Blog reader Bill is starting out on his plan. He’s figured out what he can pay himself from his financial nest egg and asks, “We now have a long string of years without a major market decline. Are we ripe for one? Should I start out spending less than my calculated SSA?” Good question! I wrestled with that question four – almost five – years ago when I started my plan. And that thought crosses my mind in early December when I Recalculate for next year’s Safe Spending Amount (SSA). (See Nest Egg Care (NEC), Chapter 9.) This post expands on my basic answer: I don’t think we are close to conditions that would lead to a huge market decline that sinks your portfolio. But if it makes you feel better and safer, increase your Reserve (See Chapter 7, NEC); that has the same effect as lowering your SSA – your paychecks from your nest egg.

 

Here are some basic reminders.

 

== Your plan always assumes the worst ==

 

The key planning assumption for NEC is that we retirees will face the MOST HORRIBLE of financial returns in history essentially starting TOMORROW. This most horrible sequence of returns will have a devastating effect on our portfolio, but we can take actions that assure zero chance of depleting our portfolio for many, many years.

 

The key action we take is to have a low Safe Spending Rate (SSR%) and that results in a low Safe Spending Amount (SSA). (Maybe we could debate: is being a low cost investor more important than this action or just a prerequisite?) I found the SSR% for Patti and me at the start of our plan – for 19 years with zero chance for depletion of our portfolio – was 4.40%. (See Chapter 2, NEC.) That equates to LESS THAN 0% real annual return over 19 years. If we had assumed 0%, our spending rate would be 1/19 or 5.25%.

 

The fact that our SSR% is based on less than zero cumulative return reflects the ugly annual declines in returns within the long sequences of 0% cumulative return for stocks (18 years) and for bonds (48 years!).

 

== The worst is REALLY BAD. And rare. ==

 

The worst sequences of returns that sinks your portfolio – basically for any mix of stocks and bonds – includes a few years of SHARP, NEGATIVE stock returns that eat up roughly 45% of the spending power of your stock portfolio. This damaging decline from stocks has to hit you in within the first five or six years of your retirement to have its most devastating effect. That’s when a large percentage decline eats the most dollars relative to your starting portfolio value. When you combine the effect of withdrawing for spending, it gets really hard to replace those dollar losses even when returns improve. Bonds have not been golden: they’ve cratered and eaten 41% of spending power over a five-year period.

 

We’ve had VERY UGLY real declines for stocks three times in the 92 years since 1926 – that equates to a 1-in-30 year event. (It’s a 1-in-50 year event had I considered the return data from 1871.) Those steep declines don’t have to hit us right at that start of our retirement to really hurt us, meaning the chance that we’ll suffer a major decline in our portfolio within a few years from the start of our formal retirement plan is greater than 1-in-30. It’s still fairly rare. You can see more scary periods of historical returns for stocks here and read about the worst sequence that drives our spending rate to a low level here. That sequence has the two-year -49% real decline from stocks and the five-year -41% real decline from bonds! Wow.

 

 

== Your Reserve buys a layer of Safety ==

 

Nest Egg Care adds a layer of safety to your plan by asking you to take 5% off the top of your total portfolio – roughly one year of spending. (See Chapter 7, NEC.) In effect, you stick that Reserve under a mattress and try not to think it even exists. You base your calculation for your Safe Spending Amount (SSA) on the net, which I call your Investment Portfolio. The 5% Reserve lowers the dollar value you’re using to get to your SSA and that lowers your SSA by 5%.

 

 

Hopefully you will never have the need to tap your Reserve, but you will use it for your spending when we hit an annual return or several years of return that are really scary. We are not selling securities – especially stocks – from our Investment Portfolio. We’re giving ourselves a shot for stocks to rebound, side-stepping severe damage to our portfolio.

 

==== Do I think MOST HORRIBLE is near? ====

 

No, I don’t.

 

• Statistically a bad 1-in-10 year event is a real decline of -17% or greater. We’ve not had a year like that for more than ten years. But that does not mean the chance of a really bad year is increasing. Our last year like that was 2008, and it was much worse than -17%; 2002 was another year; we have to stretch back 27 years to 1974 to find the next prior year.

 

• I think it’s the economy that will drive the next steep decline: recession, depression, or out of control inflation. We combined several recessions and very high inflation averaging over 7% per year for the 15 years starting in 1969 – that’s the start of the Most Horrible sequence of return that we use to set our SSR%. I don’t see any conditions that suggest we are close to those conditions. Do you?

 

• The other concern is an over-heated market or over-priced stocks. All three of the years that kicked off declines (1930, 1969, 2000) came after a period of very high stock returns. You can see those run-ups as deviations well above the long-term trend line in the graph below. They even look like bubbles. When I look at the pattern of stock returns now, I don’t see a deviation – a bubble above the long-term trend line.

 

== We make decisions based on emotion ==

 

We make decisions by emotion and not by logic. We’re human! I can completely understand that if Nest Egg Care tells me a spending rate is safe then by gosh I’m going to do something to make it even safer. It’s just too important. I can do two things that are logical for greater safety:

 

#1) Lower my spending rate. Bill’s absolutely right. That’s the number one lever to increase safety by far. Lower spending BY JUST A LITTLE means a longer shaft length of your hockey stick – the years with zero chance of depleting your portfolio. (See Chapter 2, NEC.)

 

 

That’s essentially what Patti and I did at the start of our plan. (See NEC, The Patti and Tom File at the end of Part 2.) Patti wanted two – no three – years of spending in Reserve. We negotiated: I put two years into Reserve. That lowered our SSA by another 5%. That is what I would recommend to you: increase your Reserve. That means you are lowering your SSA. I like this approach better than just spending less than your calculated SSA. You don’t want to get into the habit of “Saving” part of your calculated SSA. That simply means you aren’t enjoying (and giving) as much as you should.

 

#2) Lower my Investing Cost to less than that assumed in Nest Egg Care (NEC) – .18%. Lower cost is always a good move, but lowering to less than .18% is a small lever: it does not come close to #1 in lengthening the shaft of your hockey stick. Our Investing Cost is less than one-fourth that assumed in NEC. That took no work: fund companies have continually lowered their Expense Ratio for the funds Patti and I own.

 

Those two ARE the options. It is not logical in my mind to have a low mix of stocks. Or to throw other kinds of investments than stocks and bonds into your mix; those actions aren’t buying you added safety that you otherwise would get from #1 and #2. Anything less than 75% stocks makes NO SENSE to me. Nothing about less than 75% stocks is “more conservative” in my mind. See Chapter 8, NEC.

 

 == Drop that extra Reserve? ==

 

Over time Bill will Recalculate (Part 3, NEC), hopefully, to a greater real SSA. Then he can rethink the need for that extra Reserve. Patti and I started at SSA of $44,000 per $1 million of Investment Portfolio. Now our SSA is 20% greater in real spending power. I have not lowered that original two-year Reserve, though. Doing that would immediately boost our SSA by 5% because it would immediately increase our Investment Portfolio. But I have no big urge to do that. No urge to explain why I want to lower the Reserve to Patti. Maybe I’ll do that the next time I Recalculate to the next real increase in SSA. Maybe not.

 

 

 

 

Conclusion. We all worry that we aren’t being conservative enough for our financial retirement plan. I assert that the Safe Spending Amount (SSA) that you get from Nest Egg Care is darn conservative. But it’s human nature to be more conservative than what someone else recommends. If you want to be more conservative, increase your off-the-top Reserve – the amount that is not part of the math to get to your SSA. In effect you are lowering your SSA. That has the effect of adding years of zero chance of depleting your portfolio.

