All posts by Tom Canfield

Is “Bonds first” a strategy for annual withdrawals for your spending from your portfolio?

My friend Jay sent me an article years ago that argued the best withdrawal strategy for retiree was “Bonds first.” You set a constant dollar withdrawal amount for spending and an initial mix of stocks and bonds. You sell bonds for your spending until you’ve depleted them; that then leaves you with a 100% stock portfolio that you’ll then sell for your spending. This differs from the normal or “Usual” strategy that one can evaluate in a Retirement Withdrawal Calculator (RWC) like FIRECalc: all RWCs assume that you rebalance back to your target mix of stocks vs. bonds at the start of a year. The purpose of this post is to examine “Bonds first” to see if that tactic gives the same safety – the same number of years of full withdrawals from a portfolio in the worst-case sequence of returns – as the “Usual” process of rebalancing back to your design mix of stocks and bonds. Conclusion: it does.

 

== The attraction of Bonds first ==

 

“Bonds first” recognizes that stocks generally outperform bonds. By selling bonds first from your portfolio, you’re allowing stocks to compound in value. When you start selling stocks only, you’ll have greater portfolio value than if you were selling them year after year. For example, stock returns have far outdistanced bonds for the three years of the six year since the start of our plan at the first of 2015. The math that gets me back to my design mix of stocks vs. bonds for the start of the next year told me to solely sell stocks for our spending. And then it told me to sell more stocks to buy bonds to get to my design mix. That means I’ve foregone stock returns and have a lower total portfolio value now than if I had previously sold “Bonds first”.

 

The disadvantage of “Bonds first” is that it is very hard to get in your head that you should ever be 100% in stocks when you are retired and withdrawing from your portfolio for your spending. I find it IMPOSSIBLE. I would go crazy if I were 100% in stocks no matter how much I had. I hate the thought of having no bonds to sell in a year when stocks crater. It’s worse than that: I can’t imagine how I would feel if I was 100% stocks and withdrawing, say, 5% from my portfolio each year and saw my portfolio decline to LESS THAN HALF its value in real spending power in 24 months. That happened in 1973-1974! That happened in 36 months in 2000, 2001, and 2002!

 

== We use an RWC to judge ==

 

We use an RWC to judge the safety of our decisions for our financial retirement plan. An RWC shows how a portfolio fares over time for sequences of returns that the RWC constructs. For a set of inputs, an RWC tells you the number of years you can count on for a full withdrawal for your spending. The fewest number of years will be result of the worst case or Most-Horrible sequence of returns that the RWC constructs.

 

The actual Most-Horrible sequence of returns since the 1870s starts in 1969. I described that sequence here and here. It’s really Most Horrible. The worst seven-year return period for stocks starts in 1969. The worst seven-year return period for bonds starts a few years later. The poor returns in that sequence, coupled with your on-going withdrawals, shrink a portfolio to its tipping point, less than half its initial value. It spirals to depletion even when returns turn to be well above average.

 

The “Usual” RWC uses a fixed mix of stocks and bonds. The RWC rebalances a portfolio back to its design mix at the start of every year. You can’t use the usual RWC to examine a different approach like “Bonds first”. The only way to do that is to build a more detailed spreadsheet that allows you to pick what you want to sell for your spending each year and start the next year with a revised mix.

 

I built a basic spreadsheet I described and link to in this post. I altered it for this post to track stocks and bonds separately. I can input “Bonds first” and calculate portfolio value year-by-year.

 

== The test ==

 

I want to compare “Bonds first” to “Usual”. Does “Bonds first” match “Usual” in the number of years of full withdrawals for spending?

 

I input the following into my spreadsheets: initial $1,000 portfolio value; mix of 80% stocks and 20% bonds; total investing cost of 0.10%; and an annual withdrawal amount for spending of $44 in constant spending power. All returns are inflation-adjusted.

 

== The two options ==

 

Option 1: This is the base case, the “Usual” way all RWC’s work. I assume a portfolio is rebalanced to its design mix after the annual $44 withdrawal for spending for the upcoming year. You see that spreadsheet here.

 

Option 2: I use the expanded spreadsheet, and I withdraw “Bonds first.” The first $44 withdrawal comes from the starting balance of $200 of bonds (20% of the $1,000). In the example, I consume the bonds in about 3¼ years. You see that spreadsheet here.

 

== The comparison ==

 

I display how many years a portfolio provides a full withdrawal for spending for the two options:

 

 

“Bonds first” for all practical purposes has the same safety as “Usual”. The portfolios have almost the same amount at the end of the 20th years, basically just enough for a full withdrawal for the 21st year, but they don’t have enough for the 22nd year.

 

I don’t display the results from other inputs to the spreadsheet, but I’d reach the same conclusions over a very wide range of spending rates, mix of stock vs. bonds, and investing cost. I find no case where “Bonds first” is significantly different in terms of safety than the “Usual”.

 

 

Conclusion: This post examined if you should consider a tactic of “Bonds first” as an approach to deciding what to sell from your portfolio for your annual spending. Is that approach as safe as the “Usual” approach of rebalancing back to your design mix every year? I judged the effect on a portfolio using the Most-Horrible sequence of returns for stocks and bonds in history. I find found that “Bonds first” and “Usual” result in the same number of years of full withdrawals from a portfolio in the worst-case sequence of returns.

I fiddled with my bonds. Should you?

For many years I fiddled annually with my stock portfolio. Decades ago, I would spend hours and hours trying to pick winning stocks. Years ago, I would spend hours trying to pick winning, actively managed stock mutual funds. I stopped all fiddling for the last seven years when I started our financial retirement plan: I concluded that fiddling was adding uncertainty to my future returns: we don’t want to add more uncertain to an already uncertain future. Stick with broad based, low cost index funds. But this past month I could not resist fiddling with the ~20% of my portfolio that is bonds. Patti and I now own three US bond funds, not just one that I’ve held for more than six years. The purpose of this post is to explain my thinking.

 

 

== Bonds are insurance ==

 

We all hold bonds as insurance against steep declines from stocks. (I’m a broken record in saying this, but most folks just don’t get this concept.)

 

You get the same basic insurance value with almost any mix of broadly diversified bond fund. This post shows that both Long-term bonds and Intermediate-term bonds outperformed stocks in their ten worst years by an average of 27 percentage points. Those Horrible Years for stocks are the years when you collect on your insurance: you will disproportionately sell – or even solely sell – bonds for your spending needs. You’re giving stocks time to recover before you must sell them for your spending.

 

Patti and I hold 5% bonds as a Reserve and 15% in the balance that I call my Investment Portfolio (See Chapter 1, Nest Egg Care [NEC].) To simplify, I have about 20% bonds in total. Our spending rate is nearing 5% (We are older.) We have, at minimum, four years of spending as bonds. We could, if stocks cratered, live off bonds for at least four years, giving stocks four years to recover. (Patti and I could easily spend less than our current annual Safe Spending Amount [SSA; see Chapter 2, NEC] and extend those years. Our SSA now is +30% greater in real spending power than in 2015, the first spending year of our plan.)

