New Phased Retirement Program Details For Federal Workers

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opmI’m always interested in non-traditional retirement stories, and saw that the US government just released their final regulations on Phased Retirement for federal workers. Phased retirement in general refers to transitioning from full-time to part-time work for a period of time before a traditional full retirement.

Participants will be able to start working half-time while collecting half of the pension they would get if they were to fully retire at that date. Then, when they fully retire, they’ll get the other half of their pension, adjusted for the additional work they did while being part-time. At least that’s my version of their lengthy explanation:

At entry into Phased Retirement, the employee’s annuity will be completed as if fully retired and then divided by two. That annuity would be paid while the individual worked a half time schedule receiving half pay. [...] When the Phased Retiree fully retires, there will be a computation of the annuity that would be payable if the employee had been employed full time and then divided by two prior to adjustment for survivor benefits. That amount would then be added to the original Phased Retirement Annuity, and that combined amount would then provide the basis for survivor annuity adjustment and benefits.

Participants will also get to keep their health and dental insurance, access to Thrift Savings Plan, and many other benefits. Fedweek has created a Federal Employee’s Guide to Phased Retirement [pdf], which is a lot easier to read than the actual regulations.

According to this Reuters article, the program should both save money and retain talent:

For the government, the program is expected to be a money saver. The Congressional Budget Office estimated recently that 1,000 employees might take advantage of phased retirement annually, and would continue work for three years. That would cut required contributions to the government’s pension system by $427 million from 2013 to 2022, and boost worker contributions by $24 million.

But phased retirement also will help the government retain talent and expertise at a time when the “brain drain” from an aging workforce is a major concern. About 600,000 people, or 31 percent of the federal civilian workforce, will be eligible for retirement by September 2017, according to the U.S. Government Accountability Office. Phased retirees will be required to spend at least 20 percent of their time mentoring younger employees.

Employess under the legacy Civil Service Retirement System (CSRS) will be eligible for phased retirement at age 55 with 30 years of service, or at 60 with 20 years of service. Federal Employees Retirement System (FERS) employees must be age 60 with 20 years of service, or have 30 years of service and have reached their minimum retirement-eligible age. Agencies can send their Phased Retirement applications to OPM for processing starting November 6, 2014.

I think this is a neat idea and it looks like there will be strong interest. I hope the idea spreads. Even if your employer doesn’t offer an official policy on phased retirement, I know of several folks who have made their own custom arrangements.

Early Retirement Lesson #3: Home-Buying and Mortgage Advice

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housemoneyHere’s another installment of what I would tell my kids about pursuing financial freedom (if they weren’t still in diapers). Previous topics have included the importance of savings rate and whether to focus on earning more or spending less. This time, I wanted to talk about buying a home and mortgages.

Should you buy or rent? Now, there are many buy vs. rent calculators. Here is the best one in my opinion. But as they say garbage in, garbage out, so be careful. Your answer will strongly depend on unpredictable things like future investment performance and/or home price appreciation. In general, the longer you plan on staying in a geographical location (say at least 5-7 years), the better it is to buy your own place. But if you are the nomadic type and want to travel the world, then renting can work out to be much better. In my experience, buying a house often ends up a lifestyle-based decision and not just about the numbers.

If you decide to buy, my opinion is that you should adjust your mortgage size and term to coincide with the date of retirement. I define retirement as when your expenses are exceeded by your non-work income like pensions, Social Security, annuity payments, stock dividends, rental income, or other investment income. Example scenarios:

  • If you love your job and plan on working for the next 30+ years, then go ahead and get a 30 year mortgage. Maybe you have a job that you could work part-time or isn’t very stressful. In this case you have lots of human capital and a long stream of future work income. Take on the 4% interest rate fixed for 30 years, and over time your salary will rise with inflation while your payment stays the same. Be sure to buy a house that you can afford while still investing for retirement. If anything, you could do a DIY biweekly payment plan and pay off that 30-year mortgage in under 24 years.
  • If you have the early retirement bug and want to retire in 15 years, then you should find a home that you can afford with a 15-year mortgage. The interest rate will be lower and as long as you can swing the payments in the beginning, you’ll quickly get used to it. The hard part is to find an affordable home with those higher monthly payments. The hardest part is to be satisfied with it as you’ll have the option and expectation from others to spend more. This is why I think the 15-year mortgage is a powerful tool for aspiring early retirees. It forces you to commit to a long-term lifestyle that fits your goals. Buy a house at age 25, and you’ll be done by 40.
  • Let’s say you receive a monetary windfall (inheritance, huge raise, IPO) and all of a sudden an early retirement is on the table. I wouldn’t necessarily pay off the mortgage completely if you aren’t ready to retire yet. You’ll want to balance the opportunity to invest in potentially higher-returning investments (stock mutual funds, dividend-paying stocks, other real estate) with pursuing the benefits of having a fully-owned house (less stress, less leverage, lower required monthly expenses). My solution would be to pay enough of the mortgage down such that with your usual monthly payments it advances your mortgage payoff date to match your retirement date. If you won the lottery and that date is tomorrow, then yes pay it all off!