Neighbors Bill and Mary, nice folks age 50, told me that they just signed on with a financial advisor. He’s going to manage $800,000 for them. He said his fee is 1%, so they conclude they are spending $8,000 per year for his advice and help. His help may be valuable to them, but I calculate that over 15 years Bill and Mary give up to nearly 30% of the expected growth of their portfolio – a total cost of nearly $450,000. By the 15th year, they are giving up the value of a Mercedes Benz SUV per year. That’s clearly not what I think they have in mind from “1%”. The purpose of this post is to explain the discrepancy between 1% and 30% and that $450,000 and the Mercedes SUV per year.

 

In fairness to the advisor, Bill and Mary are not confident in making financial decisions. They don’t have much knowledge about investing. It sounds complex to them. They don’t have a will, and the advisor said he would help them get that task completed. They want to decide on disability insurance. He’ll help with that.

 

== Total Investing Costs ==

 

The advisor did not mention the internal fund costs they would incur for their portfolio, the weighted Expense Ratio for all the mutual funds, ETFs and securities he would select for them. I’ll guesstimate this at .6% of the value of their portfolio, which is below the average for actively managed funds.

 

We have to conclude that Bill and Mary’s resulting Investing Cost of 1.6% per year with their advisor is, in essence, a direct reduction of the annual return rate that they get to keep. That’s their Investing Cost. We can not assume the actively managed funds their advisor picks will outperform the market before deduction of those fund costs and result in a lower net cost than 1.6%. The chance of a mix of actively managed funds doing that is just too darn low. That’s clear from many, many studies and the thorough one described here.

 

== Compare two options over 15 years ==

 

We need to clearly think through the two options. It isn’t a one-year comparison of cost. I’m measuring their cost as the difference in the amount they would have in a future year, not simply the annual differences in fees that they pay. This is the right way to look at it, don’t you think?

 

Here we go: I pick 15 years as the time period we want to look at. I assume $800,000 now and that Bill and Mary contribute $15,000 in today’s spending power to their investment account each year. Here are two options.

 

Option #1. Spend $10,000 now on a consultant to help them construct the will, pay the legal fees for the will, and a hire a consultant to help them sort and recommend disability insurance. ($10,000 sounds like too much to me for these tasks, but let’s go with it.) Invest the $790,000 balance themselves at low Investing Cost. Let’s use 6% of 1% or .06% as the Investing Cost for a simple portfolio in this case of just two funds that own all the stocks in the world. As reference, my Investing Cost is a shade over 4% of 1% or .04%.

 

Option #2. Invest the $800,000 with the advisor. I’ll assume he actually pays the legal fees for their will, but that would not be usual from my experience. Investing Cost is 1.6% per year.

 

I compare the growth of their portfolio for the two options. The difference between the two is their cost. I use Excel’s Future Value Calculation, but you can also see the same result in more detail on this spreadsheet.

 

 

Wow! Bill and Mary start with $800,000 and the difference in the two options in 15 years is nearly $450,000. That sounds almost mathematically impossible, but it isn’t. Option #2 costs them $450,000 more than Option #1!

 

The average cost works out to be about $30,000 per year ($448,000/15 years). In the early years, the cost penalty for Option #2 is about $12,000 per year, but that grows every year eventually to about $58,000 in the 15^th year. The percentage penalty in annual growth from Option #2 also increases. Both dollar penalty and percentage penalty will increase each year thereafter. On average Bill and Mary bought the equivalent of a $30,000 new car each year for their financial help: their advisor, his firm, and fund managers. In later years, they are buying them a luxury SUV every year.

 

 

== Results with different Expected Returns ==

 

In the example above, I used a 100% stock portfolio for Bill and Mary. I assume that 15 years is their holding period: they won’t sell any of that before they glide into their formal retirement plan somewhat after 15 years. That may be too ambitious for them. I can run this same analysis using a lower mix of stocks and greater mix of bonds.

 

 

A mix of more bonds (less stocks) results in lower portfolio expected annual returns and less of a dollar difference between the two options. But this surprised me: the percentage penalty of Option #2 increases as the mix of Bonds increases. Option #2 is relatively worse for them with a greater mix of bonds. The penalty of Option #2 is 25% at a mix of 0% bonds (100% stocks). The penalty of Option #2 is nearly 30% at a mix of 35% bonds (65% stocks). That’s primarily because the advisor fee of 1% cuts much deeper – a much greater percentage reduction – into the expected return for bonds: if you have more bonds you’ll suffer a deeper cut of your total expected portfolio return.

 

 

== Will they ever know? ==

 

When Bill and Mary go down the path of Option #2, will they ever reach a point of understanding that their returns could be so much more? I doubt it. In our initial example of an all stock portfolio, at expected returns they would see their $800,000 portfolio and their annual additions grow to $2.1 million in 15 years. They’d feel very good about that. Will the financial reports from their advisor clearly show that their returns lag market returns or a benchmark return for their mix of stocks and bonds? They’ll never see that comparison. They’d have to do the work to understand. They’d have to do the calculations or by run a side by side experiment using low cost index funds with a portion of their portfolio.

 

 

 

Conclusion. Investing costs are in essence a direct reduction of your net returns in your portfolio. My Investing Costs are a low .04%. That means I get to keep about 99.4% of the expected real return on my portfolio of 85% stocks and 15% bonds (6.34%/6.38%). If I incurred investing cost of 1.6% I’d get to keep about 75% (4.78%/6.38%). When you measure the growth in portfolio value for different net returns that you keep, the difference between high cost and low cost is ENORMOUS: in 15 years an initial $800,000 portfolio invested with high Investing Cost could be $450,000 less than the same portfolio invested with low Investing Cost.

I read this article that suggests Rental Real Estate is a good investment for retirees. I hate even thinking about investing in rental real estate. Or why I’d hold onto it if I had it at this stage in life. This post discusses why I think owning rental property is a really bad idea for us nest eggers.

 

== Why I don’t like rental Real Estate ==

 

Oh, let me count the ways!

 

1. Rental Real Estate is a non-financial asset that can’t consistently give you cash for FUN. Yes, there is modest income that you can spend. But you have most of your money locked up so that you can’t spend to ENJOY. You can’t gift enough to your children’s retirement accounts. You can’t gift enough to your grandchildren’s 529 education plans. Only financial assets consistently give you cash and the potential for more cash for FUN, FAMILY or COMMUNITY while you are alive. I view these non-financial assets largely as a dead weight hanging around your neck.

 

You want some non-financial assets, though, as a deep, deep reserve to your financial retirement plan, which is fueled by your financial assets. [See Chapter 1, Nest Egg Care (NEC).] My guess is that you already have enough non-financial assets – primarily the equity in your home. You don’t need more.

 

Most folks I know have TOO MUCH non-financial assets and no HELOC (Home Equity Line of Credit). Because they are overloaded with non-financial assets – or underloaded with financial assets – they are limiting what they can spend on Fun, Family, and Community. Because they have no HELOC, these folks are spending their FUN MONEY on NOT-FUN when the non-financial assets need cash to keep them up to snuff.

 

2. Rental real estate can’t get close to the potential for increases for your spending. At other than Most Horrible sequences of financial returns, your Safe Spending Amount (SSA) will increase in real terms. (See Part 3, NEC.) Over the first four years of our plan (Patti and me), our SSA has increased by 20%. All nest eggers saw an increase in their SSA over those four years. And the average return rates over the four years were not outta the ballpark by any means. Rental real estate isn’t going to come close to paying you 20% more in four years – that would only come from increasing rents by a real 20% over four years. Your renters would revolt at an increase like that.

