The Nastiest, Hardest Problem in Finance: Decumulation

Decumulation

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).

The Anchor: Physician on FIRE – Our Drawdown Plan in Early Retirement

Link 1: The Retirement Manifesto – Our Retirement Investment Drawdown Strategy

Link 2: OthalaFehu – Retirement Master Plan

Link 3: Plan Invest Escape – Drawdown vs. Wealth Preservation in Early Retirement

Link 4: Freedom is Groovy – The Groovy Drawdown Strategy

Link 5: The Green Swan – The Nastiest, Hardest Problem in Finance: Decumulation

Link 6: My Curiosity Lab – Show Me The Money: My Retirement Drawdown Plan

Link 7: Cracking Retirement – Our Drawdown Strategy

Link 8: The Financial Journeyman – Early Retirement Portfolio & Plan

Link 9: Retire by 40 – Our Unusual Early Retirement Withdrawal Strategy

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

Decumulation

Stocks

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!

Tax Status

Let’s start with asset allocation. As I have alluded to in prior posts, our current allocation is outlined below.

Decumulation

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.

Decumulation

Tax Optimization

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:

Decumulation

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.

Conclusion

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.

Wrap-Up

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

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52 Comments

  1. Very interesting! I like how you have strategies based on phases of life (soccer parents, empty nesters, gray hairs). We have a 2 year old and figuring out how to adjust our plans with kids is one thing I have wondered about with FI. Thank you for sharing!

    1. Thanks! It certainly helps me think about how expenses may evolve over early retirement. Hope it’s helpful as you plan for your situation. Thanks for the comment!

  2. JW, thanks for joining “The Chain Gang”! You’re officially in as “Link #5”. Thanks, also, for bringing up Mr. Sharpe’s research. Ironically, I came across him after I proposed this chain concept, and I’m pleased to see he’s following our lead (should I ask him if he’d like to be a member of the Chain Gang?). Also, I’m considering having all of these articles converted into an e-book, with all proceeds going to charity – your thoughts?

    I like your Roth Conversion Ladder concept. As you’ll see, we’re following the same. On a broader issue, it’s impressive what you’ve been able to accomplish at such a young age. I’ve enjoyed getting to know you as a fellow blogger, and look forward to watching as your plan unfolds!

    1. Thanks Fritz, I’m excited to be part of The Chain Gang! Kudos to you for the great idea and for organizing. That would be awesome if Mr Sharpe joins! Think he has Twitter? 🙂

      I think that’s a great idea with the ebook! Let me know how I can help.

      Thanks Fritz, it’s been a pleasure getting to know you as well and I’d love to meet up if you’re ever around Charlotte!

  3. Thanks for sharing your strategy! And you are 100% right: while the accumulation part is simple (hence the book title by Jim Collins) the decumulation is much harder. There is no one-size-fits-all, i.e., everything has to be much more customized: The SWR (which depends on equity/bond valuations), the tax strategy, the order of withdrawals, Social Security hacking, etc.
    Best of luck!

  4. Thank you for sharing, JW. I love it. The quote from Mr. Sharpe is awesome, but this quote from your strategy was my favorite:

    “We plan on walking softly and carrying a “4×4” into retirement.”

    I don’t see any flaws in your plan. The “Teddy Roosevelt” guide to retirement–make sure your nest egg dwarfs your income needs–puts you in a great position to mitigate taxes and take advantage of Roth conversions. Very well played, my friend.

    Mrs. Groovy and I are very interested in Roth conversions as well. The only problem we have is that they may not make sense giving our Obamacare subsidies. The more we convert, the more subsidies we lose. And we have to pay federal and state income taxes on those conversions to boot. I’ll be running the numbers this week to see if Roth conversions are worth it. Damn, Mr. Sharpe was right. Decumulation is the “nastiest, hardest problem in finance.”

    1. Definitely a good point about the interaction between subsidies and conversions. I need to research if 72T distributions fall into the same category as conversions, as far as that formula goes? This hard problem would be a whole lot easier if the laws and regulations surrounding these decisions had some greater degree of permanence. I have a fairly detailed plan, but I’m hesitant to refine it any further until some stability kicks in for healthcare in particular.

    2. Thanks Mr Groovy. It’s all about being safe rather than sorry later so we aren’t afraid to work a couple more years to have cushion, especially given our hopefully long retirement time horizon!