One of my reasons for matching mortgage payoff with retirement date is psychological. When you are working, your paycheck is the same every month. This matches well with a fixed mortgage payment. But investment income is often variable. If the tenant in your investment property decides to squat and you have to spend months going through eviction proceedings, your rental income may drop to zero for a while. Many experts now recommend a dynamic withdrawal strategy from your investment portfolio, which would also result in a variable income. But mortgages are like an alligator. You must feed it; if you don’t then it eats you. Other expenses like travel and dining out, those can be adjusted. So I don’t like the idea of having a mortgage in retirement, especially if it is a large percentage of your overall expenses.

However, paying off the mortgage too early can also cause regret if the stock market is rising while you’re piling money into a 4% mortgage. If you are still in the accumulation phase, at times like now you’ll be reminded that you could be investing your paycheck in the market generating higher returns. But if you’re retired, that meant your nest egg was already big enough. If the market goes up, your next egg goes up and you are happier. If the market drops, hey, you already have a paid-off house. So that is why I don’t recommend paying off the mortgage too early, either.

Finally, early retirement with a paid-off house is great because lower expenses means smaller withdrawals from your portfolio, which also means a lower overall tax rate. In fact, with a mix of Traditional and Roth IRAs, we’ve seen that a couple could withdraw over $50,000 a year and still pay zero taxes on retirement. A lower income can also help you qualify for things like health insurance subsidies.

Short version to my kids: If you want to retire early and don’t move around much, buy a modest home where you can afford a 15-year mortgage payment and save at least 25% of your income. If your lifestyle entails lots of moving around, rent and save 50% of your income.

(Related: Pay Off Mortgage Early vs. Save More For Retirement? Digging Deep Into The Details)

Affordable Care Act (Obamacare) and Out-of-Pocket Cost Subsidies

healthPlease consider this an addendum to my previous post on Early Retirement and The Affordable Care Act.

In addition to subsidies on health insurance premiums, the Affordable Car Act (ACA) provides subsidies on out-of-pocket costs to qualifying households when buying insurance from an exchange. The income requirements are more restrictive, but they further improve affordability for those with lower incomes by reducing their deductibles, copayments, coinsurance, and total out-of-pocket maximum limits.

Income eligibility requirements. In this case, the income cutoffs are 200% and 250% of the Federal Poverty Level (FPL). Modified adjusted gross income (MAGI) is used for income. Modified takes your AGI (Line 4 on a Form 1040EZ, Line 21 on a Form 1040A, or Line 37 on a Form 1040) and adds back in certain deductions like non-taxable Social Security income, foreign income, and tax-exempt interest.

For reference, here are the 2014 FPLs by household size listed with the 200% and 250% levels, as calculated by the Department of Health and Human Services (for 48 contiguous states, higher in Alaska and Hawaii).

2014 POVERTY GUIDELINES FOR THE 48 CONTIGUOUS STATES AND THE DISTRICT OF COLUMBIA
Persons in
family/household
100% FPL 200% FPL 250% FPL
1 $11,670 $23,340 $29,175
2 $15,730 $31,460 $39,325
3 $19,790 $39,580 $49,475
4 $23,850 $47,700 $59,625
5 $27,910 $55,820 $69,775

 

Deductible, copayment and, coinsurance subsidies. These cost-sharing subsidies are only available if you start with buying a Silver plan. Now, the idea of a Silver plan is the insurer will pay 70% of covered health expenses across the entire population, leaving the insured to pay 30%. However, if your income is 150% FPL or less, you’ll only have to pay 6% of covered health expenses. If your income is between 150% and 200% FPL, you’ll only pay 13%. If your income is between 200% and 250% FPL, you’ll have to pay 27%.

