Hello folks! A key question on many early retirees’ minds is investment drawdown strategies. Even the great Nobel Laureate William Sharpe has been contemplating retirement planning lately (more to come on that in future posts). As a matter a fact, Mr. Sharpe said decumulation is the “nastiest, hardest problem in finance” to tackle which is saying something considering Mr. Sharpe was the mastermind behind the Sharpe Ratio and the Capital Asset Pricing Model (CAPM).
So I thought I’d spend a little time today discussion my plans. While my retirement is still 5 years away or so, I am nearing Financial Independence so it will be good to start framing up my initial plans.
Retirement Investment Drawdown Strategy
Some good blogging buddies of mine have also recently posted their strategy on investment drawdowns which has spurred me to action. If you are looking for a few more case studies to compare your own plans to, be sure to check out Physician on FIRE, The Retirement Manifesto, Othala, Plan Invest Escape and Freedom is Groovy.
I’ve replicated the format of the above mentioned articles to allow easier comparison between us all and be on the lookout for this to continue among others. Fritz from The Retirement Manifesto has taken it upon himself to organize a chain of similar articles from any personal finance bloggers looking to participate; to which I’ll continue to update links from my post to all others in the chain (see below).
Link 5: The Green Swan – The Nastiest, Hardest Problem in Finance: Decumulation
Link 10: Early Retirement Now: The ERN Family Early Retirement Capital Preservation Plan
Link 11: 39 Months: Mr. 39 Months Drawdown Plan
Link 12: 7 Circles: Drawdown Strategy – Joining the Chain Gang
Link 13: Retirement Starts Today: What’s Your Retirement Withdrawal Strategy?
Link 14: Ms. Liz Money Matters: How I’ll Fund My Retirement
If you’d like to join the chain with a post of your own, simply backlink to the articles already posted in this series, tweet your post using #DrawdownStrategy, and tag any blogger who is already in the chain.
So, without further ado, let’s go ahead and tackle my investment withdrawal strategy.
What We’re Starting With
Here’s a couple quick stats to show you where Lucy and I are currently sitting:
- Family of four: Lucy (31), Myself (31), Cygnet #1 (3), Cygnet #2 (3 months)
- Current net worth is over $1.3 million with over $1.2 million invested (remaining ~$100K consists of home, cars, some cash, no toy dinosaurs but plenty of GI Joes, etc)
- College funds are set and ready to go (no additional planned contributions)
- Our tentative plan is to hit Financial Independence by age 35 with around $2 million, then work a few more years to build cushion and retire early at 37-38 with $3 million
Stocks, stocks and more stocks. I am definitely on the aggressive side of the investment spectrum as I am invested 100% in stocks. I’m young so why not? Plus, they are the clear winner in terms of long term wealth creation. I have no intention of reducing this allocation. There is even a case to be made with an aggressive investment strategy throughout retirement, especially for early retirees with long retirement horizons (we need our wealth to last!!).
I’ll save the details of our investment philosophy for another time. As a matter of fact, a detailed post on our evolving investment philosophy has been drafted and currently in queue to be posted soon. Stay tuned!
Let’s start with asset allocation. As I have alluded to in prior posts, our current allocation is outlined below.
However, most of our contributions going forward are being funneled into our pre-tax 401k plans and our after-tax taxable brokerage account. But more important than our current allocation is what I expect our allocation to look like at the time we retire.
I’m a proud and self-proclaimed personal finance nerd so I’ve always fancied myself some nice looking excel charts. Would anyone be surprised if I hadn’t already modeled out my expected balances in each respective account? Obviously these estimates are subject to change, but as I have refined them year after year I have become more and more comfortable with the expected outcome.
As such, the asset allocation I expect at retirement is outlined below.
As you can see the pie chart above showing my breakout by tax status, there is some management to be done in retirement to reduce this potential liability. For regular readers, you know I’ve already outlined how to go about estimating how tax-efficient your retirement accounts are as well as detailing my strategy on how to never pay taxes again.
The big picture idea though is living on our taxable account while simultaneously rolling funds from my pre-tax 401k to a Traditional IRA (immediately at the time of retirement) and then rolling it into my Roth IRA over time in what is known as a Roth conversion ladder.
The longer my taxable accounts last, the longer I can spread out my Roth ladder conversion timeline and the less taxes I will pay. Since converting Traditional IRA assets to my Roth IRA is a taxable event, I would prefer to roll over only the amount I can up to my standard deduction (currently $12,700), exemptions (currently $16,200 with family of four), and other miscellaneous tax credits and therefore my taxable income is de minimis.
That’s the plan today anyway…so long as tax law doesn’t change. It has been long speculated that the Roth conversion ladder may be in the cross-hairs in future tax reform legislation. We’ll see.
First Moves We’ll Make When We Retire
Step 1: Execute on Tax Strategy
First thing we will do is begin executing on our tax optimization strategy which includes the Roth conversion ladder, but also includes other steps on reducing the imbedded capital gains liability in our taxable brokerage account. See my post on never paying taxes again for the details.
Step 2: Spend Money and Live Life
It is hard to assess and project spending levels on an annual basis for 50 years, but that is in essence the task at hand for early retirees. And that is part of why Mr. Sharpe thinks ‘decumulation” of wealth is such a tricky problem.
