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.

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  1. I have done ok with saving through the years but have been so scared to invest, i’d love to retire early but i’m 40 now and have such a long way to go. I do have aprox. $200000 saved up but investing is another story… I admire what you have done.

  2. “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.”

    Can you explain this statement more fully for someone not well versed in the topic? Thanks.

    • I also found this a little confusing…My understanding is as follows: When you sell a “naked put” you are selling an options contract without owning the underlying security (that’s the “naked” part). Since a “put” is an option where you expect the underlying security to go down, when you “sell a put”, you’re effectively betting on the security to rise. So his options position is long the underlying security…However, the security he’s writing the options on is an engineered short ETF…Therefore he is actually taking a short position on treasury (i.e., he’s “long” a “short” position). He wants to short treasuries because, according to him, he has significant fixed income holdings and he also gets an income stream from selling the options contracts.

      Seems like a convoluted way to get the exposure he’s looking for, but I don’t have much market experience with options contracts.

  3. Seems like a lot of risky and high-cost investments….

    • The costs are a bit higher than a low cost index fund, but most of the closed-end funds I have purchased have expense ratio below 1%. I think the direct investments will prove to have relatively lower expense ratio as well since they are essentially removing the middle-man.

      There is interest rate risk, but my view is that rates will stay low for an extended period of time. Overall my target return is about 6.7%, which is kind of crazy considering I could make 4% in a CD back in 2007-2008.

  4. Also, at what point do you buy back the TBT puts if the position moves against you?

    • At this point I have never had to buy the TBT as I sell very far out of the money puts. This is a risk, but I only hedge a small amount of my bond position so any loss on TBT would be offset by an increase in my bond portfolio.

  5. Brilliant job……I think your approach highlights the difference between the plain vanilla retail investor (like myself) and someone who knows how to use all the tools available to him to manage risk and maximize return. I’m just barely squeaking 4.2% out of my portfolio and already think the amount of risk I’ve had to assume as I chase yield wherever I can is too high.

  6. So if you are trying to hedge against a rise in rates that would hurt your bond portfolio I’m not sure writing puts is the best approach. I see that if rates spiked the TBT would go up, but then your puts would just expire worthless. You get to keep the premium, but that doesn’t really effectively hedge your risk, which is a function of the magnitude of the up-move in rates, right?

    • You are correct. I am an income oriented investor so I am mostly looking to hedge the monthly cash flow. If rates spike, the value of my bonds would decline and it would not be offset by the cash I generate from the put premium. The key point is my cash flow is hedged each month and that is my primary goal.

      • Thanks for your response!

      • Focusing on yield/income at the expense of the principal? How long would that last if you decide to live on income down the road?

        • Higher rates do not impact the absolute cash flow of a bond if it is held to maturity. The value of the bond declines due to the discount rate. If a stock is not growing its cash flows the stock price would decline as well in a rising rate environment. The good news about high levels of cash flow is I could always invest the income in growth investments if I thought inflation was eroding my purchasing power.

  7. What a great post! Thank you for sharing your experiences and thoughts! I hope you do expand a little more on your thoughts about selling the short puts.

  8. Thanks for the article. I was previously unaware of the two crowdsourced real estate services, Fundrise and RealtyMogul.

    Like the author, I’m a long-time investor at LendingClub. I use their automated investing service, and am happy to receive a reasonable return without having to spend time (or possess expertise) in evaluating individual loan applications.

    What are your thoughts, in that particular respect, about these real estate services? Like LendingClub, can an average investor do OK there without specific knowledge of real estate analysis? i.e. Would an investor like do OK there in choosing (more or less) random investments, but having lots of them (to provide risk diversification?)

    Thanks for your thoughts.

    • I am always looking to diversify and before I make an investment I track the correlation to my existing investments. Highly correlated investments must offer higher returns, but poorly correlated investments can carry lower returns. I think real estate is a key part of any income based portfolio, but I was always worried about the leverage and lack of diversification. I think crowd-funding is a great alternative because you get the diversification and leverage is not such a bad thing now with rates so low.

      • Hi Bob,

        Thanks. What I’m specifically wondering about though, is how knowledgeable a person needs to be to invest successfully in these crowd-sourced real estate investment services? At LendingClub, you can do just fine without any knowledge of how to analyze/assess a personal loan application, and I’m wondering if the same is possible within these services — i.e. if you invest $5k in a large number of properties, are you likely to do OK?