Each plan will have a different way of implementing this overall requirement, usually by tweaking deductibles and copays. These may be referred to as Cost Sharing Reduction (CSR) plans.

Out-of-pocket maximum subsidies. The Affordable Care Act limits your maximum out-of-pockets expenses per year. Once you reach this limit, your insurance will pay for all of your covered healthcare expenses for the rest of the year. However, if you are under 200% or 250% FPL, these limits are even lower.

Modified Adjusted Gross Income 2014 maximum annual out-of-pocket cost, individual 2014 maximum annual out-of-pocket cost, family
100-200% FPL $2,250 $4,500
200-250% FPL $5,200 $10,400
> 250% FPL $6,350 $12,700

 

Note that you may read conflicting information elsewhere about reduced out-of-pocket limits being available to anyone at 400% FPL or less. That information is outdated (source). Those numbers were in the original law, but it was since revised to what is shown above.

Recap. These subsidies for out-of-pocket expenses provide another important income cutoff point to consider when purchasing health insurance independently from an employer plan. Your total healthcare expenses could vary significantly if your income is just $1 over the cutoff points of 200%, 250%, and 400% FPL.

More: Healthcare.gov (really wish this site was better), Kaiser Family Foundation, UC Berkeley Labor Center

Non-Traditional Retirement Story: 50% Savings Rate and Year-long Vacations

Rarely are people who achieve a non-traditional retirement profiled on mainstream media, and when they do it’s usually with a “omigosh look at these crazy people” type of article. So I was surprised when I ran across this couple who talk casually about saving 50% of their income and taking year-long vacations every few years on a Nationwide Insurance commercial. Via ERE Facebook page.

Further digging revealed their full names as Richard Ligato and Amanda Bejarano-Ligato, who run their own website and wrote a book Wide-Eyed Wanderers: A Befuddling Journey from the Rat Race to the Roads of Latin America & Africa in 2005. Here’s another brief description of their story from a USA Today article:

“The key is living like you did when you were a student,” says Rich Ligato, 45, who lives in San Diego. While not completely financially independent, Ligato and his wife, Amanda, stopped working steady jobs more than a decade ago. Their goal is working for three years, taking odd jobs, saving their money, then enjoying a year-long vacation break, doing something such as living in India or biking along the Western coast of the U.S. When they return, they take entirely different jobs.

Rich is currently teaching biking classes and managing an apartment, while Amanda is teaching yoga. “It’s not about money, it’s about freedom,” he says. “If you’re just driving to make things secure and safe, think about what that means. There’s nothing interesting in life. You might as well die.”

(Updated to add: I haven’t read the financial particulars of their situation, but given their 50% savings rate alone the math would say they could work one year and take the next year off if they just kept their spending rate constant. But they work 3 and take 1 year off. So even if they spend double what they do when working, then they could put away 1 year of savings for retirement, and then spend the other 2 years on their year-long vacation. That’s still more than the average person puts away (1 full year of expenses every 4 years, or 25% of their combined annual salary every year). This may be off, but roughly how I imagine it working out.)

I always get excited by stories like this; they may not be “retired” but they are living consciously and achieving their dreams. (I’m really looking for one of these stories where they have kids and travel the world.) I still bought their book and starting reading it already. Not sure how new this is, but Amazon does this neat thing now when you order a physical book, they let you start reading the beginning on the Kindle while you wait for it to arrive. Nice for us who prefer physical books but are also impatient. ;)

Australian “Social Security” to Raise Retirement Age to 70 by 2035

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sscard200The current “full” retirement age for Social Security is 66, although you have the option to start taking benefits at a permanently reduced rate at age 62 (did you know that over 35% of people take this permanent ~25% cut in benefits!). The full retirement age for Social Security in the US is 67 years for workers born after 1960, but that is always subject to future change. Here’s a Wikipedia page comparing the current “standard” retirement ages in various countries.

Why do I bring this up? Last month, Australia announced that it plans to increase its official retirement age to 70 by the year 2035. Here’s an AARP article about 14 countries — including Germany, Italy, Spain, Greece and Ireland — who are planning to increase their retirement ages to between 67 and 69 by 2050.