 

Here’s the extreme example: Stocks declined by 37% real return in 2008. Obviously, you don’t want to sell stocks when they’ve declined that much. You would have sold your Reserve (bonds) at the end of 2008 for your spending in 2009. (Long-term bond returns were +25% real return in 2008!) At my mix, you’d have at least three more years of spending as bonds: you could sell only bonds at the end of 2009 for your spending in 2010; you could do the same at the end of 2010 and again in 2011 for your spending in 2012. Let’s assume that you’d be out of bonds, and at end of 2012 you would have to sell stocks for your spending in 2013. But by the end of 2012, stocks had clawed back all their decline. You would not have sold stocks at a value lower than their value in January 2008.

 

 

== Better returns? ==

 

I changed by view from this post. I decided to chase a slightly better returns from bonds:

 

The expected return for Long-term bonds is 3.1% and it’s 2.2% for Intermediate-term bonds. My choice of total market bond fund, IUSB, and the average duration of all of its holdings (5.8 years for 9,747 different bonds!) means it’s really an Intermediate-term bond fund. Since all broadly-based bond funds have the same basic value as insurance, shouldn’t I invest more in Long-term bonds for the added expected return?

 

 

The 0.9 percentage point difference in returns cumulates to 7% more from Long-term than from Intermediate-term over the past 6.7 years. Had I invested in only Long-term bonds, I would have expected to have about 7% more bonds than I do now. That’s not peanuts for Patti and me. I should not dismiss that dollar difference for Patti and me or for those who will ultimately benefit from our portfolio.

 

Those long run averages from 1926 both have ~45 year stretches of 0% real return. Maybe the comparison of returns shouldn’t be from 1926 to the present. Maybe I should compare returns after the nadir for bonds in the mid 1980s. I can draw a line point-to-point over the last 20 years on the graph above – from 1990 through 2020 – and see that the lines are steeper than those long-run averages. That means the annual return rates have been greater than the averages from 1926. I find that Long-term bonds have outpaced Intermediate-term bonds by an average of 3.7 percentage points per year over the past 20 years. If I assume those return rates over the past 6.7 years, I’d have about 26% more in bonds than I do now. Now were reaching a serious dollar difference.

 

 

Finally, I can compare returns for a specific Long-term bond index fund and IUSB over the past 6.7 years. I pick VCLT from the short list I displayed in this post: the ETF for Vanguard’s index funds of Long-term Corporate bonds. (Its expense ratio is .05%, a shade less than that for IUSB.) If I had solely been in VCLT, my return would have been +5% more per year on average, and I’d have about 40% more in bonds than I do now. I certainly can’t dismiss that!

 

 

No one knows what the future will bring. Prices of bonds move in the opposite direction to interest rates. Long-term bonds are more sensitive to increasing interest rates than intermediate term bonds: prices of bonds will fall more than intermediate bonds. Interest rates will increase with inflation, and inflation has increased. Is this the exact worst time to hold Long-term bonds? I don’t know. I said the heck with thinking about timing, and decided to sell some IUSB in our retirement accounts to avoid any tax consequences to hold VCLT. In essence, I’m adding more Long-term corporate bonds than IUSB already owns. Patti and I now have VCLT as 20% of our bond holdings.

 

== Is FBND better than IUSB? ==

 

I generally DISLIKE actively managed funds. Morningstar lists funds that it judges are in the same category of “Core-Plus” total market bond funds. FBND is one I find in that prior post that has bettered IUSB over the past few years. FBND started just about the time that IUSB started, in mid-to late 2014. Its expense ratio is 0.36% compared to 0.06% for IUSB. That’s a 0.30% mountain it must climb every year just to match IUSB, but it’s beaten IUSB by an average of .5 percentage points per year over the last 6.7 years.

 

 

 

I decided to sell some IUSB, again in our retirement accounts, to buy FBND. Our total bond portfolio looks roughly like this now:

 

 

My plan is to stick with FBND for at least three years. FBND has the highest expense ratio of any fund I own, but since I own so little relative to the total (about 6% of the total), I still will have a total weighted expense ratio of less than .07%.

 

 

 

Conclusion: I’ve been very good about not fiddling with our portfolio. I did not make a change in more than six years. But I fiddled and added two bond funds (ETFs) to my portfolio. I added the index fund VCLT for a greater weight of Long-term bonds than I get from my Total bond fund, IUSB. I added FBND as a direct alternative to IUSB, since it has performed better over the past six or seven years. In my view, these changes do not harm the safety of my portfolio, but they may add a bit of return over time. The power of compounding tells me means that a slightly better return could add a relatively significant dollar amount over time.

Is it safe to travel abroad?

I have no idea if you like to spend on travel. Patti and I really look forward to traveling, and it’s our biggest category of discretionary spending by far. It’s been 22 months since we traveled abroad, and we just got back from our trip to the UK. This post gives my opinion: it is safe to travel abroad. If you have a trip planned, keep it on the books. If you don’t have one planned, go ahead and plan it.

 

We judged that COVID would be on the wane in August and Patti bought our airline tickets to England in March at the bargain price she seems to always find. We went a bit longer this time and added four days along the best part of Hadrian’s Wall Path slightly to the north and east of the Lake District, an area we have visited a number of times.

 

We walked on trails of at least four miles for 14 days straight. My iPhone says we averaged over 15,000 steps per day. I was happy that, at my age, I did not fall apart. It was GREAT to feel earth under my feet and not the sidewalks I’ve been pounding on our routine walking routes here in Pittsburgh. And, oh man, the views – if I only take time to not look down for my next step!

 

Lone hiker working uphill. Near Hadrian’s Wall.

 

== COVID tests ==

 

I described the logistics related to COVID and the UK in this post. The process was more of a hassle to understand what to do than to actually complete the steps:

 

1) We took a PCR test here (and test negative) before travel. 2) We completed a UK locator form online. 3) We had to pay for a UK test kit that was delivered to where we were first staying; we had to take the test in our room and then mail in the tube + swab. 4) We took US text kits with us and took that test using video on our iPhones; someone had to watch us take the test. All those steps were not hard to complete.

 

Note: No one asked to see our vaccination cards. Good thing, since Patti forgot to bring them! (We had images on our iPhones and would have been OK.) The UK locator form asks you attest that you have been double vaccinated. If they find you have not, you are subject to ~$15,000 fine. I also think they judge that no international traveler would travel unvaccinated.

 

I think you’d have to do three of the four steps for any international travel. I think only the UK requires a test upon arrival.

 

We rigorously kept our distance inside; used masks inside; and Patti regularly squirted hand sanitizer. Still, we were a bit nervous waiting for results in the UK: if we had tested positive there, we would have had to quarantine for 10 days.

 

== Air flight logistics changed ==

 

The other logistical hassle with travel to the UK is that our flights over and back were changed: UK travelers are not allowed in the US, airlines can’t fill flights easily. Our direct flight from Philadelphia to Manchester was changed to New York – Amsterdam – Manchester. Our return flight from Manchester to Philadelphia was cancelled and we had to take a two-hour train to London to fly from Heathrow to Boston, and then we were saddled with a long layover to get back to Pittsburgh.