 

3. Rental real estate is painful work. Oh, the headache and hassle: the uncertainty of how long tenants stay; the cash outflow when you aren’t collecting rent; the costs to ready the property for new tenants; the marketing costs to find new tenants; the general and surprise repairs and maintenance; the record keeping. Really, why would anyone ever buy into that? It’s the exact opposite of FUN to me, and this is the time of life to really focus on what’s FUN.

 

4. You’re hurting your heirs as well as yourself. If you have rental property, sell it and put the proceeds into your financial nest egg.

 

I am surprised at folks who say, “I’ll hang on to this property because my heirs will get a step up in value when I die; they avoid capital gains taxes that I would otherwise pay.” These folks have the cart before the horse.

 

My friend, Roy, tells me that he and his wife own a 1,000 square foot house with a lake view. That size might more properly be described as a cabin. His sole, single renter has been there for years and causes no problems; he even paid for the new refrigerator when the old one went kaput. Renting to him has been headache free. Roy hasn’t raised rent much over the years because the tenant has been so good, but Roy has close to no net cash rental income now.

 

Roy thinks he can net $150,000 from a sale. But he tells me his problem is that his depreciated cost basis is $20,000. His tax preparer told him, “DO NOT SELL!” – or to sell it and reinvest the proceeds in rental real estate again – to avoid paying capital gains taxes in his lifetime. At the death of Roy and his wife, their children get the step up in value. They could sell then and not incur the capital gains taxes that Roy would incur if he sold. Roy and his wife HATE the idea of paying nearly $20,000 in added taxes now, and they conclude their tax preparer is giving them solid advice. Smart guy, I’m sure.

 

 

Does that recommendation make sense? NO! This is an example of failing to thoroughly engage the computational part of our brain to compare the two opportunities.

 

Roy has two options: #1 Not Sell. Hold on to the property or sell it and put the proceeds in similar rental property. His heirs never pay capital gains taxes. #2. Sell. Pay gains tax and put the net proceeds into his financial nest egg. I use expected real returns for his real estate (1% per year) and for his mix of stocks and bond (5% per year after taxes each year). (See here for expected real return rates for stocks and bonds.)

 

 

Option #2 wins handily. If he sells, pays tax and invests the proceeds in his mix of stocks and bonds it would take just four years to have more money than his heirs will ever get from the real estate. Roy or his heirs would have nearly $47,000 more money in a decade. (If I had used 2% real growth in value for real estate – highly unlikely in my view – Option #2 pulls ahead in five years, not four.)

 

This comparison gets ridiculous if I run this out 20 years. Roy’s heirs have than $160,000 more in spending power in 20 years.

 

 

== Sell and NO future taxes ==

 

I personally like this course of action: Sell and Invest the proceeds in 529 plans for the grandchildren. That means NO future capital gains taxes. The grandchildren are very young. The total can compound from a greater mix of stocks than Roy and his wife might want in their retirement portfolio. I calculate this adjustment – the effect of avoiding future taxes on gains – means Option #2 results in $65,000 more in a decade (not $47,000), and that grows to $230,000 more in today’s spending power in 20 years.

 

 

Conclusion. Some folks recommend rental real estate as a solid investment for retirees. It’s tough to come up with something that’s worse in my opinion. Non-financial assets can’t come close to your financial assets in providing cash for you to spend to enjoy. They can’t touch the growth potential of financial assets at expected return rates. I suggest you sell rental real estate, pay the gains taxes, and put the net proceeds in your nest egg. My guess is you already have enough non-financial assets – your home. You don’t need more. It’s time for FUN.

Patti and I have slowly changed our spending habits, but the change was not in the way that you might think. We slowly changed to be more tolerant of spending that gives one or both of us pleasure. We no longer are bugged by the relatively small amounts the other spends on things they enjoy. That’s primarily stemmed from the process of truly trusting our annual Safe Spending Amount (SSA). [See Chapters 2 and 12, Nest Egg Care (NEC).] It also helps, obviously, that our paychecks – the monthly deposits into our checking account that add to our total SSA –are 20% more in real spending power now than they were in 2015. This post explains the evolution of our attitudes about spending money.

 

== $20. Decades ago. ==

 

Patti’s spending habits could be described as frugal. She could treat nickels as if they were manhole covers. This spending habit comes from her Mom, in particular, and was passed on in spades to her three daughters. Two sons missed out on this gene.

 

Years ago Patti’s habit was to ask if she could spend $20. We both remember the location and instance of this conversation. Patti, “I like this sweater. It is on sale for $20. (You can tell that was decades ago.) Is it okay if I buy it?” Tom, “Yes, but please don’t ask me for permission to spend $20. You can spend $20 all you want. $20 purchases will not have a meaningful effect on our finances now or in the future.”

 

That was a turning point for Patti. I think it was important, though, that I kept reminding her, “We’re just fine financially. Don’t sweat the small stuff.”

 

== About five years ago ==

 

Once I was retired, however, I became annoyed at Patti’s purchases. The $20 amount climbed to perhaps $60. That’s probably not far off from $20 adjusted for inflation, but the number of purchases and packages arriving on our doorstep started to bug me. It’s a lot easier now for Patti to spend $60. She can buy with a few clicks on the computer.

 

My annoyance also had something to do with not being totally certain as to what was safe to spend. I knew we had been good savers and investors for decades, and I always thought we had enough for retirement. But I never was sure that this was true or how to translate what we had to an amount that was safe to spend so we’d never run out. I was not comfortable in saying, “We’re fine financially. Don’t sweat the small stuff.”

 

== The shoes. The room at the Awahnee. ==

 

Two annoyances bubbled up to the surface. One for me and one for her at about the same time. I was annoyed at another pair of shoes purchased on sale from Little’s in Squirrel Hill or the FedEx delivery to our front door from Cole Hahn. I would nip at her, “Not ANOTHER pair of shoes! You don’t NEED another pair of shoes. When will this stop?”

 

Patti also was annoyed with me. We were planning a visit to Yosemite. I found three options in the valley. For the dates we wanted, one was not available. One that was available was $280 per night and the spectacular Ahwanee Lodge was $500 per night. Of course, I went for the Ahwanee for $220 more per night. I booked it and charged one night as a deposit to our credit card. Oh, did that raise eyebrows when she saw that on next month’s statement! “This is for just ONE NIGHT at Yosemite?”

 

== Now that we know ==

 

We got over those bumps after I calculated our Safe Spending Rate (SSR%). (See Part 1 Nest Egg Care.) Our SSR% was more than the general Rules of Thumb I had in my head. And I didn’t trust the general Rules: they provided no details as to how their Rules  were calculated. I trust our SSR% because I know the details, and I hope from Chapters 2, 3 and 4 you will trust yours.

 

We first started paying ourselves our Safe Spending Amount (SSA) in 2015 directly to our checking account each month. Paying ourselves is a big psychological edge. I do not decide that we NEED to withdraw more money for our checking account. The paycheck just arrives like clockwork. It’s the third monthly paycheck directly deposited into our checking account – we each get a direct deposit from Social Security. We get these three paychecks even though we don’t show up for work!

 

With the mobile banking app from PNC, I can see our checkbook balance at any time. We always have a large checking account balance. I like it sloppy. It’s silly to worry about $60 purchases now and then or even the infrequent $500 purchases.

 

By going through the process in NEC, Chapter 3, this has also sunk in: we don’t have that many years left together. It’s not pleasant to look at our probabilities of living: I can calculate that it’s 50% probable that one of us will have die in fewer than nine years (end of 2028). We’re both in excellent health, and we feel like we will beat those odds, but the odds are fact. Lesson: if it gives us a tiny bit of joy, just forget the amount spent. Don’t sweat details.