I’m in my mid-30s now, and unlike some I still expect Social Security to be around for a long time. But I also predict that the full retirement age for Social Security will be raised in a similar, and that I won’t get full benefits until age 70.

Check out how the math is working against younger workers, via Businessweek:

mill_benefits

Also consider that 1 in 3 people born today are expected live to 100, so for the system to work they’ll likely be expected to work at least 50 of those years. That could be 50 years of 50-hour workweeks (especially if you include commuting) for 50 weeks of the year. Yikes. No wonder I like to learn about the principles behind financial freedom, so I can teach them to my kids!

Reader Story: Early Retirement by Age 40 with Income-Focused Portfolio

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The following is a guest post contributed by reader Bob, who started getting serious about financial freedom about 10 years ago and plans to reach early retirement next year at age 40. Thanks Bob for candidly sharing about your personal experiences and income-oriented portfolio.

monodiv_220I started following Jonathan’s blog about five years ago because I shared the same interest in personal finance and the goal of early retirement. I’ve made a lot of investing mistakes over the years, but with my 40th birthday coming up later this month I thought I’d share my approach which had the primary goal of income generation and capital preservation.

My initial goal was to cover my fixed expenses each month (housing, transportation, utilities, etc) from investment income. Once I had covered my fixed costs I expanded the goal to full income substitution for an extended period of unemployment (24 months), and later to full income substitution for 10-15 years. I’d like to say I was focused on a fixed target, but as with everything targets changed based on circumstances.

I started focusing on saving in the summer of 2005. I had graduated with an MBA and took a position at an Investment Bank in New York. I completed my MBA at the University of Texas at Austin largely because the tuition was low and I could graduate debt free. Looking back, this decision turned out be a very good one as I was able to secure a high paying job while investing relatively little in my education. In my view, maximizing revenue and minimizing costs is what personal finance is all about. However in life’s little ironies, I ended up paying through the nose for my wife’s graduate degree at UT in 2013-2014 but at this point we are far more capable of supporting this investment.

One thing I learned early on was that I did not want to be working in investment banking beyond ten years. The job takes a lot out of you and while the money is good and you learn a lot, it can be a very volatile business. Given the volatility in the markets and our annual bonus I decided I’d invest largely in fixed income and as a single guy in New York it made sense to look at tax-free munis. I don’t pretend that I had the foresight into the real-estate and financial crisis of 2008-2009 but I did witness a lot of risk taking and leverage deployed in the pursuit of returns.

I will not go into all details of my portfolio rather I’ll just go over the highlights.

$800,000 in taxable accounts which generate about 6.5% yield through investments in closed-end funds, utilities, and REITs. The vast majority is in muni bond funds as I’d prefer tax free income but qualified dividends also enjoy a lower tax rate. REIT income offers no tax advantage but I hold them as until recently we always rented our home. There is obviously a high degree of interest rate risk in my portfolio, but given I have deployed leverage in other part of my portfolio I’m comfortable with it. Overall I think taxes will go higher and so I’d much prefer munis to treasuries. I also hedge my bond holding by selling naked puts on the TBT (leveraged short treasury ETF). This has the positive impact of boosting my cash returns and hedging my long bond position.

$100,000 in LendingClub which generates a 7-8% return inclusive of defaults. I was hoping for a returns closer to 9% but given the institutional money chasing loans and tepid demand for loans it is not a surprise returns are lower than expected. Hopefully LendingClub does not relax underwriting standards in pursuit of loan growth. I still like this asset as the loans are short-term, payments include interest and principle, and you can invest as little as $25 at a time but I’ll moderate my contributions in the future.

$200,000 in direct real-estate investments through RealtyMogul and Fundrise. I only started investing nine months ago, but I have aggressively added to this asset class. I get geographic diversification across the country and by assets class (residential, commercial, debt, equity) and you essentially cut out the fees paid to fund managers and REITs so I see this as a win-win. It is still too early to estimate returns, but I’m hoping to generate 7.5% on a cash on cash basis and any capital appreciation would be a bonus. Most of the investment promise IRR’s north of 10% so I think the 7.5% is reasonable. I also think this asset class will prove to be better than LendingClub given these are secured investments and debt financing is cheap. On the downside there is zero liquidity, lead times are very long, and the minimum investments are very high.

