The proven path to early retirement ignoring the 4% rule

The proven path to early retirement ignoring the 4% rule

 Personal finance has “personal” in it for a reason.

What I means is: the only proven path to retirement, for you, is the one you create and manage.

I firmly believe that.

I also believe however you can and should learn from others whenever possible. This site is all about that.

Passionate readers of this site will know my timeline and financial goals for semi-retirement, while bold, are getting closer:

1. We hope to own a $1 M portfolio to start semi-retirement with (that portfolio value is outside my accumulated ~18-year pension at work; it excludes any part-time work (including this blog); it excludes any part-time or full-time work beyond the blog that I may continue enjoy with my current employer).
2. We hope to be debt-free in a few years.

The combination of items 1 and 2 above should put us in a good financial position to make some changes or simply continue working – but those decisions would be on our own terms.

Whether early retirees are from the U.S. or Canada and anywhere around the world for that matter, I enjoy hearing from them and how they “got there”. Every story seems to be a bit different and nuanced, even if their approaches (including the use of low-cost indexed products) might be the same.

You can find a number of early retirement essays and case studies on this dedicated page here.

Early Retirement Now

I recently got a chance to meet the cerebral and entertaining blogger behind Early Retirement Now at the big FinCon conference in Washington D.C. this year. We had a chat about investing while waiting in line for some of our adult beverages at one of conference evening festivities. Karsten has certainly been very successful when it comes to investing and he has a great deal of knowledge to offer aspiring retirees – on any side of our Canadian or U.S. border – now that he is retiree himself.

Karsten was kind enough to answer a bunch of questions as part of this retirement essay.  I hope you enjoy the read…

Karsten, how about a short bio for my readers predominantly in Canada?

Sure Mark.

I’m from Germany originally and I came to the U.S. for my doctorate degree in economics at the University of Minnesota. After finishing school, I worked in two different jobs: Between 2000 and 2008 at the Federal Reserve Bank of Atlanta and between 2008 and 2018 for Bank of New York Mellon Asset Management. Both my wife and I retired in 2018. I’ve been writing about our journey toward early retirement since 2016 on my blog EarlyRetirementNow.com and now continue writing about personal finance in general and safe withdrawal strategies in particular.

Awesome. Karsten, welcome to the site!

Thanks, Mark. Glad to chat with you!

I’ve been a quiet reader of your site for many years now, including some epic posts I’ll link to in a bit. One of the things I’ve been thinking about more as I get closer to my own FI goals, is the notion of having a modest emergency fund. Say 1-year in cash.

I intend to keep 1-year in cash reserves as part of my bucket approach to retirement income planning, and likely live off dividends for the rest.

What’s your take on emergency funds in general? How much should most people consider holding in cash? What % of cash is your early retirement portfolio now?

While still working Mark, I never had an emergency fund. I had a large enough savings rate and I could deal with all cash flow shocks, like home and car repairs and medical bills simply from my positive cash flow. So, my conclusion from my own experience was that I never had much use for a designated emergency fund because I pretty much invested everything in the stock market!

When I wrote about my $0.00 emergency fund in my post in 2016, to present my approach I got pushback from two angles:

1. People pointed to all sorts of sob stories about people whose car broke down and they had no money to fix it. Again: I never proposed having no money at all. I saved 50+% of my income and plowed that all into productive assets rather than leaving the money in a money market account earning hardly enough to recover the inflation rate.
2. Someone pointed out that that if your spending shock were to occur right at the time the stock market was down then, indeed, it would have been best not to invest your emergency fund in stocks but keep it in a money market fund instead. But that’s a red herring. You are myopically looking at one single emergency. But over your entire lifetime, some emergencies will happen when the market is up, and some when the market is down. So, I wrote a follow-up post “How crazy is it to invest an emergency fund in stocks?” and found that it’s not crazy at all to invest your emergency fund.

So, in a nutshell: invest your money!

Don’t let 6+ months worth of expenses languish in a money market fund!

Very interesting.  Something for me to consider.  That is definitely not the advice some Certified Financial Planners (CFPs) tout. 

OK, on the subject of planning, even though I believe robo-advisors can help investors train their investing brain…I’ve read that you’re not a fan of these companies. You believe folks can easily invest on their own. Is that true? If so, what do you recommend new investors do or how they should invest?

I think that robo-advisors are a really bad value proposition. Sure, they are cheaper than a full-service advisor but you get what you pay for: very generic, middle-of-the-road asset allocation advice that you could have gotten for free with just a few clicks on the internet. In fact, back when I did my research on the robo-advisors, you could just enter your information (age, investment horizon, risk preferences etc.) and they will tell you their recommended asset allocation. The frugal investor could just replicate that exact same allocation in their own brokerage account for free. Why pay 0.25% per year for that?