 

 

I’m very tolerant of Patti’s purchases. As I mentioned in this post, Patti gets a real shot of joy when those shoes arrive. Here was the delivery today: not shoes! “These Athleta pants just fit great. They cost $99, but they were on sale for $39.99. I had a $40 reward credit, so these didn’t cost anything. I still have a penny credit.” Tom, “Great. I like the design. You needed another pair. You’ve got a lot of work to do to catch up with Alice in the variety of exercise pants you wear.”

 

Patti now pitches in to spend more for a better room. We get a much better room when we travel for a lot less than the $220 for the Ahwanee. I just looked over our bills for our May trip to the Lake District in England. I made the reservations for 12 nights. Patti made them for two. All were the best room, in my opinion, that each place offered. I calculate that we averaged $42 more per night than the lowest priced room of the four places we stayed. We really like the places we stay and the rooms were terrific. That’s $42 for added joy each day on the trip: peanuts at this stage in our lives.

 

 

 

Lessons:

 

1. Assuming there are two of you, one of you has to have a clear grasp of the three key decisions that lock in the number of years you have with zero chance of depleting your portfolio. That person has to clearly understand the underpinnings of your annual Safe Spending Amount. That person has to grow to absolutely trust that amount.

 

2. That person needs to state your financial retirement plan in simple terms. Maybe state it often so the two of you are on board. “If we don’t spend more than $xxx per year, we just can’t run out of money. I can remind you of the details if you like. We’re doing just fine this year. Let’s not sweat the small stuff.”

 

3. Pay your annual SSA as monthly paychecks. That paycheck will arrive as reliably as your Social Security payments. Seeing the total each month makes your annual spending budget much clearer. You shift your thinking from “What do I need to withdraw for our spending?” to “How are we going to enjoy this money that keeps rolling in?”

 

4. Recognize that the sands of time are running. Depending on your age, you can’t count on that many more years, especially that many healthy years. A probability of living calculator helps you see this. If something gives you a shot of joy, go for it.

 

5. My guess is that the things that give you shots of joy throughout the year don’t cost that much. I particularly like staying in a better place and room when we are on vacation. (Patti has grown to like that, too.) Patti gets shots of joy from the new shoes, blouses, pants, or dresses purchased at a deep sale price. (I get pleasure from her enthusiasm when she tells me about her latest bargain.) And to be honest, she saves far more on airfares – almost a passion for her – than she spends on those things.

A financial retirement plan with 65% stocks is inherently NO SAFER than plan with 85%. A plan with 85% stocks can have NO RISK or uncertainty in the life of your portfolio – the number of years your portfolio will pay you a Safe Spending Amount. If you then change your design choice to 65% stocks, you are adding nothing to safety. You can’t get lower than NO RISK. It’s a mistake to then lower your mix: if we ride a sequence of returns that is close to the average we would expect, that low of mix of stocks costs you and your heirs a LOT of money. The purpose of this post is to explain how a plan with 85% stocks has NO RISK and is a better plan.

 

== What is risk? ==

 

Risk is uncertain, variable results that lead to financial loss. We retirees want to make decisions for our financial retirement plan that lessen uncertainty and the chance of loss.

 

The wrong picture of uncertainty and loss: I argue the typical retiree and financial advisor focuses on the wrong time horizon and measure of financial loss for us retirees.

 

They focus on the chance of a one-year decline in the value of our portfolio. The annual expected real return for stocks (7.1%) is triple that for bonds (2.3%). [See here.] But one-year stock returns are about three times more variable in return. Very poor stock returns of ≤ -20% return occur about 1 in 16 years, while bonds returns of ≤ -20% occur in about one in 75 years. A mix lower in stocks always has less chance of portfolio decline in a year and therefore is less risky.

 

 

The investor just has to make a judgment on his or her personal comfort level – their emotional tolerance of a possible decline in the value of their portfolio, and then they decide on a comfortable mix of stocks. That’s the sole decision to lower risk.

 

The right picture of uncertainty or loss. The risk point I worry is about two decades away, and it’s a different definition of loss. I’m not unconcerned about a financial return that’s below 0% for a year, but my central concern is a multi-year sequence of really HORRIBLE annual returns that – in combination with the fact that I need to withdraw from our portfolio for spending – can destroy our portfolio.

 

At the start of our plan, my concern could be expressed as, “I want to know what’s safe to spend such that I DON’T RUN OUT OF MONEY for many, many years.” The loss I was worried about was a decline in my portfolio to the point it not longer would support another year of spending. I wanted our portfolio to be healthy enough to support a Safe Spending Amount year after year for decades.

 

That view adds a second factor to the risk equation: spending rate. That makes perfect sense: you have less risk if you spend less. Duh. How can those other folks ignore spending as part of the equation for risk?

 

== Eliminate the uncertainty of future returns ==

 

Once we eliminate the uncertainty of future returns in our planning, our Safe Spending Rate (and Amount) is clear.

 

We eliminate the uncertainty of future financial returns by using a planning trick. We plan for the worst – we assume we will face the MOST HORRIBLE sequence of future stock and bond returns. We use a Retirement Withdrawal Calculator (RWC) that shows how a portfolio fares over time for a given spending rate.

 

• We set our target number of years.

 

• We make a choice for our mix of stocks and bonds. (All RWCs require this as an input.)

 

• The best RWC I find I find – FIRECalc – requires us to decide on our Investing Cost, and this turns out to be a very important decision. Investing Cost is the expense ratio for the funds and securities we own and advisor fees we pay each year. (See Chapter 6, NEC.) Those costs are generally expressed as a percentage of our total portfolio and, in essence, are subtracted from market returns each year. They’re a real drag.

 

• Then the RWC (basically) spits out the spending rate that gives us ZERO CHANCE OF DEPLETING for our target years using the MOST HORRIBLE sequence of returns it constructs. (See Chapter 2, NEC.) We make that rate our official Safe Spending Rate (SSR%).

 

With those three decisions you eliminated all uncertainty that result in fewer years that the target you set. At the start of our plan Patti and I had ZERO risk of not being able to take a full withdrawal for spending to my age 90.

 

 

You also get a bonus feature with FIRECalc: you see complete range of portfolio values for all the sequences it builds, and it gives your ending portfolio balance if you rode the expected sequence of return. If your investing cost is not too high, that result is always more than you started with!

 

 

== What’s MOST HORRIBLE look like? ==

 

I am not one to trust someone else – FIRECalc – to show me a result for something as important as my financial retirement plan without understanding the details. I wouldnt be eliminate the uncertainty of market returns if I did not trust FIRECalc’s choice of the MOST HORRIBLE sequence of return.

 

FIRECalc constructs sequences of returns we may face by using the historical record of stock and bond returns in the order that they occurred. I can easily find the data sources it uses on stock and bond returns. I can construct the same math it does to show how long a portfolio lasts to verify its accuracy (I did that here.) And I can see details of the worst sequences of return. (You see examples here and here.) Wow, they look really bad to me. Our brains forget how bad it’s been at times in the past. I conclude the worst sequences are breathtakingly bad. They are so bad that I conclude I don’t have to construct hypothetical, worse sequences for my planning. I’m comfortable that my plan truly uses a MOST HORRIBLE sequence of returns.

 

== Answers I give ==

 

It’s the hockey stick. It’s the hockey stick. My image of our plan is a hockey stick. The shaft of the stick is the number of years of zero chance of depleting my portfolio. That was 19 at the start of our plan about five years ago. I’ve LOCKED in that point. The only thing that could make it fewer years is worse than MOST HORRIBLE returns, and I’m sure that’s basically impossible. (Patti and I could screw up and exceed our Safe Spending Amount or increase Investing Cost, but we’re sure not going to do those things.) The blade angle is the rising chances of depleting in later years. The first year I have a chance of depleting is so far away that odds, unfortunately, do not favor that either Patti or I are alive then.