      Quite a conundrum with the healthcare subsidies. Current talks on the repeal and replace would change the subsidies from income based to age based so that may help.

      It is nasty and hard isn’t it!? Thanks for the comment!

  5. Thanks for sharing. Fascinating that so many plans in the chain overlap.

    Don’t know much about your situation on housing and healthcare (inc. dental/vision) plans but we budget the following FIRE costs for a family of four:

    Healthcare $20,000 – gold-plated coverage through (soon to be former) employer; cutting corners on healthcare will never be in our plan
    Home maintenance $7,200

    1. Thanks Mr Pie! I don’t disagree on the potential cost of healthcare. Our estimate may be a little low but we’re comfortable with our extra cushion. Hopefully we can refine our estimate a bit once we understand the potential changes to the health insurance exchanges.

      We’ve owned our home over five years now and done a lot of the home maintenance ourselves besides replacing the roof two years ago. Over the five years our average expense hasn’t come close to my estimate but I may need to look at this closer in terms of future expectations.

      Thanks for the comment!

  6. Your timeline and strategy almost exactly matches mine (older of the two authors at DoD) minus two kids and minus an equivalent chunk of change. I plan to fall back on simple 72T distributions if the Roth conversion ladder fails me. We’re so close on the timeline I’m wondering if I should issue a challenge :).

    I love my HSA – filled it to the brim while I was fresh out of college, and I’m leaving it invested aggressively as super frail old man money. I have a post in my back pocket to publish soon called “The Thematic HSA” where I invest my HSA dollars 100% in healthcare bluechips just for kicks. I keep hoping that if ONE good thing comes out of the current administration, maybe just maybe they’ll fulfill a campaign promise to bring HSA’s to all. I’d rejoice.

    1. Had trouble with the “Post Comment” button disappearing after my comment went to 3 paragraphs. Tacking on a final thought —

      The two biggest variables I see in the next 5-8 years are an upcoming correction/recession and healthcare. I’d prefer that the former happen soon so that we can accumulate straight through the doldrums and come out at retirement time glistening with capital gains. For the latter, I’m actually rooting for deadlock: just leave it as-is and I’ll be happy.

      1. Oh weird, sorry about that. I’ll check to see if there are character or word limits…

        Completely agree on those two points! If we’re going to have a sell off let’s have it now!

        And with the current setup of healthcare subsidies, early retirement is a huge loophole. Would love to take advantage!

    2. Ha that’s great! It’s great having someone in a similar boat on timing to bounce ideas and strategies off of. I agree, the 72T is a good backup option. I don’t like how it permanently sets withdrawals though, I wish it was more flexible!

      Love the idea of a thematic HSA! I think its performance would have done well the last five years. 🙂

      I’ve been finding mine up as well. Hard to imagine not having access for healthcare related expenses as I age!

  7. Great post. Two excellent components that stand out to me:

    1. Your three phase budget. I know that some expenses will come and go as our boys get older, then leave the nest, and then we get older, but I had never broken it down categorically as you have done so well here. Pretty nifty how all three phases have a similar total budget. I think you’ve saved me the work of breaking it down for myself.

    2. The size of your budget. It’s similar to ours and represents a very comfortable lifestyle without sacrifices. Even better, you’ve got plenty of fluff that can be trimmed in the event of an ugly bear market or crash.

    Thanks for participating in the #DrawdownStrategy series!
    -PoF

    1. Thanks Doc! The three phases did work out fairly well and it was a helpful exercise for me to comprehend potential blind spots in my future budgets. Glad to hear it may help you too!

      Completely agree with how you worded point 2. Having fluff and cushion to cut back if need be can add longevity to investments and peace of mind!

      Thanks for getting the ball rolling on this fun drawdown series!

      1. All credit goes to Fritz @ Retirement Manifesto for getting the ball rolling. It is beneficail to see the different thoughts and strategies. Cheers!

  8. Nice post! I haven’t tried to write about this because it seems so specific to individual financial situations and I wasn’t sure how helpful it would be for others. But it’s something that we all really need to strategize around so it’s a good topic to bring up. I love the idea of collecting/linking multiple case studies. That way all of us can take ideas from each and create a better plan for ourselves.