 

== COVID in the UK ==

 

The UK is “not recommended” for travel by the CDC, but Patti and I judged it to be no greater risk than travel in the US. The UK got a MISERABLE start with COVID (It’s cumulative death rate was about the highest in the world for many months.), but it has made big strides. It’s been hit with the Delta variant earlier and harder than in the US: the current rate of new cases is higher than in the US. But this table shows that they have a far lower percent who are unvaccinated than the US, and as a result they currently have far fewer hospitalizations and deaths.

 

 

== Masks not required ==

 

The biggest difference we noted from practice here was that masks are not required on public transportation: that’s buses and trains for us; we don’t rent a car when we are there. The temperature every day was in the mid 60s and the buses had open windows. I’d say about 80% of bus passengers still wore masks. Trains, obviously, don’t have open windows and were nearly full; we seemed to be sitting where other travelers chose to wear face masks.

 

The four places we stayed and all stores had hand sanitizer stations prominently displayed and asked that you use them. Some stores had signs that stated that masks were preferred – similar to our grocery stores here – and I’d guess about 70% of customers wore masks. (I’d guess the practice in grocery stores here in Pittsburgh is near 100%.)

 

One of the places we stayed delivered breakfast to our room. Lunches were always on the trail. We did take out and ate in our room or on a table outside where we were staying about five nights. When we didn’t eat outside, we seemed to get tables that were not close to other diners. Most restaurants in the honeypot towns where we stay are fully booked for weeks ahead. UK citizens could not travel to Europe this summer, so they are traveling in England, and the Lake District, in particular, is a popular destination.

 

== Go ==

 

Patti and I don’t go on many group tours. We know England well enough to organize what we want to do; we use tour companies to organize the logistics for self-guided walking elsewhere. Our biggest effort to avoid COVID when we are there is to keep our distance and masks on. I think traveling on a group tour would be fine, since all those on the tour will be fully vaccinated and will have recently tested negative; you’re in the same bubble of people; your tour will likely have greater control of close interactions with others than Patti and I had.

 

== Trip Highlights ==

 

We did not realize how much we missed the green paths and sweeping views. England has excellent walking trails, most with fantastic views. I don’t think we’ll ever grow tired of them.

 

My favorite walk is Catbells close to Keswick. After breakfast we walk to the boat launch on Derwentwater, about 3/8 mile from where we stay. We take the 9:30 boat for about ten minutes across the lake to Hawes Landing. From there we walk the less steep route around the back side of Catbells to the top. We walk down to Littletown Farm at the head of Newlands Valley and buy lunch to eat at a picnic table, and then it’s about 30-minute walk back to Hawes Landing and a boat ride back. Back by 3:00. Terrific!!

 

Newlands Valley from the path leading up to Catbells.

 

We really liked the area of Hadrian’s Wall. It did not hurt that I picked the best place we’ve ever stayed in England. I blew an added $150 per night for four nights, and it was worth it. I picked out the best 20-25 miles of the Hadrian’s Wall Path. A bus runs each direction hourly on the road just south of this section of the Wall and just in front of where we stayed. It was easy for us to get to our starting point each day and get back to where we stayed. We visited three sites/museums that are excellent: Vindolanda, the Roman Army Museum, and Housesteads. We’re thinking we will go back next year and walk more of the path.

 

 

Conclusion: Patti and I have pent up desire or demand – and money that we have not spent for almost two years – for travel abroad. We just got back from our favorite area in the UK. While the UK currently has a higher rate of new cases than the US, Patti and I felt relatively comfortable. I judge it is no greater risk of getting COVID there than here. If you have a trip abroad planned, I think you are taking no greater risk traveling abroad than traveling here.

Do you want to buy an annuity to substitute for bonds in your portfolio?

You DO NOT want to buy an annuity to substitute for bonds in your portfolio! I read this article about a month ago, “Using Annuities During Retirement: When to consider annuities rather than bonds.” The article suggests that one should seriously consider buying an annuity rather than hold bonds because an annuity provides a larger stream of annual payments than the interest earned on a bond. The purpose of this post is to explain why I think YOU SHOULD NOT BUY AN ANNUITY to substitute for bonds in your portfolio.

 

== Why Bonds? INSURANCE ==

 

The article states that the primary benefit of an annuity rather than bonds is to provide a better stream of cash payments than the interest from bonds. This is the incorrect way to judge bonds. We don’t hold bonds in our retirement portfolio based on their potential for cash payments. WE BUY BONDS AS INSURANCE. We want to sell bonds when stocks crater, and stocks can really crater, and we can judge bonds by their ability to provide insurance – protect the value of our portfolio given that we retirees withdraw from it every year for our spending.

 

This post describes the value of bonds as insurance. Stocks outperform bonds by almost a factor of better than 2.5 times over the long run: stocks 7.1% real return and 2.6% for the average of intermediate+ long term bonds. If we could count on that every year, the decision as to what to hold would be EASY. But stocks don’t outperform in all years. Bonds have outperformed stocks in 28 of the 95 years since 1926.  In the ten worst years where stocks have tanked, they averaged -27% real return while bonds in those years average 0% real return. Bonds outperformed stocks by an average of 27 percentage points in those years. And look at that most recent disaster for stocks in 2008. Wow! Now, that’s what I call INSURANCE.

 

 

== Where’s the insurance? ==

 

Let’s assume you decide on a mix of  bonds 25% bonds and 75% stocks. (Patti and I are 85% stocks and 15% bonds.) Let’s follow the logic of annuities and assume you substitute annuities for ALL the bonds you would otherwise have in your portfolio. What’s that mean? You have a portfolio of 75% stocks in your brokerage account. That’s it. Stocks are only thing you can sell for your spending from your nest egg. When stocks crater, you have no bond insurance to tap. You are forced to sell stocks when they’re depressed. This makes NO SENSE to me. It makes no sense to give up any portion of what you consider as your bond portfolio – your insurance – for an annuity.

 

== How do they pay more than bond interest? ==

 

How do the companies selling you an annuity provide a greater payment stream than the interest from bonds? You think they’re doing something magical as to how they’re investing in bonds and they’re not. They invest mostly in stocks! The companies hold an investment portfolio very similar to the one you’d have with Nest Egg Care: let’s assume they settle on 75% stocks and 25% bonds. They use a Retirement Withdrawal Calculator similar to FIRECalc, to find the payout, somewhat analogous to your Safe Spending Amount. They then figure out how much they want to keep – a big chunk of it – and how they can dress up what they want to pay you to make it look attractive to the retiree fretting about low interest rates for bonds.

 

== The payout to you is low ==

 

You will receive far LESS than you’d calculate for your Safe Spending Amount (SSA, Chapter 3, NEC) on the amount you’d pay for the annuity contract. The folks who sell annuities don’t pay out ANYTHING CLOSE to the spending power that you calculate as your SSA in NEC. Your SSA at least adjusts for inflation each year. They pay out a flat dollar amount per year. They can make that flat payout per year look attractive in the early years, because you’re absorbing the inevitable loss in spending power due to inflation. If inflation is 3% per year, You’ve lost 15% in spending power in about 5 years; 25% in 10 years; and your last payment of a 20-year annuity will have about 55% of the first-year spending power.