 

 

Someone may ask about my mix of stocks and bonds. I tell them my mix is 85% stocks. They typically say, “Whoa. That seems really risky.” I immediately know they don’t have the image of a hockey stick in their head. We’re not going to connect on this point.

 

My answer is, “The amount I spend each year gives me zero chance of depleting my portfolio to at least age 90. It’s only about 15% probable that I’ll be alive then. Do you think my choice of age 90 is too risky?” They generally have no response or mumble some kind agreement that 90 is Okay. But I know their brain is stuck on the view of one-year decline as their model of risk while my brain sees my hockey stick.

 

== Why 85% and not 65%? ==

 

If you decide your Safe Spending Rate based on a portfolio of 85% stocks, switching then to a mix of 65% buys you NOTHING. You already have ZERO chance of depleting, and you can’t get below ZERO chance of depleting.

 

But a lower mix of costs can cost you. We’re ALWAYS better off with a greater mix of stocks when the sequence of returns we face is not MOST HORRIBLE. We’ll have much more in our portfolio. That means we have more chances to Recalculate to a greater Safe Spending Amount (See Chapter 9, NEC). Or if we never changed our annual spending amount, we’d accumulate far more for our heirs. Patti and I could accumulate $400,000 more per starting $1 million Investment Portfolio.

 

 

 

Conclusion. A financial retirement plan with 65% mix of stocks is not inherently safer than one with an 85% mix of stocks. With Nest Egg Care you make the three key decisions that LOCK IN the number of years you know your portfolio will give you a Safe Spending Amount. That’s ZERO risk in my view.

 

Your plan should start with the input of 85% stocks. You don’t gain lower risk if you then have second thoughts and move to a lower mix of stocks. You can’t go below ZERO risk. The lower mix just means you will accumulate far less if the future sequence of stock and bond returns is close to expected returns.

 

You plan looks like a hockey stick. Few have this image in their head. Most everyone will look at you strangely when you tell them your plan has 85% stocks. You may have doubts. If so, start out at a lower mix, say 75%. Stick with it for a couple of years. Get comfortable with your plan and your Safe Spending Amount. Then move up to a greater mix of stocks.

A possible change in tax law would require heirs of our IRA to fully distribute them over fewer years. The change, described here, (“… It Could cost Your Kids Thousands.”) would require that our IRAs be fully distributed within ten years of our death. Here’s another article that describes the effect as a “confiscatory death tax mainly on … middle-class [and] is egregious.” Will this cost our heirs $thousands? Yup. But is this unfair and confiscatory? I offer my views in this post.

 

== Two issues are at play ==

 

1. Under proposed law tax-free growth on my IRA after death would be shortened by decades. As I describe here, the big advantage of an IRA is tax-free growth. You avoid gains taxes – primarily capital gains taxes – on growth of your contribution for as long as you keep your money in your IRA; you’re compounding growth without the drag of taxes. Once you withdraw an increment, you end its tax-free run and then, in essence, all future growth on that increment is taxed at 15% capital gains rates. This lowers your real return rate by 15%. Example: the real expected growth rate of my IRA is 6.34% per year. Once my money is subject to capital gains tax, my expected growth rate is 5.39% (85% of 6.34%). Money compounds to roughly 15% less over time.

 

 

2. Under proposed law, our heirs will pay a greater marginal tax than they would under current law. Most of us have Traditional IRAs and small or even no Roth IRAs. I started contributing to my IRA in 1981 and only Traditional was available. Certain types of plans that I contributed to over the years (SEP-IRA) were only Traditional. Roth first became available in 1997, and I had already made the bulk of my contributions. While I have converted some Traditional to Roth, I’m basically 100% Traditional. I’m therefore sensitive to the marginal tax rate I pay when I withdraw. I would like that rate to be as low as possible. I certainly don’t want to bump into a painful marginal tax rate that I could otherwise avoid.

 

== #1. Tax-free growth: 10 years vs. 80 years ==

 

Under current law when you leave your IRA to a non-spouse beneficiary, it continues to exist for ~85 years less the age of beneficiary at your death before the final withdrawal depletes it. Last week I used the example of how my IRA existed 50 years in my lifetime and would exist 30 more years for my hypothetical, non-spouse beneficiary age 55. If I had left my IRA to a beneficiary age one, my IRA would have existed more than 80 years after my death! I think of my 1981 contribution: some part of it would grow tax-free for 50 years in my lifetime and 80 years thereafter: 130 years of tax-free growth!

 

Yes, shortening the maximum number of years of tax-free growth to ten years after my death means that tax-free growth runs fewer years and capital gains tax on growth kicks in earlier.

 

But I don’t have a problem with this. The idea of my IRA lasting and growing tax-free for 80 years after I’ve died is crazy. Ten years after I’ve died seems much more rational.

 

Also, Patti and I want our heirs to be able to use money that we can leave them earlier not later – we’d ideally like to get most of what we’d like to leave them while we are alive. I like the thought that they are able to use more money when they are younger. We want our heirs to use what we can leave them to make a difference in their lives SOONER, not later. Maybe they’d use the money for their kids’ education; take far better family vacations; spend to improve their home; or contribute to their own IRAs. I have no problem in them getting it all from my IRA (withdrawing it all) in ten years.

 

Actually, I recoil a bit at the thought that my IRA is going to hang around for decades after I’m dead and be, in effect, a very large part of an heir’s retirement plan. I don’t see that as our responsibility.

 

 

 

== #2. Income in a higher marginal tax bracket ==

 

This is the problem of 1) a large initial Traditional IRA that grows because expected returns are well below RMD percentages for many years; 2) RMD percentages that eventually are large; and 3) leaving your IRA to too few heirs. Those factors combine to result in large RMDs for an heir – perhaps so large it throws him (her) into a painful tax bracket that he would otherwise avoid.

 

• We may have this problem: it’s not limited to our heirs. At expected returns for stocks and bonds, our RMD will be twice our first RMD as I describe here. That’s from the play of factors 1) and 2) above. Example: When I am 82 my RMD (about $73,000 in this example) will be about twice my first (about $36,500). My IRA at age 85 ($1.24 M) is 24% more in spending power than it was at my age 70 ($1 M). Note: Through my age 85 I withdraw roughly $930,000 and have a balance of nearly $1.25 million. Nice result from that $1 million start!

 

 

 

Depending on the size of your beginning IRA, an RMD that is twice what it was at age 70½ could throw some part of your income into a painful tax bracket. The painful transition is from 24% to 32% marginal rate. You keep 11% less on the part that falls into the 32% marginal bracket.

 

 

This problem of some part of income falling into too high marginal tax bracket is limited to folks with very large IRAs and therefore very high RMD: the trip point that starts the 32% marginal tax bracket is over $310,000 taxable income for married, joint filers. (That’s nearly $340,000 in gross income.) I think we’d all like to have this problem.

 

• Under current tax law, my heir will have larger RMDs from my IRA than I will have. I used the example last week of an heir age 55. She may fall in into a marginal tax rate that she really would not like for MANY years.

 

Her $1.24 million Inherited IRA has 24% more spending power that it had at my age 70. Her initial RMD percentages are well below the expected return rate and her Inherited IRA grows in real spending power. It grows to be much bigger than mine ever was: oh, the power of compound returns and time.

 

When she is age 66, her RMD ($85,000) will be greater than mine at age 85 ($84,400). When she is 77, her RMD will be double and it will eventually be triple this amount. It gets so big that it alone almost places her in the 32% marginal tax bracket. And this is on top of RMDs she’ll be taking from her own Traditional IRAs and Social Security and other income. Wow!