I’ve taken a stab at it though and surprisingly I have estimated a reasonably tight range to annual spending. Below is a snippet of a chart from the linked post broken out by our three expected “phases” in retirement:
Certainly things will fluctuate. We’ll live life and go with the flow. Sometimes spending will be more than expected, other years it very well may be less. That is part of why we are building so much cushion…we plan on walking softly and carrying a “4×4” into retirement.
In terms of order of operation, we’ll be tapping our taxable account first. Once that is dead and dried up, we’ll move on. While we are spending our taxable account though, we’ve been simultaneously executing on our Roth conversion with the intent of eventually having our 401ks completely rolled into our Roth IRAs.
That will then be our next source of funds to live on. Specifically, we will be withdrawing our contributions from the Roth which can be withdrawn tax and penalty free at anytime (no need to wait until 59 ½). And mind you, contributions would include the annual contributions we’ve made leading up to retirement as well as said Roth conversions.
Yes, those Roth conversions are considered contributions since at the time of conversion, which is a taxable event, we are theoretically using after-tax funds. In the eyes of the IRS, those are contributions. But again, we’ll see if this “loophole” in tax law lasts the next round of tax overhaul legislation. If not, plans will change…
Step 3: Reassess Annually
Generally speaking, we plan on abiding by conventional wisdom and using a fixed “safe withdrawal rate” to estimate our ability to be financial independent and retire early. The safe withdrawal rate we are abiding by is ~3.5%, slightly more conservative than the standard 4% safe withdrawal rate often used as the rule of thumb.
This leads to the other reason why I think Mr. Sharpe calls “decumulation” a nasty problem, or at least a bone he has to pick with the use of “safe withdrawal rates”. And that is using a non-volatile spending plan (the safe withdrawal rate…) while using a risky, volatile investment strategy (relying some mix of stocks and bonds as the primary investment vehicle through retirement).
Nonetheless, we use 3.5% because it is simple and relatively more conservative than the 4% Rule. And the reality of the matter is that life is lived in the real world and not in models and graphs. Our spending patterns won’t necessarily be “non-volatile”. I think it is only human nature to curtail spending a little when you see the economy go into recession and your investments suffer, even if the safe withdrawal rate says it doesn’t matter.
We won’t be deaf to what is happening to our investments. We’ll reassess annually and maybe move certain flexible spending categories around year to year depending on market performance. For example, maybe we’d do a smaller and less extravagant vacation in certain years or delay buying a replacement car and instead elect to repair our current vehicle to avoid selling as much of our investments in a down market.
Long Term Strategy Items
Given retirement is still a handful of years away for Lucy and I, we plan on keeping our eye out for a couple things and have summarized those below.
- Healthcare: Healthcare will continue to evolve, but we’ll control what we can by living a healthy lifestyle (hence one of the main reasons we went vegan). There are a few options for healthcare for early retirees and we’ll monitor these as we near retirement.
- Tax Legislation: The Roth conversions are an important part of our early retirement strategy. If tax law changes before we execute on this strategy, it won’t cripple our retirement plans, but we’ll have to stay flexible and adjust.
- Leaving a Legacy: We have not focused much on leaving an inheritance for our kiddos. Our focus is maintaining enough for retirement, although based on our conservative plans I would expect a relatively good chunk to be passed on to heirs. But hopefully that won’t be anytime soon! In all likelihood it will be well past the time they would need it. If we pass sometime after age 70, they’ll be 40 years old and beyond…if they are anything like Lucy and I they’d be retired…
- Instead, our intent is to be present during childhood, lay the foundation for them to be productive and functioning members of our society, teach them the ways of the world and help them through college.
- All in all, leaving a legacy for the kiddos is not a priority.
- Health Savings Account: Our H.S.A. plan will be extra cushion for us in retirement. It will serve somewhat as an emergency fund in case of future healthcare needs arising. But also, we’ve been saving and accumulating qualifying healthcare receipts which will allow us to make qualified withdrawals (no tax or penalty) for any future need. Currently, these receipts amount to a few thousand.
- Life Insurance: Life insurance doesn’t suit us right now. We analyze this regularly, but haven’t found the need for it. I don’t anticipate this changing.
Our retirement investment drawdown strategy is built on being conservative. I don’t know how that could not be the case for early retirees in particular, like ourselves, who are looking at a potential 50+ year retirement horizon.
Without having read through all the work Mr. Sharpe has put into tackling the “nastiest, hardest problem in finance” (which I intend to do and will subsequently write an article or two to share my concluding thoughts with you all), I think the only solution is to approach retirement with the intent to rather be safe than sorry later on.
We’ve given a lot of thought to contingent plans and conservative assumptions which I detailed in the post on walking softly and carrying a 4×4 to secure retirement.
Otherwise, I think our strategy is fairly straight forward. Lucy and I are millennials so of course we don’t have pensions or retiree health insurance plans available through our employers. We also don’t have a crystal ball into whether we’ll have access to social security when we reach traditional retirement age (even though we’ve been paying into it…). I assume it will be overhauled and preserved, but that could result in means-based testing in order to be qualified. Who knows, but either way we’re better safe to assume it won’t be there for us.
I hope you enjoyed this post and that it gave you something to ponder as you develop your own retirement investment drawdown strategy. I certainly appreciate your thoughts and comments on our strategy. If you think we missed something or have something to add, please let us know in the comments below.
Thanks for taking a look!
The Green Swan