 

 

You get no benefit if stock and bond returns – what they’ve really invested in – are anywhere close to expected returns: 7.1% annual real return for stocks and 2.6% as the real return for the average of intermediate and long-term bonds. They have many annuity contracts spread over many years, and they know that they’ll average close too average returns over the years. But you’ll never see that.

 

What might you miss? Patti and I started with a payout for spending in 2015 of $44,000 per initial $1 million invested. Stock and bond returns have been above average over the last six year – and the look good so far this year – and our SSA payment on has in six years $62,700 for spending in 2021 – +43%. And it looks like we’re on track for another boost, greater than an adjustment for inflation. An annuity totally loses out on this potential.

 

You are giving them, unless you structure a death benefit or special features, the terminal value of your investment. Without special provisions that you pay for, you get no payout at the end of the annuity period and perhaps on death.

 

Graph 2-4 in NEC shows that at expected returns, a retiree who takes out 4.4% ($44,000 in constant spending power relative to $1 million initial portfolio) will have about 40% MORE in real spending power at the end of a retirement period than he or she started with; that assumes the mix assumption for the graph and average stock and bond returns. But even at poor future returns, one can see from the graph that a retiree will wind up with more than half of their initial portfolio’s spending power. Not zero. The obvious exception is the MOST HORRIBLE sequence of returns – the few chances out of 100 – that will eventually deplete a portfolio.

 

 

Conclusion. An article suggest retiree should consider buying an annuity contract for the bond portion of their retirement portfolio. This makes NO SENSE to me. The logic is incorrectly focuses on the annual payout of the annuity relative to interest received on bonds. We retirees don’t buy bonds in our retirement portfolio based on interest rates. We buy bonds as INSURANCE to protect us with stocks crater. We want to hold bonds to solely sell or disproportionately sell when stocks have cratered. We sell bonds to buy time for stocks to recover.

 

The economics of annuities are poor: they pay out far less than you’d calculate as your Safe Spending Amount, following the decisions you’d make for your plan following the steps in Nest Egg Care. Typically you’re giving up a significant terminal value that you’d like to pass on to your heirs.

How do I best use my Roth account during retirement?

When Patti and I officially started our Nest Egg Care retirement plan in December 2014, I had no Roth IRA. All our retirement accounts were Traditional IRA, and most of our money was in retirement accounts. I posted here and here about the importance of Roth IRAs. I converted some of my Traditional IRA to Roth in 2018, 2019, and 2020. Our total in Roth is small relative to the total if our retirement accounts – less than 5% of our total – but I see Roth as a valuable tool to avoid taxes that I would otherwise pay. I described my thinking on using Roth just in May, but this post links more clearly to my tax planning of three weeks ago: it’s a clearer description of when to withdraw from Roth to get most bang for your buck – more tax dollars saved relative to the taxes you paid when you contributed to your Roth.

 

== Review: why convert Traditional to Roth? ==

 

You incur no cost when you convert from Traditional IRA to Roth – Traditional or Roth result in the exact same after-tax dollars to spend in the future. Yes, you pay taxes at your marginal rate in the year you convert, but you are avoiding the same (or more) marginal taxes in a future year. Both have the same benefit of tax-free growth, and if you use Roth to save the same marginal taxes that you paid when you contribute, you wind up with the same after tax proceeds.

 

 

Roth gives you the opportunity to avoid higher marginal taxes that you would pay in the future had you not converted. You can get more than you paid.

 

Example: each year I have to pick my sources for our Safe Spending Amount (SSA; Chapter 2, Nest Egg Care). I described this in the post three weeks ago. Our age-appropriate Safe Spending Rate (SSR%, also Chapter 2) is always greater than our RMD percentage. (Patti and are both subject to RMD.) Therefore, our SSA is always greater than RMD. Each year I withdraw more for our spending from our Traditional IRAs than our RMD total.

 

Let’s assume I paid 22% marginal tax on the amounts converted. I breakeven – I wind up with the SAME after-tax dollars to spend – if I use Roth to replace withdrawals from our traditional IRAs that would be taxed at 22%.

 

I come out AHEAD with Roth – I gain after-tax dollars to spend – if I can use my Roth for spending and avoid a tax that I would pay if I used another source for our spending. I potentially avoid two taxes by planning out our Adjusted Gross Income and taxable ordinary income, like I did three weeks ago.

 

• I gain after tax dollars if I can use Roth to get under a tripwire of total income – Adjusted Gross Income – that triggers an increase in Medicare Premiums. (I consider premium increases as added taxes.) This is clearly the most important use of Roth: I can save an incremental $1,700 by using, as an example, $10,000 of Roth: I get an immediate 17% incremental return.

 

Our Medicare Premiums are deducted from our Social Security benefits. $1 of income above the first tripwire costs us $1,700 and others tripwires cost much more. I need to estimate how close I am to a tripwire every year. Because the tripwires don’t automatically adjust with inflation; I’m being pushed closer to a tripwire with no real increase in taxable income. This is the first thing I looked at when I did my draft tax plan for 2021 three weeks ago. The tripwires are spaced about every $50,000 of total income for married, joint filers and about every $25,000 for single filers. This post shows the Medicare tripwires for 2021.

 

• I come out AHEAD when I use Roth if we (or Patti or I) would ever be in the 24% marginal tax bracket. I paid 22% marginal tax, and I come out ahead if I can avoid falling into the 24% marginal tax bracket. This is an incremental 2% benefit, but I should take advantage of it assuming I will still have enough remaining to avoid a tripwire for increased Medicare premiums.

 

== Roth is more important when there is one of us ==

 

Taxes change when it’s just a single taxpayer and no longer joint, married taxpayers. It’s highly probable that the taxable income of the survivor of the two of us will crawl into the 24% marginal bracket. And the 32% marginal bracket is not out of the question for some retirees if the survivor lives long enough and if returns for stock and bonds track close to their expected return rates. See here.

 

Why are taxes higher? The marginal tax brackets for the survivor – single taxpayer – are half that for married, joint filers. Yet, the single tax payer will record the same real increases greater portfolio value as if both were alive; that leads to greater real amount of spending power subject to RMD; and RMD percentages increase with age.

 

This gets hairy, and each of us needs to figure out if we want to spend the time to keep track of this. I do like to keep track, since I think over time I’ll “make” $1,000s by spending a few hours each year to make best use of my Roth.

 

== An example ==

 

Here’s an example of how taxes and Medicare tripwires can change: assume a couple, Herb and Wendy, have total ordinary taxable income of ~$105,000. They pay total tax of $14,700. About $15,000 of ordinary taxable income is taxed in the marginal 22% bracket. They aren’t close to a Medicare tripwire that would increase the premium.

 

 

Let’s assume Herb dies. Wendy will have lower total income: she’ll lose the lower Social Security benefit, as an example. She would have about $20,000 less taxable ordinary income in this example, but would pay $16,400 in tax – about 25% more than if Herb was still alive. About $50,000 of income is taxed at the 22% or 24% marginal tax rate. She also would cross a Medicare tripwire that would cost $860.

 

 

This PDF shows greater detail than these two images.