Overall I’m generating about $6200/month in tax advantaged income and my goal is to eventually get this up to $7000. My savings suffered over the last 12 month as we incurred costs for my wife’s graduate degree, we relocated from Berkeley, CA to Austin, TX and we purchased our first house. I feel confident in ramping up savings over the next months and hitting full income substation before my 41st birthday next year.
I’m sure other will ask how I intend to offset the impact of inflation I also have $500K in tax deferred retirement (IRA, 401K) accounts but these are broadly diversified across domestics and international index funds so not much to say. I think continuing to invest in tax deferred accounts along with real estate investments will help offset the impact of inflation.

If you have constructive questions or feedback, please leave them in the comments. Please remember to be respectful! If you’d like to share your own story, please contact me.

Early Retirement Lesson #2: Earn More vs. Spend Less

travelplane

Here’s more of my “old man wisdom” about early retirement. I call it that because the lessons that I learned may or may not fully apply to you, but they worked for me and that is why I’m sharing them. Last time I talked about savings rates and how you need to save between 30-50% of your income in order to retire early. That’s a lot, and it leads to another long-running debate: Should you spend your energy trying to earn more money, or spend less money?

The “Earn More” or Capitalist argument is that you can’t save your way to being financially free. You need more money. You need a positive attitude, the willingness to work hard, and a desire to be rich. Capitalists tend to talk about things like entrepreneurialism, multiple streams of income, passive income, leverage, real estate opportunities, and occasionally some sort of multi-level marketing program like Amway or Herbalife.

The “Spend Less” or Frugalist argument is that unnecessary spending is the core problem. You don’t need all that stuff. You just need more spending discipline. Most American households have an amazing, luxurious lifestyle with huge houses, more than one car per person, and enough calories to feed a football team. People who earn more, just spend more. It is amazingly common to earn $250,000 a year and still live paycheck-to-paycheck. Look at athletes like Antoine Walker and Vince Young who have each earned over $100 million and $30 million respectively but still filed for bankruptcy shortly after they lost their jobs.

The easy answer – which I have used myself – is to do both. What a cop-out answer! :) Let’s try harder.

Studies have found that happiness is doesn’t go up after $60-$75k of annual income. Why is that? Perhaps it is because $60k will get you all the you need to be physically and socially comfortable. A house that isn’t embarrassing, reliable transportation, the ability to enjoy a dinner at Applebee’s with friends, the ability to travel occasionally. The median household income in the U.S. is roughly $51,000 a year. $60,000 is roughly 20% higher than that, making you “above average”. If you were to upgrade to a gated community, a Bentley, eating at 3-star Michelin restaurants, flying only on full-fare business class tickets, that won’t get you any better-quality friends. If you already make $200k and aren’t happy, then making $400k or $800k won’t make much difference.

Back to that 50% savings rate. If you’re happy with spending $60k (on average people spend 97% of their income), then you’d need to earn roughly $120k in order to save half. That seems like a good upper bound. If I already earned $120k or more, I’d probably focus on adjusting my spending to the 60k level instead of trying to make more.

On the flip side, as your income drops far below the median you start feeling the pinch more and more. A family of three that earns under $25,000 a year can be eligible for food stamps and other government subsidies. Earning $50k and saving 50% of that means living on $25k a year without being eligible for most government subsidies. Now, some people do live on less than 25k, but is rarely by choice (extreme counterexample). If I earned $50k and really wanted financial freedom, I would focus my energy on earning more money.

Now these numbers should probably be adjusted for the cost-of-living in your area. Look up the median income in your city or county; start here and here).

If your household income is less than 150% of the median income in your area, I would focus on earning more money. Start your own business. Invest in yourself through career advancement or a job change. For example if it is $60k, I would try to get to a household income of at least $90k. (That could be two people earning $45k each.) You could do a little frugalizing and spend $45k to get to a 50% savings rate.

If your household income is more than 200% of the median income in your area, I would focus on managing your expenses. If median income is $75k and your household income is $150k, then try and see if you can get to the spending level of a $75k household. Examine all of your expenses one-by-one. You will need to prioritize and probably cut back on areas that are less important to you. Early retirement is a big goal; you might need to make some big changes like moving to cheaper housing or dropping a car payment.