 

 

• My heir will have this problem under proposed law. If my heir has to fully withdraw from my IRA over ten years, she’ll have at least one large withdrawal that will result in very high taxable income. The simplest way to see this is to assume my heir age 55 sticks with the RMD schedule under current law. That means no difference relative to current law for nine years. But then at the end of the 10^th year she withdraws the final balance – a total withdrawal of +$1.6 million.

 

 

She’d pay 37% tax on taxable income greater than $510,000. (The chart is in $constant and brackets adjust for inflation, so that’s an accurate statement.) She’d keep 63% of the total. If she otherwise would have been in the 24% bracket she would have kept 76% of the total. The added tax cost results in roughly 17% less for her.

 

 

My guess is that the impact over ten years is a lot less dramatic than 17% difference. With planning she can lower this impact: withdraw more earlier so less is taxed at that very high marginal rate. I can’t easily compare this to the tax effect under current law because I can’t reasonably estimate the tax impact of those high RMDs for 20 years – her age 66 to 85.

 

I don’t get agitated about this problem. This affects very few of us in my opinion. This would be a nice problem to have and to work to solve. Also, total withdrawal of your IRA in ten years has much less tax impact – perhaps no impact – if you leave your IRA to more heirs.

 

Think of this way: you start out with a $1 million IRA. You withdraw +$900,000 to enjoy in 16 years. Let’s assume that’s the balance of your lifetime to age 85. And then your heirs get to withdraw $2.1 million in the next ten years to enjoy in their lifetimes. Wow! I really like that.

 

 

Conclusion: Proposed tax law may require our heirs to totally withdraw the total in the IRA they inherit from us in 10 years. That is decades shorter life than current law. Shorter life means fewer years of tax-free growth and an earlier start on capital gains tax on growth. That’s a loss relative to what seem crazy to me: my IRA could exist and grow tax-free for 80 years after I died.

 

Greater annual withdrawals from higher RMDs could throw (us and) heirs into a marginal tax bracket that they really don’t like. That could happen under current law and proposed law. High marginal tax on withdrawals is an issue for the rare few of us with large IRAs and few heirs.

 

The bottom line for me is this. You start with $1 million. Under proposed law and expected rates of return, you withdraw +$900,000 to enjoy in your lifetime. Your heirs withdraw $2.1 million over the next decade. They get to enjoy twice as much as you did. You have to like that.

A possible change in tax law would cut the number years our IRAs that we leave to our children or other heirs will grow tax free. The change, described here, would require that our IRAs be fully distributed within ten years of our death. Under current law my IRA that I leave to an heir could easily exist for 30 years after I’ve died. Some part of my first contribution to my IRA in 1981 grows tax-free for 80 years! That part will have grown by 256X in real spending power. This post explains how under current tax law I get 80 years of tax-free growth on my first contribution to my IRA in 1981.

 

Last week I discussed the two basic advantages of IRAs.

 

• You get to play the game of different tax rates. A difference in your marginal tax rate 1) when you contribute and 2) at time you withdraw can mean you net more to spend than if the marginal rates were the same at both those times.

 

• Your IRA nets you more to spend than the alternative of keeping it invested in a taxable account because you are avoiding taxes – primarily capital gains taxes – for all the years your contribution is in your IRA. Each withdrawal from your IRA ends that tax-free run on that amount.

 

I calculate that tax-free growth is the greater benefit of the two, and I focus on this effect in this post. I’ll address the issue of marginal tax rates that heirs may pay from greater annual distributions (over 10 years vs. 30 or more years) – which seems to have alarm bells ringing for some – in the next post. The immediate question to answer:

 

• How do I get an 80-year run of tax-free growth on some part of my first contribution to my IRA in 1981 and what happens to it over time? We’ll follow what happened to that first contribution in 1981– the bottom layer in my total IRA – in this post. You’ll get the idea of what happens to all the other contributions.

 

 

== My first 33 years of tax-free growth ==

 

I made my first contribution – $2,000 – to my Traditional IRA in 1981. My 1981 contribution grew tax-free for 33 years to 12-31-14 before I was first required to withdraw a part in 2015 for my Required minimum Distribution (RMD).

 

I know invested my 1981 contribution in a stock fund that returned no less than the index fund VFIAX – one of the few that existed in 1981. Using VFIAX as the measure, my $2,000 in 1981 was about $71,400 on 12-31-14. That’s a combination of real growth and inflation. Let’s drop inflation and state all future dollar values in the constant dollar spending power of 12-31-14.

 

 

== RMD and the next 17 years ==

 

My first four years of RMD. My first RMD of 3.66% in 2015 was based on the value of my IRA on 12-31-14. My four RMD withdrawals have averaged about 3.8% per year. Real returns on my portfolio have averaged 5.9% per year. (If you follow the investment advice in Nest Egg Care, that also would have been your real return.) My portfolio has grown in real spending power by 2% per year and was 8% greater on 12-31-18. The $71,400 on 12-31-2014 increased in real spending power to $77,300 by 12-31-2018.

 

 

The balance of my lifetime. At expected return rates for stocks and bonds and my low investing cost, my IRA will continue to grow in real spending power for about the next ten years. I described this in this post: RMD percentages are less than the 6.34% expected real return rate for my portfolio through 2028. In 2029 – my age 84 – the 6.45% RMD percentage – first exceeds the expected return on my portfolio.

 

 

At the end of 2030 the value of the remaining part of my 1981 contribution to my IRA is $86,800 measured in 2014 spending power. That’s +20% from 12-31-14.

 

 

== The next 30 (or more) years ==

 

Let’s assume I name a non-spouse heir as beneficiary of my IRAs. I’m simplifying here; of course Patti is the first beneficiary of my IRA, but let’s assume I leave it to a non-spouse heir.

 

Assume I die at age 85 in 2030. My IRA passes to an heir age 55. My IRA is then subject to an RMD schedule that is different from my RMD schedule. Her RMD applies to both Roth and Traditional IRAs, ending the run of tax-free growth on the amount withdrawn.

 

In the first year she must withdraw based on her Life Expectancy Factor from that table: 29.6. That translates to an RMD of about 3.4% (1/29.6) in 2031. That’s about half the percentage I took the year before. Her RMD in future years calculates by subtracting 1 from her starting 29.6 Life Expectancy Factor. Her RMD percentage increases fairly steeply each year. It first exceeds the 6.34% expected return in 2045 when she is 69. My IRA is fully depleted in 2061, 80 years after its start.

 

 

At expected returns my heir will see my IRA increase in real value to $112,100. That’s 57% more than on 12-31-14 – 30 years earlier. In this example, some part of my initial contribution has ridden 80 years tax-free growth at 7% annual returns: that’s eight doublings or real grown in spending power of 256X. Whew! All this from one $2,000 contribution in 1981!

 

 

If I left my IRAs to a younger heir, that heir would see more years of real growth in my IRA and my IRA would be depleted after 2061. If my heir was age 30 at my death, my IRA would run 55 years to 2086! A total of 105 years. That is more than ten doublings for some part of my initial $2,000: far more than 1024X in real spending power.

 

 

Conclusion: A possible change in tax law could limit the number of years that an IRA we leave to an heir can grow tax-free. An inherited IRA would have to be fully distributed within ten years. This post explains how under current law my IRA could exist 30 years or more (!) after my death and for a total of 80 or more years: a part of the $2,000 I contributed in 1981 grows tax-free for 80 years. At expected return rates some part of my initial contribution will increase in real spending power by a factor of 256X.