 

== My annual checklist and story to Patti ==

 

It’s important to use your Roth wisely. Here is my checklist when I do my draft tax plan each August. I redo this in the first week of December, when I know exactly the tax implications of our SSA for the upcoming year. I will be much closer to our full year tax return. I ask these two questions:

 

1. Can I substitute Roth for Traditional this tax year to drop our Adjusted Gross Income to avoid a Medicare tripwire?

 

2. Can I substitute Roth for Traditional this tax year to avoid paying tax in the 24% tax bracket?

 

My story to Patti is this: after I’ve died, use Roth generously. Try to complete a tax plan (or have someone help) to at least avoid a Medicare tripwire EACH YEAR. Any Roth that you use if you cross into the ≥24% tax bracket is a good use of Roth.

 

 

Conclusion: I recommend you convert some Traditional IRA to Roth, being careful not to cross into a higher tax bracket when you convert. Conversion costs you noting in terms of future after-tax dollars to spend. Roth, however, gives you opportunities to avoid future taxes that you do not need to pay. You need to spend some time each year to sort this out, but the two opportunities are to 1) use your Roth for spending and not another source that records taxable income that crosses a tripwire that increases your Medicare Premiums; and 2) it is very likely that the survivor of a couple will be pushed into a higher marginal tax bracket; use Roth generously when that happens.

What changes in your financial retirement plan when a spouse dies?

What changes in your financial retirement plan and, most importantly, how is the surviving spouse’s financial well-being affected when one spouse dies? This purpose of this post is to describe the key changes as I see them. The key point is that the surviving spouse’s Safe Spending Amount (SSA; Chapter 2, Nest Egg Care [NEC]) will at least be the same as if both of you were alive. I conclude that Patti will be just fine in the future after I die.

 

== Expenses will decrease ==

 

Expenses for one will be lower than for two; that should be obvious. I estimated our routine spending in this post. If it was just one of us, the major expenses that would decline are car (sell the second car for cash; pay no annual insurance or on-going expenses), food (not an insignificant amount!), and airfares on travel. My rough estimate is that these lower expenses roughly match the effects of lower Social Security income.

 

== Social Security benefits will decrease ==

 

If both collect Social Security, and one spouse dies, the surviving spouse retains the highest benefit and foregoes the lowest benefit. Example: Patti and I both receive Social Security benefits. One is ~70% greater than the other or +60% of the total. If one of us dies, the other will retain the higher benefit and not the lower benefit: the gross Social Security benefit will decline by about 40%.

 

You may have other distributions from a defined benefit plan or other sources of income that will change on the death of one of you. For Patti and me, the changes would not be significant.

 

== SSA will not decrease ==

 

The Safe Spending Amount that you now pay from your nest egg for spending in a year will not decrease. Depending on which spouse dies first, it could increase.

 

Your SSA is your Safe Spending Rate (SSR%) times your Investment Portfolio. (See Chapter 2, NEC). SSR% is determined by the number of years you choose for ZERO CHANCE of depleting your Investment Portfolio in the face of the MOST HORRIBLE sequence of stock and bond returns in history.

 

Patti and I decided to use her longer life expectancy for our choice of the number of years we wanted for ZERO CHANCE of depleting our Investment Portfolio. (See Chapter 3, NEC.) That choice set our initial SSR%, and the logic of using her life expectancy sets all our future age-appropriate SSR%s. I use the appropriate SSR% in the calculation that tells me if our SSA increases in real spending power for the next spending-year or simply adjusts for inflation.

 

If I die first, nothing changes: Patti uses the same SSR%s that we have already scheduled for all years in the future. If Patti dies first, I’d reset the SSR% schedule based on my life expectancy: I’d use a greater SSR% than we now have scheduled.

 

Example: At the start of our plan in December 2014, Patti’s life expectancy was 19 years. Nineteen years for ZERO CHANCE for depleting an Investment Portfolio translates to an initial SSR% of 4.40% – $44,000 spending power per $1 million initial Investment Portfolio. (See Appendix D, NEC.) My life expectancy at the time was 14 years; that would have translated to a higher SSR%.

 

It’s now mid 2021, almost seven years later. We use the age-adjusted SSR% – based on Patti’s life expectancy – that I’ve laid out on my calculation sheet in this post. That was 4.85% last November 30; Patti’s life expectancy from the Social Security calculator then rounded to 15 years. I will test to see if I can use 5.05% this December; her life expectancy then rounds to 14 years.

 

If I die first, NOTHING CHANGES in Patti’s calculation of SSA. The age-adjusted SSR%s do not change for any future year. My retirement accounts first pass to Patti; our taxable accounts are held jointly; therefore, our total Investment Portfolio does not change. She can pay herself the same SSA that we both would have received.

 

If Patti dies first, then I’d use my shorter life expectancy to set a new schedule of SSR%. If Patti died now, I’d use the SSR% associated with my 11-year life expectancy for the calculation this November 30 – 5.80% (See Appendix D, NEC). It looks like our portfolio will earn far more than we withdrew for our spending last year (4.85%). That tells me that I’d use the new, greater SSR% to calculate spending for 2022. If that still holds to the end of November, my SSA for spending in 2022 would be 23% greater than if would be if it is the two of us or just Patti alive [(5.80%-5.05%)/5.05%)].

 

 

== Taxes will increase but will not damage ==

 

The surviving spouse will pay more total tax than the married couple. Even though the Social Security benefit declines, Patti’s total income will roughly 80% of the total for the two of us. That will result in higher taxes because higher marginal tax brackets start at half the income for a single taxpayer as for a joint, married taxpayer: more of the total is taxed at higher marginal rates. Also, the tripwires that result in increases in Medicare Premiums are half the total income as for a joint, married tax payers. 

 

I worked through this for Patti and me as a single taxpayer relative to us as married, joint filers and find the increased taxes are meddlesome – the surviving taxpayer will pay perhaps a couple of $1,000 in higher income tax than the two of us pay now and would cross a Medicare tripwire that the two of us do not cross. (I give a specific example in next week’s post.)

 

I conclude Patti clearly have enough for spending after taxes each year to enjoy the money we worked so hard to accumulate. She’s may judge that she has More-than-Enough. (See Chapters 5 and 10, NEC.)

 

== With planning, the survivor can lower taxes ==

 

If one is a stickler like I am, it is more important to take an annual snapshot of a tax plan, like I did here two weeks ago with this spreadsheet. My Roth will be more valuable to the survivor of us, because there will be more annual opportunities to avoid taxes that he/she does not need to pay: added Medicare premiums and higher marginal tax rates than we paid to contribute to Roth.

 

I’d likely do that annual tax planning; I like those details and finding if I can completely avoid paying a tax. Patti REALLY likes to save money, but she’s not a spreadsheet person. I think she is up to learning how to save perhaps $1,000 per year, though. That’s much more than she saves on another set of plastic food containers – that we don’t need – from The Dollar Store!

 

 

Conclusion: If you follow the plan in Nest Egg Care and you are a couple, I conclude you can be comfortable thinking that the survivor will be just fine in the future. Expenses will decline. Some income will decline – Social Security benefits are the key example. Total taxes paid on the same sources for SSA will be higher for a single taxpayer than they were for married, joint filers. But, most importantly, the Safe Spending Amount you pay yourselves now will be the same for the survivor in the future. SSA never declines; it can only get better. I am not at all concerned about Patti’s financial future if I die.