    My own strategy involves a mix of an income floor through a pension, some deferred income, and dividends and then sales of stocks for additional spending needs. I don’t want the income floor to be too high because I want the flexibility of a low tax bracket, especially for capital gains sales. It would also allow me to make a small income if I want. But I don’t want to depend on just capital gains. An income floor provides some peace of mind.

    So it’s a complex mix of tax management, asset allocation for growth, risk management (including sequence of returns), and some relevant psychological considerations. It’s certainly easier to know how to add money than it is to take it out!

    Thanks for the post!

    1. Very good points and considerations. Having too much income has been a consideration and deserves some focus. I too do not want to be above the 15% tax bracket for capital gains tax reasons. Hopefully I have some flexibility to manage that but starting with a cushion is important.

      Thanks for bringing that to light and the great comment. I’d love to see more of the details of your plan. Always nice to draw similarities and comparisons to others.

    1. That’s what I call carrying a 4×4 into a secure retirement! I think a conservative approach is the way to go. Thanks ATL!

  9. Hi JW,

    Thanks for sharing! I am glad to see that I am not the only one who is investing only in Stocks (excluding my FA managed accounts that is) – I just don’t see them as that risky as long as you have a couple of years in cash when you retire I do think that should see you through fine.

    We don’t need to worry about leaving a legacy to family as we aren’t having children, however I would like to look at what we can do to help on the volunteering side, but I am glad you are thinking about the tax implications. Tax can take a huge bite out of your income – luckily here in the UK we have some relatively generous schemes (for myself and the other half, we can put £40k a year of post tax income into an ISA which means it grows tax free, and any income is tax free – thank you!) as well as our equivalent of the 401k.

    Also interesting to see how little variance there is between your three stages of retirement 🙂
    Cheers,
    FiL

    1. Glad to see we are thinking the same on stocks! They are volatile in the short term period buy not so much over the mid to long term.

      Oh nice, your ISA kicks our Roth IRA’s butt! Contributions are limited to $5.5k! Maybe there is some hope ours will loosen one day and allow more in contributors… but I think that’s a dream.

      Thanks for the comment FiL!

      1. Hi JW,
        Yes – seems few people are willing to stay 100% in stocks (and to be fair, I am not given I have bonds in my IFA managed stuff) but it just seems you are wasting money not!
        Yes, the ISA over here is currently rocking – no tax at all once the money is in (or withdrawn) – it is a superb investment vehicle!
        Here’s hoping that the tax cuts “The Donald” promised helps to some degree for you – $5.5k seems such a low level, but from what I have seen you don’t get hurt as much on dividend income 🙂
        Always a pleasure to join the conversation 🙂
        Cheers,
        FiL

  10. Lots of great info to sift through here!

    Re: your comment above about not wanting to broach the 15% tax bracket to keep capital gains at 0%.

    If one does creep up into the 25% tax bracket and incurs 15% capital gains tax, that 15% is assessed ONLY on the amount above $73,800, correct? Compared to ordinary income taxes before retirement, it’s would be quite a small tax bill if one lands just above $73,800 in capital gains.

    Then again, paying 0 taxes is always better than paying anything 🙂

    Dr. C

    1. No my understanding is that if you enter the 25% income tax bracket than all capital gains are taxed at the 15% rate. I’ll have to double check this quick though.

      Thanks for the clarifying question, Dr C!

  11. Pretty cool there is a “chain gang” 🙂

    I honestly don’t think I can ever touch principal. It HURTS too much. So, I just plan to try and make more than I spend, forever.

    Best retirement drawdown strategy is to just work!

    1. Beginning to touch principle would be a tough psychological hurdle to get over. For me, the “drawdown” stage would be easier knowing that my expenses would be comfortable less than the earnings my portfolio kicked off. Seeing my net worth go down would not be comfortable!

  12. I love how much you’ve thought about your phases of life & that you’ve realized you’ll likely be spending the same overall amount with just a change in category. I’m with you on the conservative 3.5% SWR and loving 100% equities since I’m young and have the time.

    1. Yeah it’s funny how that worked out so well. And it makes sense that as the stages of life evolve so will the primary spending categories.

      Thanks for the comment!

    1. I’ll continue to contribute about $130K or more per year plus my estimate for stock market performance at 8% which adds almost $100K per year and growing. While I don’t expect that strong stock performance year in and year out, that is my long term expectation.

      Thanks for the question, Lawrence!

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