If you are in between 150% and 200% of the median income in your area, that is more of a gray area, and you may just need to do a little of both.

You can argue about the exact percentage cutoffs, but the basic idea is that I want a rule of thumb that accounts for the tendency of most people to maintain their social relationships (which are closely linked to happiness). At very low spending levels, it gets harder to maintain your social relationships and the self-discipline and energy needed can be better spent making more money. At a certain point, spending more money does not improve your relationships.

Early Retirement Lesson #1: Savings Rate

savingsrate

I’ve now spent nearly 10 years and 10,000 hours actively reading, thinking, and writing about money and the pursuit of financial freedom. I’ve still got a few years until early retirement but I can finally see the finish line. I’ve been meaning to summarize some of the lessons I’ve learned over time, as I’d like to make something more permanent that I can share with my everyone including my own kids.

In retirement planning, your “number” is usually defined as the amount of money you’ll need to retire. Something like a million dollars, like I used as a goal when starting this blog. Well, I was wrong. Your savings rate is the most important number!

If you take your annual income, your annual spending, and your annual investment returns, most people will admit that they have the most control over the first two. Your income minus your spending equals your savings. Your personal savings rate is thus the percentage of your after-tax income that you can save (and invest) each year:

savingsrate

I’ll leave the details out, but with some accounting equations and rough assumptions you can determine the number of years until your savings can create enough income to support your expenses.

savingsrate2

Rule of thumb: If you start at zero, you will need a 50% savings rate to retire in 15-20 years. You will need a 30% savings rate to retire within 25-30 years.

I’ve found that the math really does work out this way. You will need to save nearly half your income on a regular basis in order to retire early. Most people will never do this. But it is possible. My net worth was negative $30,000 in 2000. My wife’s was zero. Over the last 10 years, we have saved over 50% of our income every single year except for one year where I quit my job and went back to school. More tips on how it can be done in future posts.

If you want financial freedom, you must calculate and focus on your savings rate.

Early Retirement Portfolio Update – June 2014 Income

There is an ongoing investing debate as to whether you should focus on income or total return. I personally believe that you should focus on total return but realize that income is a critical part of that total return. If you want to live off the income produced by your portfolio, you should make sure it is stable and will grow with inflation. Reaching for yield via riskier stocks or lower-quality bonds is dangerous.

A quick and dirty way to see how much income (dividends and interest) your portfolio is generating is to take the “TTM Yield” or “12 Mo. Yield” from Morningstar quote pages. Trailing 12 Month Yield is the sum of a fund’s total trailing 12-month interest and dividend payments divided by the last month’s ending share price (NAV) plus any capital gains distributed over the same period. SEC yield is another alternative, but I like TTM because it is based on actual distributions (SEC vs. TTM yield article).

Below is a close approximation of my most recent portfolio update. I have changed my asset allocation slightly to 60% stocks and 40% bonds because I believe that will be my permanent allocation upon early retirement.

Asset Class / Fund % of Portfolio Trailing 12-Month Yield (6/5/14) Yield Contribution
US Total Stock
Vanguard Total Stock Market Fund (VTI, VTSAX)
24% 1.74% 0.42%
US Small Value
WisdomTree SmallCap Dividend ETF (DES)
3% 2.48% 0.07%
International Total Stock
Vanguard Total International Stock Market Fund (VXUS, VTIAX)
24% 3.08% 0.74%
Emerging Markets Small Value
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
3% 3.39% 0.10%
US Real Estate
Vanguard REIT Index Fund (VNQ, VGSLX)
6% 2.72% 0.16%
Intermediate-Term High Quality Bonds
Vanguard Limited-Term Tax-Exempt Fund (VMLUX)
20% 3.25% 0.65%
Inflation-Linked Treasury Bonds
Vanguard Inflation-Protected Securities Fund (VAIPX)
20% 1.74% 0.35%
Totals 100% 2.49%

 

As you can see, the overall weighted yield is roughly 2.5%. This means that if I had a $1,000,000 portfolio balance today, it would have generated $25,000 in interest and dividends over the last 12 months. Now, 2.5% is lower than the 4% withdrawal rate often recommended for 65-year-old retirees with 30-year spending horizons, and is also lower than the 3% withdrawal that I prefer as a rough benchmark for early retirement. My ideal situation is to get by with just spending this 2.5% in income every year. The paranoid part of me likes the idea of just spending the dividends and interest while not reaching too far for yield. That way, theoretically if I owned say 1% of GE or ExxonMobil, if I never sold shares I’d keep owning 1%.