How do we meet COVID-19 requirements to enter the UK and return to the US?

This post doesn’t have anything to do with financial retirement planning, but I thought I would describe the current COVID-19 requirements to travel to the UK and to return to the US – as best as I understand them. That’s because this was the all-consuming task for Patti and me this week. We must have spent more than 10 hours to sort this out and implement the steps. We did not find a succinct description of what to do and how to meet the requirements. I’ll be shocked if this went smoothly for other passengers on our flight to the UK.

 

We had planned a trip in May of 2020; we try to go that time every year. It was the first trip we cancelled in 2020. Patti bought new tickets this March, soon after we’d been vaccinated. Right now, the CDC suggests not traveling to the UK because of their rate of new cases, which is very similar to ours, but we still plan to go.

 

 

I display the steps:

 

 

== Meet UK requirements before we leave ==

 

• Get a proper NAAT COVID test in the US within three days of departure. 0 is your departure day. Our departure day is Wednesday. We have to get tested no earlier than Sunday. We booked a test time on Sunday at a CVS MinuteClinic about a mile from us. They overnight all tests to a lab, and we will get results on Monday or Tuesday with a link to results. We’ll have to show the printed report or documentation on our phone of the negative test results before we get on our initial flight from Pittsburgh and, I assume, again on arrival in the UK.

 

• You need to purchase a UK approved “Day 2” test. We need to complete the test within two days of arrival: 0 is your arrival day. We arrive on Thursday. We need to complete the test by Saturday.

 

We needed to order this test a couple of days before our flight, since we need evidence – a Locator Reference number provided by the company that supplies the test. That number is stated on our receipt. The number is required for the UK passenger locator form we must fill out within 48 hours of departure (see below).

 

We used this site to find UK government approved testing companies. From the site, we picked 1) Day 2 test, 2) self swab at home, and 3) location of North East England: that’s the area where we first stay. We get a long list of providers (373!). The test kits we ordered, including next day delivery to the first place we are staying, were about £75 each – roughly $100 each. We ordered the kits six days before arrival. Our provider sent us an email as to exact time of delivery, and the place we are staying confirmed today that they have our kits.

 

A test kit has instructions and a return envelope for our swab. We mail that envelope in a “Priority” Royal Mail Box that is collected at the end of every day with tests delivered to testing labs the next morning. There are 35,000 in the UK. This site shows the identifying label. This site tells you the location of a nearby priority mailbox. It lists where we are staying has a priority post box or is a priority collection point.

 

 

We will get test results emailed to us within 72 hours. The NHS also gets those results. We’re assuming we will be negative, but if not, we’ll follow the instructions that I’m sure we will get in the email. If positive, I assume for now that we would have to quarantine and totally change our internal travel plans.

 

While new case rates are slightly higher in the UK, I think our risks are no worse than traveling in the US. As of now, 75% of all adults are fully vaccinated in the UK as compared to about 50% in the US.

 

• Complete a passenger locator form no earlier than 48 hours before we arrive in the UK. We arrive in the UK about 5:30 AM on a Thursday, Pittsburgh time. We must fill out the form after 5:30 AM on Tuesday.

 

== Meet US requirement before we return ==

 

We need to present a negative test for COVID before we depart. This is a “supervised” home swab test. We need to carry the correct test kit with us to the UK to use within three days of our return flight from the UK. 0 is the departure day. We leave the UK on a Monday. We need to complete the test no earlier than Friday.

 

The test is a BinaxNOW Ag Card home test made by Abbott. The supervision is a video-connected observation of us taking the test and then reading the result displayed on the test card. That’s with a company called eMed. We get an App for our iPhones: NAVICA. We’ll use that App when we are ready for the test and video connection to eMed. If we are negative, they’ll give each of us a digital health pass, a QR code similar to an airline boarding pass, on NAVICA. We’ll have to present passes before we board and maybe at passport control when we arrive.

 

We bought the test kits from eMed. The basic package has more than one kit. We’ll take two each. The test is not as accurate as an NAAT/PCR test and can have false positives. I’m sure we would use the second kit if the first test shows we are positive.

 

We fly Delta, which links to a form that we use to attest that we have a negative COVID-19 test. We complete that form online and print it or we can complete the form at the airport.

 

 

Conclusion: Patti and I are traveling to the UK next week. We had difficulty understanding what we had to do and by when to meet COVID-19 requirements to enter the UK and then to return to the US. This post describes the requirements and how we will complete them.

Have you started on your tax planning for 2021?

My tickler file tells me that this is the week to take my first draft cut on my tax plan for 2021. This post is to describes my steps. I get three things from this process: 1) a rough guess of our Safe Spending Amount for 2022 (SSA; see Nest Egg Care (NEC), Chapter 2); 2) an estimate total income and taxes for the year; 3) a good estimate of the net cash we will have by the end of December for our spending in 2022.

 

This is the second year that I’ve done this in August, and its getting easier to complete. I suggest that you spend a bit of time to sketch out your 2021 tax plan. This post is similar to my post this same week last year; I think I improved the spreadsheet you might use for your tax planning.  

 

It’s the same steps as last year:

 

Step 1. Estimate our Safe Spending Amount for 2022.

Step 2. Decide where I will sell securities to get our total SSA into cash.

Step 3. Estimate our total taxes for 2021 based on those decisions.

Step 4. Calculate the net cash we’ll have this December for spending in 2022.

 

In this post I ignore the wrinkle of how I handle money left over at the end of the year – our current SSA that I have not fully spent or gifted by the end of the year. We donate what is left over. I don’t throw it back into our Investment Portfolio. The math wrinkle is that I take an added Qualified Charitable Distribution or QCD for the amount we will donate. (Patti and are over age 70½ eligible for QCD.) You should always donate using QCD if eligible. You gain the full tax benefit of your donations in addition to your Standard Deduction.

 

Step 1: Estimate our SSA for 2022. I made a rough guess of our SSA for 2022 assuming the full year will match our portfolio return for the 8 months December 1 – July 31: that’s +16% nominal return for the year. I estimate that’s +11% real return if inflation is 5%; that’s the average annual rate for the last three months. The 11% real return means we would earn more in spending power than the 4.85% that I withdrew last December: when you earn back more than you withdrew, you always get a real increase in SSA.

 

 

I plug +16% nominal returns and my inflation assumption in the spreadsheet from this post or the one in this post. Patti and I are on track for a 10% real increase in our SSA for 2022 – and 16% nominal dollar increase. Wow. This would be the fifth increase in seven years and +45% in spending power from the start of our plan in 2015. This is getting out of hand!

 

 

Step 2. Decide where I will sell securities to get our 2022 SSA into cash. Patti and I both are subject to RMD from our IRAs. After we withdraw our RMD, we have three sources for the added amount I should take to equal our SSA. I list them in terms of least tax consequences to greatest: 1) my Roth = 0% tax; 2) sales of securities in our taxable account = roughly 6% total tax; and 3) further withdrawals from our IRAs that I’ll assume are at 22% marginal tax for this post.