        • It is a good question and it is far too soon to say if this will be a success. I am putting a lot of faith on the management teams and the due diligence of the sponsors. I figure if unsecured loans can generate 7.5%+ the secured loans backed by real estate and low borrowing costs should do just as well.

  9. I find it Interesting that there are is no allocation to common stocks in your investment portfolio mentioned. Is this driven by income requirements or valuations?

    • I do have a small amount of common stocks, mostly REITs and utility stocks in my taxable accounts. I will not buy equities unless they hit a 4% dividend yield so I try to be opportunistic and buy when there is blood in the streets. This has worked well on a few purchases (CNP, PNM) and hopefully will work with a recent purchase (ARCP).

  10. Congrats!
    I have been working on this goal myself. You are ahead of me by a comfortable margin. But hearing your story is very inspiring. Thanks for sharing.

    When I am projecting out one of my biggest concerns is always healthcare. Having always had employer sponsored healthcare I have no clue what it is like outside of that. What are your plans for healthcare after early retirement for you and spouse?

  11. Patricia says

    Thank you for sharing your portfolio and strategies with us. I’m retired, on SS and have about half the amount of nest egg as you have laid out here. My question regards your take on whether it’s better to be in ETF or mutual funds in the various sectors of a balanced portfolio. Or does it matter. Is one form “safer” than the other in terms of the fund being there down the road. I’m in name brand funds (both varieties) currently, ie vanguard, fidelity, schwab and pimco. Appreciate any thoughts you care to share. Thanks

    • My guess is the name brand funds are less volatile and offer much better liquidity. I think closed-end-funds are great, but they can be very volatile, may be less liquid, and many employ leverage to boost returns. Investors should be very careful when investing in CEFs. I think the risks are manageable but I will not be adding much more to my CEFs as I don’t want to increase the risk profile of my portfolio.

  12. All it takes is a 2008 crash to wipe out what u built. A lot of risky ventures there.

  13. Congrats! What do you plan on doing post retirement? Its always interesting to see different strategies…especially one that mostly concentrates on income producing assets. I – like probably most readers here – mostly allocate towards domestic large cap.

    • Good question. I think investing is all about buying cash flow, as Warren Buffet has said, if your buying something in anticipation of selling at a higher price you are speculating. With that said I think with the solid cash flow from investing I will probably look to pursue higher upside in my employment. I was thinking now would be a good time to go and work at a startup. Perhaps take very little salary and just work for potential equity upside.

  14. Is $1.5 million at age 41 enough to retire…? That’s a lot of time to have left.

  15. You did not mention that large state income tax savings as a result of moving from CA to TX. That’s huge! Was that a motivating factor in your move?

    I am in the middle of moving from MN to WA (like you, moving from a very high tax to low tax state). The tax savings was a MAJOR factor in my decision to move.

  16. Thank you for sharing. But for other readers benefit, I’d like to provide some (polite, I hope) criticism to the municipal bonds decision. It’s not clear from the post what your marginal tax bracket is, but the research is pretty clear that you need to be in the highest bracket to even consider them. Plus, there is a reasonable default risk on them (even in a diversified pool), especially when compared to no-risk T-bills. Finally, even if your bet is that taxes go higher, I’d note that it might not be income taxes (i.e. we could get a consumption tax like every other industrialized country has), it could be an income tax boost that doesn’t hit you, or it could be that they start taxing municipal bond interest! So to Jonathan’s readers, I encourage you to think carefully on that type of investment.

  17. Thank you for sharing.

    Would you be willing to share the ETF/Fund Names and the % allocation of your taxable account portfolio :
    “$800,000 in taxable accounts which generate about 6.5% yield through investments in closed-end funds, utilities, and REITs.”

  18. Wow.. incredible amount in cash invested if that $1M or so figure has no borrowings attached to it. Are you able to elaborate on this?

    I’ve just ‘semi’ retired at 34 and am enjoying my time, but I say semi because I have only $450,000 equity and over $1M borrowings. My rents from investment housing exceeds outgoings by a good amount. I still have a mortgage but it’s low. If I only ever took part time jobs here n there to keep a bit of income coming in then I can expect to make around $1M each 10 years in capital and leverage into more real estate. In 10-20 years I feel we could just start using the equity to live off and continue to hold the assets or sell them and place funds into shares for divdends and growth but they wouldn’t be leveraged.

    My current retirement is that of early retirement extreme and I’m happy with that because it allows retirement much sooner than otherwise possible.

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