Does it ever make sense to not add to your IRA when you have money saved that you won’t spend for many years? My friend Jim, years younger than I am, asked me, “I have money to invest. I don’t plan on spending it for many years. I’ve contributed to my IRAs for years, and I have a healthy amount now. I’m thinking I should stop putting more into my IRAs and that I should just keep it invested in my taxable account. Does this make sense?”

 

I used to be confused about this: I thought my Traditional IRA was converting what would otherwise be taxed as capital gains to income taxes. That is not correct. The  answer – with one remote exception – is to ALWAYS put as much into Retirement Accounts as possible. You ALWAYS gain the fundamental advantage of a retirement account relative to a taxable account: you AVOID capital gains taxes on the growth of your investment for as long as you keep it in your IRA. The purpose of this post is to explain this fundamental advantage.

 

== Two types of IRAs are basically the same ==

 

Many folks are not clear on this, but as I mentioned in this post, a Roth IRA and Traditional IRA are essentially the same. You either pay income tax when you contribute (Roth IRA) or you avoid paying tax when you contribute but then pay the tax when you withdraw (Traditional IRA). You wind up with the exact same net amount from either type of IRA if your marginal tax rate when you contribute matches the marginal rate when you withdraw. This example shows that a  $5,000 invested in a Roth IRA or a Traditional IRA net the exact same amount for spending.

 

 

== The game of different marginal tax brackets ==

 

The two don’t give the exact same spending power if the marginal tax rate when you contribute differs from the one when you withdraw. You play this game when you choose which kind of IRA to contribute to based on your view of the marginal tax rate when you (or your heirs) withdraw the money for spending.

 

• Roth over Traditional: You’d pick Roth if you are in a low marginal tax rate now and think you’ll be in a higher one when you withdraw it from your IRA for your spending. Example: your marginal tax rate now is 12%, and you withdraw it for spending when your are in the 22% bracket. You’ll win the game by paying income tax now at a 12% rate and not at a 22% rate.

• Traditional over Roth: You’d pick Traditional if you are in a high marginal tax bracket now and judge you will be in a lower one when you withdraw. Example: you’re in a 22% marginal bracket now and withdraw it for spending when you are in a 12% bracket. You’ll win the game by not paying 22% income tax now but paying 12% later.

 

You don’t win much in this game if the differential in marginal tax bracket is small. If the current tax rate is 22% but is 24% in the future, Roth results in about 2.6% more to spend than Traditional.

 

 

You win most when your marginal tax rates are very different when you contribute and when you withdraw. Using our current tax rates, the difference in adjacent marginal tax brackets could be 8 or 10 percentage points: 12% vs. 22%; 24% vs. 32%. Here’s a summary of what you might win (or lose) in this game:

 

 

== The 13% benefit from avoiding capital gains taxes ==

 

You ALWAYS win from IRAs because you AVOID capital gains tax on the growth of the amount you’ve invested and held for many years in your IRA.

 

To understand the benefit of avoiding capital gains taxes, I’m going going to exclude the game of different marginal tax brackets. I’m going to assume our player, Carl, nets the same from either Traditional or Roth when he withdraws. That makes it clearer to understand the benefit of avoiding capital gains tax: we calculate the capital gains tax effect as if we had invested in a Roth IRA. It’s the same effect as for a Traditional IRA, but it’s easier for our brains to understand the effect when our IRA is expressed as a Roth IRA.

 

Carl is 45. He has $2,000 – after paying his income taxes – that he can invest. He puts $1,000 in his taxable account to grow in the future. He puts $1,000 into his Roth IRA. He will hold these two accounts for 20 years and then sell the securities for his spending.

 

I’ll assume Carl invests solely in stocks with essentially zero investing cost (He’ll invest in an index fund.) and earns the expected 7.1% real return rate over two decades. That simplifies our math: we’ll consider that as two doublings or growth of a factor of four. I’ll assume Carl’s 7.1% growth in his taxable account is solely price appreciation. He only pays capital gains tax in the year he sells the stocks for his spending.

 

How much more does Carl have from his Roth IRA? Carl nets about 13% more for spending from his IRA than from his taxable account. This is the smallest advantage from an IRA than I can calculate, and it’s more than from winning the game of different marginal tax rates.

 

 

== It’s really more than 13% ==

 

I calculate that the benefit is greater than 13% more to spend with more years and different assumptions.

 

1) If I stretch the holding period to 30 years the benefit grows to 15%.

 

2) If Carl pays capital gains each year for 20 years on the 7% annual increase – not just in the 20^th year on the total accumulated growth – he’d net over 20% more from the IRA. That nip of taxes on each year’s growth in his taxable account means there is less to compound.

 

3) The real capital gains tax rate is greater than 15% because the cost basis is not adjusted for inflation. The effect is that Carl pays capital gains tax on the inflation portion of any dollar gain. Example: even with no real growth in the value of his initial $1,000, Carl would record a taxable gain of +$600 on his initial $1,000 from inflation at 2.5% per year for 20 years. After paying the tax, he’d wind up with less spending power than he started with. I calculate the real capital gains tax rate is 17%, not 15%, for that 20 year period. That makes the benefit of the IRA about 15%.

 

4) The capital gains tax rate may  be greater because of state taxes. I live in Pennsylvania. I pay 3% on capital gains. The total capital gains rate then is 18%. But I pay no tax on any withdrawals from IRAs.

 

== Avoid Capital Gains tax for many decades ==

 

I made my first contribution to my Traditional IRA in 1981, and it grew for 30 years before I withdrew any for our spending – I was first subject to RMD 34 years later in 2015. I’ll die with a balance in my IRA. My IRA is almost solely Traditional. RMD percentages will never deplete it. And I don’t have an incentive to withdraw more than RMD for our spending. Sales of securities from our taxable account will alway have the lowest tax cost and net more for us to spend (or gift) in our lifetimes.

 

== The one wrinkle for Jim to consider ==

 

If my friend Jim thinks his IRA is large now, it will only be larger in the future at expected returns for stocks and bonds. That means he may have a very large RMD in the future and fall into a higher marginal tax bracket. Jim could lose the game of different marginal tax rates.

 

Jim has a number of years for his current portfolio to grow before he takes his first RMD. As I discuss in this post, your RMD roughly doubles from age 70½ to age 83 at expected return rates. That’s because 1) the RMD percentage is less than the expected real return rate on your portfolio for all those years; that means the real value of your IRA will increase. And 2) the RMD percentage increases each year: by age 83 it’s about 70% greater than at age 70½ (6.13% vs. 3.65%). That large increase in RMD may mean a significant portion of income from his Traditional IRA is taxed at a high marginal rate: the jump from the current 24% marginal rate to the 32% rate is the biggest enemy.

 

 

Conclusion: You always want to invest as much as you can for retirement into your IRA. The fundamental benefit of an IRA is that you AVOID paying capital gains taxes on the growth of your portfolio for many years. I calculate that the 20-year benefit is about 15% more for you to spend by investing in your IRA as compared to the alternative of leaving it in your taxable account.

 

You also play the game of different marginal tax rates when you contribute to your IRA and when you withdraw from your IRA. You’d pick Roth IRA or Traditional IRA in this game. In some cases the decision as to which is best is clear. Many times it is not. The benefit of this game is secondary to the benefit of avoiding capital gains taxes.

Like most all of us, I look often to see how the market and my holdings are doing. (Patti has it right: she never looks!) My looks are quick: is the market up or down today? Are my holdings up or down today? I know US stocks are generally up 10% or so in 2019, but I don’t calculate how we are doing overall very often. This week I calculated our six-month return ending May 31. May 31 is our six-month mark, because I use the 12-month results ending November 30 to calculate our annual Safe Spending Amount (SSA) for the upcoming calendar year. This post shows my calculations, states what I think our return implies for the end of the year calculation, and describes my view of needed actions now. That’s easy to summarize: NONE!