 

 

Step 3. Estimate our total taxes for 2021 based on those decisions. I have to add the impact of those decisions on a pro forma tax return for 2021. My accountant sends me a PDF of my 2020 tax return, and it’s a snap to get good estimates of most all the items for my 2021 return; they don’t change much from one year to the next. The biggest source of routine income for us, other than RMD, is the taxable portion of Social Security Benefits; that will be 1.3% more than last year.

 

 

When I look at the result – I focus on MAGI – I see I don’t need to tweak my initial decisions: I am not near a Medicare tripwire that would tell me that I should withdraw from my Roth to avoid it.

 

Step 4. Calculate the net cash will have for spending in 2022. That’s the gross sales of securities less the amount I’ll withhold in taxes in the distribution I’ll take from our IRAs the first week of December.

 

I pay some estimated tax in the year using EFTPS, but I pay about 75% of our total tax bill in that withholding. I’ve gotten free use of those tax dollars for roughly a whole year; I earned more than $2,000 on the free use this year.

 

== I always pay more than the absolute minimum taxes ==

 

I don’t minimize taxes each year. If I had done that, I would obviously have first DEPLETED my Roth account; then I would have DEPLETED our taxable holdings, and I’d derive all our spending from our IRAs: I’d take our RMD and then take more from our IRAs. I would have paid much lower taxes in early years of retirement and much higher taxes when I’ve depleted the first two. And I could be, at some point, in an uncomfortably high marginal tax bracket for IRA distributions, and that would defeat the whole benefit of tax-free growth in retirement accounts.

 

I try to keep about three or four years of spending in taxable securities + my Roth. I’ve had to work to keep that level: I refinanced our mortgage and took a bigger one to get cash out to increase our assets in our taxable account. I want to that level of three or four years now, and the excellent returns over the last three years have given me room to sell chunks each year, but I still withdraw more from our IRAs than just RMD for our spending. I’m more comfortable doing that – paying 22% marginal tax on some of our spending and not 6% or 0% – to preserve a level of lower tax-cost sources.

 

In my mind, those lower tax-cost sources are a form of insurance that will help preserve the health of our portfolio in times of stress. The biggest stress relief for our portfolio is to use out Reserve for spending and skip a whole year of withdrawals from our Investment Portfolio. Keeping low tax-cost sources is similar. I could decide to withdraw less than our SSA; if I use more of the sources with low tax cost and less from our IRAs, I’d have much less impact on the net that we can spend.

 

I’m very stingy on withdrawing from my Roth. I already paid income tax on the amount I contributed. I want to get the best tax benefit when I withdraw from it for our spending. The painful tax or cost Patti and I could incur is a tripwire that increase Medicare Premiums; those premiums are deducted from our gross Social Security benefits, and the amount deducted increases if we cross specific levels of income (Modified Adjusted Gross Income or MAGI). The first tripwire costs us $1,700 and others are more expensive. I get biggest bang when I use Roth as a source for our spending and lower our total income to avoid crossing a Medicare tripwire. (A Roth distribution as not part of MAGI.)

 

== What I now know ==

 

1. I have a reasonable estimate of our gross, pre-tax SSA for 2022: that could be +15% nominal increase!

 

2. I do not need to withdraw from my Roth this year: I am not near a Medicare tripwire that I can avoid.

 

3. I know the total amount of taxes to withhold from the distribution I will take from our IRAs the first week in December.

 

4. I have a reasonable estimate of the cash I will have in December for our spending in 2022. I know our monthly paycheck that I transfer from our Fidelity account to our checking account could be 15% more than our current pay.

 

 

Conclusion: We all should spend time thinking through our tax plan for 2021. We all have choices as to what securities we will sell to get the cash for our spending. The wrong decisions could result in added taxes that we don’t need to pay. This post discusses the steps I take develop our draft plan.

 

I draft my tax plan for the current calendar year in the first week of August. That’s 8 months into our calculation year which runs December 1 – November 30. I now have a reasonable expectation of 15% increase in our Safe Spending Amount for 2022; I ~know what I should withhold for taxes when I take our withdrawal from our IRAs in December; our net pay for 2020 may increase by 15%.

Will we really be able to travel across the pond?

Patti and I traveled this week to Denver (Patti’s sister and family) and to St. Louis (my brother and his wife and family of Patti’s brother who died last spring). So, this post is far lighter than normal. The good news this week for Patti and me is that it finally looks as if we can take on our almost-annual trip to England. We’ve had that trip planned for late August-early September. The UK will now let in vaccinated travelers from the US without having to quarantine. The purpose of this post is to remind ourselves: the sands of time are running for us retirees, and we should spend to make sure we enjoy the time we have left.

 

Patti and I are ticking off a number of ways to be happier that I described in this post: 1) we’re spending our money on an experience that we know we will enjoy;  2) it’s a special treat since we haven’t been able to travel abroad for the last year and a half; 3) we’ve prepaid at least half the total that we will spend: the airfare and our lodging for at least one of our stays; I’ll soon buy advance-fare train tickets at half price; that will feel good, and in total it will feel like we will be spending very little when we are there.

 

I’ll go through my checklist of final actions. I’ve found in the past that we need dinner reservations at several of the spots we’ve liked. I’ll be thinking of past meals we’ve had there and anticipating eating there again. Anticipation is a bit of happiness.

 

 

We need to be sure of the final requirements for entry to the UK: I don’t think that gets updated until Monday. I’m not clear on the procedures to get back into the US: we may have to test for COVID a couple of days before we return. And I don’t know what that might mean if we have an asymptomatic case before our return flight. As the chart shows, new cases in the UK shot straight up and but have fallen dramatically.

 

Source: https://ourworldindata.org

 

 

Conclusion. We retirees should spend money to Enjoy. Now. Most all the discretionary money Patti and I spend is on travel, and it looks like we might be getting back to our regular pattern of one or two trips abroad each year. As of this coming Monday, the requirements to get to the UK are not constraining. Patti and I are hoping we can take the trip we have planned for the end of August-early September.  

What mix of stocks should you have before retirement?

How do you set your mix of stocks and bonds before the start date of your retirement? Patti and I officially started our retirement plan in December 2014. That was the first year we took a full withdrawal from our nest egg for our spending in 2015. I decided on a mix of 85% stocks during retirement. (I recommend you decide on a range between 75% and 85%, and you’ll find my logic in Chapter 8, Nest Egg Care [NEC].) How should we have been invested prior to that date? The purpose of this post is to describe my thinking on your decision on your mix of stocks vs. bonds prior to retirement. My basic conclusion: your retirement nest egg should be invested 100% in stocks for most all years prior to retirement.

 

== How to Invest ==

 

Let’s knock off this checklist:

 

You’ll invest in financial assets – stocks and bonds. Stocks and bonds have a long record of real growth – returns over time that are greater than inflation. Stocks return about 7% per year and bonds return about 2.6%. (I average the real returns for long-term and intermediate return bonds.) Non-financial assets, real estate and commodities as examples, are components of the calculation of inflation. They keep pace with inflation; they don’t outdistance it; in general, they have no or very low real return over time.