So how am I doing? Using my 3% benchmark, the combination of ongoing savings and recent market gains have us at 85% of the way to matching our annual household spending target. Using the 2.5% number, I am only 71% of the way there. We’ll have to see how much full retirement appeals to me once I reach my goal at a 3% withdrawal rate. I’m not opposed to working part-time if the work is interesting to me, so I’m keeping my options open.

Early Retirement Portfolio Update – June 2014 Asset Allocation

1406_actualaa

I want to get back to doing quarterly updates to our investment portfolio, which includes both tax-deferred accounts like 401(k)s and taxable brokerage holdings. Other stuff like cash reserves (emergency fund) are excluded. The purpose of this portfolio is to create enough income on its own to cover all daily expenses well before we hit the standard retirement age.

Target Asset Allocation

aa_updated2013_bigger

I try to pick asset classes that will provide long-term returns above inflation, regular income via dividends and interest, and finally offer some historical tendencies to balance each other out. I don’t hold commodities futures or gold as they don’t provide any income and I don’t believe they’ll outpace inflation significantly. In addition, I am not confident in them enough to know that I will hold them through an extended period of underperformance (and if you don’t do that, there’s no point).

Our current ratio is about 70% stocks and 30% bonds within our investment strategy of buy, hold, and rebalance. With low expense ratios and low turnover, we minimize our costs in terms of paying fees, commissions, and taxes.

Actual Asset Allocation and Holdings

1406_actualaa

Stock Holdings
Vanguard Total Stock Market Fund (VTI, VTSMX, VTSAX)
Vanguard Total International Stock Market Fund (VXUS, VGTSX, VTIAX)
WisdomTree SmallCap Dividend ETF (DES)
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
Vanguard REIT Index Fund (VNQ, VGSIX, VGSLX)

Bond Holdings
Vanguard Limited-Term Tax-Exempt Fund (VMLTX, VMLUX)
Vanguard High-Yield Tax-Exempt Fund (VWAHX, VWALX)
Stable Value Fund* (2.6% yield, net of fees)
Vanguard Inflation-Protected Securities Fund (VIPSX, VAIPX)
iShares Barclays TIPS Bond ETF (TIP)
Individual TIPS securities
US Savings Bonds

Changes
I joined the exodus out of PIMCO Total Return fund earlier this year after their recent management shake-up. It actually coincided with my 401(k) allowing a self-directed brokerage “window” with Charles Schwab that allows me to buy Vanguard mutual funds, albeit with a $50 transaction fee. But my 401k assets are finally large enough that the $50 is worth the ongoing lower expense ratios. I’m buying more REITs and TIPS in order to take advantage of this newly-flexible tax-deferred space. I’m still holding onto my stable value fund, but I may sell that position as well in the future.

I think I mentioned this elsewhere, but I am now accounting for my Series I US Savings Bonds as part the TIPS asset class inside my retirement portfolio. Before, they were considered part of my emergency fund. They offer great tax-deferral benefits as I don’t have to pay taxes until they are redeemed. I don’t plan on selling any of them for a long time, at least until my tax rate is much lower in early retirement.

Sustainable Withdrawal Rates from Merrill Lynch Wealth Management

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Here’s another data point in the debate about safe withdrawal rates, or how much money you can safely withdraw from an investment portfolio each year without running out of money. Merrill Lynch Private Banking recently released a whitepaper on “sustainable wealth” aimed at high net worth individuals. Supposedly, in more than 67% of rich families, their wealth fails to outlive the generation following the one that created it, and 90% of the time, assets are exhausted before the end of the third generation.

Rich people problems? Sure, but one of the reasons for this high failure rate is that many people don’t have a reasonable idea of what makes a sustainable spending strategy. This applies to anyone who will eventually draw income from a portfolio for an extended period of time. Making a portfolio last generations is very similar to planning for early retirement. As we are talking about percentages, the numbers apply just as well to smaller portfolios.

Here are the results from a survey of wealthy families ($5M+):

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Here are the safe withdrawal rates they calculated for a 60% stocks, 35% bonds, 5% cash portfolio based on “Merrill Lynch capital market and fee assumptions”.

