tax free. A 500K SPIA pays 30K/yr foreve with taxes, your Roth in the 10% scenario, can pay $35K/yr at age 70 with 98% success to age 90 (essentially forever). This is a 3 epoch calculation, in accumulation epoch 1 was super safe 4.2% risk. Epoch 2 grew under bad circumstances, 35 years along the 10% line, and the deflation epoch, epoch 3 was along the 10% line. DO NOT WALK UNDER LADDERS, you’re one unlucky dude. But you still have 35K/yr to spend in retirement.
These are worst case projections. There is a 90% chance you will do better. You don’t have to wait till your sick to get the tax free 35K but if/when the time comes that 35K is spoken for and it pays better than a SPIA. If you have a wife then save 11K/yr x 10 years do the same routine. At 70 you will get $70K/yr as a couple and if one gets sick it breaks back to 35K/35K. If you both get sick it’s 35K each and it cost you a 110K cash money outlay plus the taxes you paid each year to get money into the Roth for end of life protection.
This plan is for what it’s for, extraordinary circumstance and some extra money late in life. It’s NOT for RE money, it is not WR money. If you want WR money or RE money make a separate plan for that. Don’t mess with the Zohan! To make it work you need 45 years of growth in a super to moderately safe 50/50 investment, but it’s virtually bullet proof. The only thing you need to do is re-balance once a year after the principal is contributed and since it’s Roth money, re-balance and withdrawal are tax free. Personally I would fund this before I paid loan debt or maxed out anything else. Time is of the essence. That “good feeling” of paying off your mortgage or student loan is going to cost you a mint in lost growth opportunity. Screw your “feelings” and do what’s smart. Dave Ramsey is good for helping credit abusers. If you’re not a credit abuser he ain’t for you. His nonsense is eating your lunch.
So what happens if instead of pulling the 10% card for your whole life you pull the 50% card for epoch 2? Again at age 24 you save $5500 in the 20/80 account till 34 resulting $85K. Notice this is epoch 1 of the accumulation. Your risk is so low 85K is virtually assured in epoch 1. It’s mostly in bonds. Then you change the risk to 50/50 and ride 50% line for an additional 35 years. Instead of the 10% level $685K you have a $1.34M insurance policy in the Roth at age 70. In epoch 3 you can pull out $45K/yr for 20 years on the 10% line and still have 1.88M in the Roth available for disaster. The risk is moderate at 50% of the market risk.
Notice how I did an epoch switch between accumulation and pay out. I did a 50/50 accumulation epoch on the 50% line for 1.34M accumulation, and a portfolio deflation on the 10% line for additional safety in retirement. If you continue to ride the 50% line you can re-retire every 5 years safely boosting up your withdrawal a bit. Such delicious control on your future!
The point of the exercise is to look at how to use modern portfolio tools to create a plan, how to use that plan to target a specific need and how to safely fund that plan. It is not a plan driven by greed which begets excessive risk. It is not a Casino plan despite it’s name. It is a plan that optimizes probability of success at minimal cost by analyzing multiple variables. You can easily tweak the plan and you get both risk and reward displayed and then projected.
The charts displays both risk and reward. The projected amount is the reward and the range of percentiles takes into account projected risk. Far superior to a FV calculator.
You now know more than 95% of the Boggelhead Guru’s, and you understand the power of epochs, Monte Carlo and Efficient Frontier. This is part 2 of the “planning tools” series Part 1 was Goalscape. A look at Personal Capital and Mint and Schwab RMD calc and SS will follow.
Using Goalscape to chronicle the plan on say a personal blog page.
The goal with a drill down from Goalscape You can chronicle a dozen scenarios on a private blog and rapidly switch back and forth.