 

• You’ll invest in index funds. You MUST be a low-cost investor in retirement, and you must be a low-cost investor before retirement. The only way to reliably keep most all the market delivers is to invest in index funds. Patti and I predictably keep +99% of what the market delivers to investors before consideration of costs; the weighted average of our investing costs is 0.05%.

 

Your mix of stocks will be greater before retirement than in retirement. I’d work backwards from your decision on mix of stocks and bonds in retirement. In Nest Egg Care I picked 85% for Patti and me. That means I should have owned more than 85% stocks in all the years before our first full withdrawal for spending. If you pick 75% as your mix for your retirement plan, you should own more than 75% stocks.

 

== Retirement >10 years from now = 100% stocks ==

 

I argue that you should be 100% stocks in all but the last ten years before the start of your retirement plan. That mix gives you by far the best odds of having more throughout the period of full withdrawals from your nest egg for your spending in retirement.

 

An example: The official start of our retirement plan was December 2014; that was the first date we took a full withdrawal – our Safe Spending Amount – for spending in an upcoming year. (See Chapter 2, NEC.) Following the recommendation in this post, that would have meant that I should have been 100% stocks up to December 2004. (Patti and I were.) I could then transition to the mix at the start of our retirement plan that I get from my decisions from Nest Egg Care: 85%. (See Chapter 8.)

 

 

 

== The odds of MORE in 10-years ==

 

How do I judge that you should be 100% in stocks if you are 10 or more years before the start of your retirement plan? I build the historical sequences of 10-year returns for stocks and for bonds and compare the two. Here are questions I would ask:

 

1) At the average of the sequences of returns, how much more might you expect from stocks relative to bonds? Is this a meaningful difference?

 

2) Stocks and bonds are variable in return. Your portfolio won’t always grow in real spending power in 10 years. How often do stocks return more than you started with over 10 years? Is that more or less frequent than bonds?

 

3) Since stocks are more variable in return, we’d expect 10-year periods where bonds outperform stocks. How often did bonds do better than stocks? How much better?

 

== 75 sequences of 10-year returns ==

 

I compiled the cumulative increase in real spending power for 75 10-year return periods ending in the years 1945 – 2020. That means I’m not including the unusual returns for stocks and bonds 1926-1935, basically during the Great Depression. I used Intermediate bonds in the comparison; I think that’s the closest to what we hold when we invest in bonds. I used the year-by-year return data that for this graph of cumulative real returns over time. I show the calculations for the increase in real spending power for all the 10-year sequences in this PDF.

 

Source: Stocks, Bond, Bills and Inflation. Ibbotson, et. al.

 

== Here are my findings ==

 

• You can expect (using the average returns from the return sequences) that you will have about 85% more total spending power from stocks than from bonds at the end of 10 years. That’s a lot! I average the results for the 76 return periods and find that stocks more than doubled in real spending power, while bonds increased by about 25%. Stocks great 5.5 times more than bonds.

 

 

 

• Stocks returned more than you started with more often than bonds. Stocks returned more than you started with in 66/76 cases: I translate that to the chance are 7 out of 8 that stocks return more than you start with. Bonds returned more than you started with in 45/76 cases: 6 of 10 chances. (I highlight these years on the PDF.)

 

I flip those numbers: stocks returned less than you started with in 1 in 8 chances; bonds returned less than you started with in 4 of 10 chances.

 

It’s better for bonds if one looks at the return periods ending the last 35 years; that’s the most favorable period for bond returns; they started their climb out of decades of 0% cumulative return. In the last 35 years, bonds always returned more than you started with in the prior 10 years; stocks returned less than you started with in three cases. Those three cases hold parts of two the four worst patterns for stock returns since 1926: the very steep declines in 2000, 2001, 2002 = -42%; and 2008 = -37% real return.

 

• Bonds returned more than stocks in 15 out of 100 cases: bonds returned more than stocks in 11/76 cases. The detail is on the PDF. Most all of those cases were when stocks returned less than 0% over the ten years. (Those are periods in the 2000s and those in the 1970s; the steepest decline for stocks since 1932 was 1973, 1974 = -49% real return.) The two best 10-year sequences for bonds relative to stocks were the two 10-year periods ending in 2008 and 2009: bonds returned twice as much as stocks.

 

 

• I flip this: stocks returned more than bonds in 85 of 100 cases: stocks returned more than bonds in 65/76 cases. In those cases, stocks doubled the return from bonds.

 

 

• Bonds returns were greater than the average return for stocks in 1 in 30 occasions (2/76).

 

== What do I conclude ==

 

I conclude the odds clearly favor stocks. I can’t construct a logic that says you should hold bonds for a 10-year (or longer) holding period. If you are ten years or more years from retirement, you should be 100% invested in stocks. That gives you the best odds to have more at the start of your retirement plan and thereafter. When you reach that 10-year mark, transition in a way that feels comfortable to you from 100% to your design mix at the start of your retirement plan.

 

== It’s just for a small slice of your portfolio ==

 

If you think about it a bit differently, you’re not making one 10-year decision on your total portfolio. You could think of your portfolio as divided into many future holding periods. In our example, the shortest holding period is ten years. You’re really making a number of decisions as to how to invest small slices of your portfolio; each slice has a longer holding period.

 

Let’s assume Patti and I had Nest Egg Care and worked through our retirement plan in 2004, planning our first full withdrawal in late 2014 for our spending in 2015. Let’s assume we found that in 2014 we would sell 4% of our portfolio for our spending. (It was actually 4.4%, but it’s simpler to use 4% in this example.) I could have viewed that I had a 4% slice of our portfolio in 2004 that had a 10-year holding period. I’d assume the next year – late 2015 – we’d sell a second 4% slice; that slice would have an 11-year holding period. And so on. I’d have a total of 25 slices with holding periods ranging from 10 to 35 years – to 2039.

 

The odds more obviously favor stocks and not bonds as the holding period lengthens. For example, there is no case where bonds outperform stocks if the holding period is 18 years or more. If I thought that way, I’d be much more confident in holding 100% stocks if I was ten years from retirement.

 

== I didn’t have the end point in mind ==

 

I had no financial retirement plan until Patti and I were basically retired. I couldn’t logically work back from the end point of the start of our retirement. Fortunately, my historical pattern of investing paid off. I’d been 100% stocks for decades, and I was 100% in stocks in 2004. Without thought, I remained 100% in stocks until the start of our retirement. I just changed in a matter of weeks in late 2014 from 100% stocks to 85% stocks.

 

 

My lack of transition or glide path did not hurt. Working backwards, stocks outperformed bonds for every holding period. I always earned more by having stocks and not bonds. My sudden transition from 100% to 85% could have not been better.

 

 

 

Conclusion: Nest Egg Care helps you make the key decisions for your financial retirement plan. One is your mix of stocks and bonds. I recommend you pick between 75% and 85% in Chapter 8. I picked 85% for Patti and me. This post asks, “What mix of stocks should I have before retirement?” It is always more than your mix at the start of retirement. This post examines the odds of having more in 10 years from stocks rather than bonds. I conclude you should be 100% in stocks all years up to 10 before the start of retirement. You can transition from 100% – changing your mix bit by bit; the exact pattern is not critical – to get to your design mix at the time you take your first full withdrawal from your nest egg for spending.