 

== Six-month Results: 1.8% ==

 

Our Investment Portfolio is up 1.8% at the six-month mark. As I describe here, I get the percentage return for each security I own using returns published by Morningstar: I only have four securities to worry about, so the calculation of the return on our total portfolio is very simple.

 

 

Results for YTD 2019 year are good, but I almost forget that stocks nose-dived in December. Bonds did not. As described in this post, that’s what bonds are supposed to do: when stocks crater, they don’t. We see a one-month snapshot of the insurance value of bonds at work. I won’t withdraw for spending for 2020 until early December this year, so this one-month view of bonds doing their job doesn’t mean anything. When I reach the 12-month mark on November 30 and sell securities for our spending in 2020, I may or may not see that same insurance effect at work over the whole year.

 

== What does that 1.8% imply? ==

 

Inflation is running about 2% per year – 1% over the last six months – so my real return over the last six months is about .8%. That’s a rate that is lower than my expected real annual return of 6.4% for our portfolio. Roughly 1% real return is not great, but it’s not horrible.

 

 

The roughly 1% real return tells me that Patti and I on track for the same Safe Spending Amount (SSA) in 2020 as in 2019. We are not on track to calculate a real increase in safe spending. I’d simply adjust our current $55,500 SSA for inflation. That’s okay because that’s a 20% real increase in spending power from the start of our plan – $44,000 spending in 2015. Here’s the summary of our calculation of annual SSAs so far. You’ll find the full explanation of the calculation in Chapter 9, Nest Egg Care, and the discussion of last December’s calculation here.

 

 

We may also be on the track for no real increase in spending for 2021. Nesteggers recalculate to a greater, real SSA when – basically – the real return on our Investment Portfolio exceeds our withdrawal rate. for example, we took out 4.6% for spending in 2017 and earned 17% real return in the year: that told me we’d have a big, real increase in our Safe Spending Amount for 2018.

 

Patti and I earned about -1% real return in the 12-months ending last November 30, 2018. We may be better but not my much this year. Let’s assume we earn less than 4% total real return for the two years. Our withdrawals will total about 9.5% for the two calendar years 2019 and 2020. That means we will have some catch up to do from greater returns for 2020 if we are to calculate a real increase for 2021.

 

== What adjustments should I make? ==

 

None. I have no reason to change our plan: spending rate, investing cost (already rock bottom; I really can’t get much lower), or mix of stocks vs. bonds. Our last real increase, calculated at the end of 2017, set us on a path of zero chance of depleting our portfolio through 2033.

 

 

The plot of the chance of depleting our portfolio looks like a hockey stick: many years of zero chance of depleting, an inflection point, and an increasing chance of depleting in the years thereafter. We locked that inflection point with our three key plan decisions. That shaft length through 2033 is to Patti’s age 86 and my 89; I can calculate that it’s 15% probable that we’ll both be alive then.

 

 

Conclusion: Every now and then we need to take a snapshot of how our portfolio is performing in the year. Unless you use December 31 as the ending date of your calculation year, the return that you want to track is a combination of one or two months of the prior year and the return year-to-date.

 

The six-month return for Patti and me, ending May 31, is 1.8%. That’s not horrible, but it is tracking to a return that leads me to think I won’t be able recalculate to a greater real Safe Spending Amount (SSA) for 2020. It looks like our SSA will be the same amount in 2019; we will simply adjust the current value for inflation. Our spending amount will still be 20% greater in real spending power than in the first year of our plan.

If you’re a diehard nest egger you only invest in Index funds. But some just can’t avoid the lure of trying to beat the market. Or just can’t make the switch to Index funds all at once. If you are hooked on trying to beat the market, this post recommends you open a new, tax deferred account for your Actively managed funds, ETFs or stocks and bonds. Put a small portion of your portfolio in the account. That allows you to continue to play the game of beating the market at a much more constrained level. You can clearly measure how good you really are.

 

== Nest Eggers and Index funds ==

 

Four Index funds do it for Patti and me. There’s no need to get more complex than that. The evidence tells me that over time Patti and I will be better than the 94^thpercentile of investors in Actively Managed funds. We’ll beat 100% of those who pay a financial advisor on top of fund fees. That’s good enough!

 

 

== Actively Managed funds aren’t good for us ==

 

Actively Managed funds damage the integrity of our financial retirement plan. Our plan looks like a hockey stick and a pile of money. We’ve made the three key decisions that have LOCKED in 1) the number of years of zero probability of depleting our portfolio in the face of the Most Horrible sequence of stock and bond returns in history – the shaft of the hockey stick – and 2) the amount of money that we would have over time if returns aren’t Most Horrible.

 

 

 

Actively Managed funds distort the shaft of our hockey stick. We don’t know from one year to the next how they will perform relative to market returns. We’ve lost our ability to predict shaft length. That means we can’t find and trust our Safe Spending Rate (SSR%) and Safe Spending Amount (SSA). About the last thing you want to do is add more unpredictability on top of future market results.

 

Actively Managed funds shrink the pile of money. Their Investing Cost on average is at least four times the default cost assumed by my favorite Retirement Withdrawal Calculator (RWC). Plug in the average cost of Actively Managed funds as an input to the RWC and you can see the pile of money shrink. Big time. (See Chapter 6, NEC.)

 

== The lure of trying to beat the market ==

 

The evidence tells us we win the game, beating at least 94 percent of all investors by sticking with Index funds. Yet it’s not easy to accept Index funds. With few exceptions, the financial industry is geared to telling you that you can beat the market. And our brains fight the decision to only invest in Index funds. I describe this problem here. We’ve view ourselves as smart, competitive and successful. Even though the evidence is that we’ll be better than the 94^thpercentile of investors, we just can’t accept returns that are a tiny bit less than general market returns. That just doesn’t feel right to some folks. They can’t resist the lure to try to beat the market.

 

== A “Sandbox” account ==

 

If you’re lured, I suggest you open an account in your tax deferred, retirement accounts and label it “Sandbox.” (It would take me less than five minutes to open a new account in my Retirement Accounts at Fidelity and then nickname it as “Tom’s Sandbox.” That’s what I’d see every time I logged in and looked at my Portfolio Page. I would also similarly be labeling Patti’s display of my account correctly.)

 

 

Then sell securities from another similar retirement account – you have no tax consequences for these sales – and transfer the money into the Sandbox. Make this your playpen for your experiments with Actively Managed funds, special-focus ETFs, or your choice of hot stocks if that is your cup of tea. Over time you will see how well your Sandbox account performs relative to your (in my case) “Tom’s Index Stocks” or “Tom’s Index Bonds”.

 

The only caveat I would recommend is to start out with a small portion of your total portfolio in your Sandbox. I’d suggest no more than 5% of your total. You may be lucky enough to be in the category of Happy Campers described in NEC, Chapter 5 with More Than Enough for their spending desires. Use some of your More Than Enough in this account. (You may have better choices as to what to do with your More Than Enough, though.)

 

 

Conclusion. We retirees should only invest in Index funds. The evidence tells us that those of us who do will be better than the 94^th percentile of all investors who don’t follow that advice. We have a financial retirement plan we can count on: we’ll know our calculated Safe Spending Amount (SSA) is indeed safe. But there is a powerful lure to do better. If you cannot resist, I suggest you open an account in your Retirement Accounts that is a Sandbox for you to play in. Keep the sandbox small and measure its performance over time against you much larger holdings of Index funds for stocks and bonds.