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I couldn’t find where they state what their confidence level is or what their “fee assumptions” are but I would assume they would at least be in the neighborhood of 1% annually. If you invest in low-cost index funds, that would theoretically mean you could increase the provided withdrawal rates by another 0.8% to 1%.

It looks like 3% is a good number if you want to be safe for 50 years, which is close to my investment horizon. Unfortunately, it is just a matter of luck whether you really need to take things that safely. From this other Merrill Lynch paper, starting with the same portfolio balance you could have taken out 5% a year (67% more income) starting in 1974 and your portfolio would have lasted just as long as if you withdrew only 3% starting in 1972. That is the potential effect of retiring just two years apart.

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If I do use the 3% sustainable withdrawal rate, that works out to putting aside 33 times my annual expenses. To increase flexibility, I also like the idea of making the withdrawal rate somewhat dynamic (adjusts with investment returns) similar to how Vanguard Managed Payout Funds are structured.

Merrill Lynch whitepaper (via BusinessInsider)

Betterment Retirement Income Review – Automated Safe Withdrawal Tool

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bettermentlogoOnline portfolio manager Betterment recently rolled out a new Retirement Income feature that will help you withdraw money from your nest egg. Unfortunately, even though I have a Betterment account I couldn’t test it out directly as it is currently only available to customers with a $100,000+ balance that have designated themselves as retired. But through a combination of reading through their website materials, press releases, blog posts, as well as asking an employee specific questions, I was able to get a good idea of how this feature works.

Factors taken in account. Here’s what they ask about your individual situation:

  • Current portfolio value. You can add outside accounts manually.
  • Asset allocation (Betterment portfolios are built-in).
  • Inflation is assumed to be 3% annually.
  • Time horizon (age and entered longevity).

Dynamic withdrawal strategy. This is very important! Betterment’s calculations assume a dynamic strategy where you come back every year to and reassess to determine a new safe withdrawal amount. Dynamic strategies are more flexible and resilient than static strategies which simply set a number at the beginning of retirement and stick with it regardless of portfolio performance. However, as a result you’ll have to deal with varying income, and it does not appear that they perform income smoothing. Here is an example scenario of how income might fluctuate with (rather optimistic) market performance (source):

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If you follow their advice, updating at least annually, Betterment estimates that there is a 1% or less chance of depleting your portfolio before the end of your designated time horizon. As with many similar calculators in the industry, their numbers are based on Monte Carlo simulations.

Sample numbers for 65-year old retiree. I asked Betterment Marketing Manager Katherine Buck about the following hypothetical situation: $1,000,000 portfolio, 60% stocks and 40% bonds invested at Betterment, with 30-year time horizon (age 65 to 95). In that case, the current model income recommendation would be $2,879 per month ($34,548 a year), or roughly 3.45% of the $1M portfolio.

Automatic withdrawals. To recreate a paycheck in retirement, you can set up an auto-withdrawal to deposit money into your linked bank account on a regular basis. You can go with their recommended amount, or you can adjust the amount as you wish.

Cost. The Retirement Income feature is included in their existing fee structure. At a $100,000 minimum balance, a Betterment charges 0.15% annually and that fee is inclusive of all trading costs and rebalancing costs. 0.15% works out to $150 a year per $100,000 invested. So a $1,000,000 portfolio would cost $1,500 a year. This is much cheaper than a traditional advisor from a major brokerage firm.

Finally, here’s a video about the feature that includes some (blurry) screenshots of the tool in action:

Overall, I think this is a smart move on Betterment’s part to start offering more features that a human financial advisor would offer that a discount brokerage like TD Ameritrade wouldn’t. The numbers appear to be reasonably conservative and the tool is definitely easy to use. A competing product that I’ve also written about is the Vanguard Managed Payout fund. In comparison with that product, I wonder if Betterment shouldn’t add a smoothing component to their recommended income amounts so that the withdrawal amounts don’t swing too wildly from year-to-year. Betterment has historically shown a good willingness to make changes in response to feedback, so I am hopeful they will consider it.

Also see my previous full Betterment review. The current Betterment sign-up promotion offers 3 months free with a $5,000 initial deposit, 4 months free with a $25,000 deposit, and 6 months free with a $100,000 initial deposit.