Admittedly, the robo-advisors also offer two additional services that shouldn’t be ignored: 1) regular rebalancing of the portfolio and 2) tax-loss-harvesting. But that still doesn’t justify paying a non-negligible AUM (Asset Under Management) fee. You just rebalance your portfolio yourself occasionally, again with a few clicks on the web. Tax-loss-harvesting is a little trick in the U.S. tax code, maybe not that interesting for the Canadian readers. (Mark – it also occurs here and makes sense only for taxable investing.) It’s also something that the average investor can easily replicate at home without having to pay 0.25% in additional fees every year. I’ve written a short summary on it on my site if people are interested.

Talking about taxes, I’ve also pointed out a major tax headache created by robo-advisers. If you move over your assets and they have built-in capital gains you could be on the hook for a huge tax bill, see my post “We just saved $42,000 by not switching to Betterment”.

So much has been written on the “4% rule”. I’m just talking about your site! You have an epic series on this subject that has been read tens of thousands of times by readers; and that’s conservative I know.

I recently wondered with a Certified Financial Planner if the 4% rule makes any sense any longer.

So, can you distill a few things for me and my readership?

1. What don’t you like about the 4% rule?
2. What would you suggest investors consider instead as a safe withdrawal rate (SWR)?
3. How are you drawing down or spending your own portfolio?

For a quick intro on why I find the 4% Rule very problematic, please check out my (slightly tongue-in-cheek) post “Ten things the “Makers” of the 4% Rule don’t want you to know”. I think that safe withdrawal strategies are way too complicated to distill into one single rule with one single withdrawal rate. It’s like recommending the same shoe size for everyone. That size will fit some folks perfectly, and others will find it too tight or too large.

More specifically, I believe that a withdrawal strategy has to be a lot more customized to take into account both the current macro environment (equity valuations and bond yields) as well as your idiosyncratic constraints, such as your age, the timing and the size of your expected supplemental cash flows (pensions, Social Security, etc.), whether you’re a renter or homeowner, how comfortable (able?!) are you with going back to work, and a myriad of other factors.

So, on the one end of the spectrum you have a 30-year-old retiree expecting no pension, very little Social Security and even that small benefit is four decades away. You probably want to use a withdrawal rate closer to 3% to make sure the money lasts the next 60 years. Oh, and you think that blog or podcast or internet business of yours will save the day? Do you have a guarantee that your blog will be around for your entire retirement? And it will make money 30 years from now? Do you still want to rely on income from a blog in 30 years? I don’t. So, I don’t even factor my blog income into my withdrawal rate analysis! (Mark – neither do I, I don’t make even minimum wage on this site!)

On the other end of the spectrum you have early retirees in their 50s with generous corporate pensions around the corner and large Social Security benefits not too far away either. I’ve seen cases where 5% or even 6+% initial withdrawals are easily sustainable because you have to bridge only 10-20 years until large guaranteed additional cash flows start.

And again: the sustainable withdrawal rate (SWR) has to depend on asset valuations. If you rely on a stock portfolio you have to calibrate your withdrawal rate to stock valuations. With very elevated price to earnings ratios and 10+ years into an economic expansion and bull market (as in “today”!!!) you should budget for a much more conservative withdrawal rate than in, say, 2003 or 2009 at the bottom of a bear market.

Another reason why there can never be a universal rule on withdrawals: the word “rule” is actually even more offensive than the 4% part! In my view, proposing a “4% rule” is financial malpractice.

What do I recommend Mark?

Do your own analysis taking into account your own supplemental cash flows and constraints. I created a Google Sheet, see my SWR Series Part 28 for the link.

My personal strategy?

We have a spending target of around 3.25% of our portfolio value. Currently, we don’t even have to withdraw that much from the portfolio because I still receive some deferred compensation from my last job that will pay me a small amount until early 2021. I make a little bit of income from the blog (less than 10% of our annual budget, though) but I don’t plan to rely on that, most definitely not in the long-term.

So, in light of the additional cash flows we’re actually extremely conservative with our withdrawal strategy. It’s because the risk profile is asymmetric: Running out of money in 30 years is a lot scarier than having too much money left over!

Well said. OK, something more controversial for you I suspect. I have a plan to “live off dividends” (or ETF distributions) in the early part of my semi-retirement.

I probably know your answer but do you like that idea?  Based on your experiences, what should I be mindful of as part of this approach?

Your hunch in right Mark, I don’t particularly like that idea.

As you point out in your post: “A dollar of dividends is = a one-dollar increase in the stock price.” There’s nothing magical about dividends. When I do my safe withdrawal simulations I look at the total returns of the various asset classes, and therefore take into account dividends and interest income. Most retirees will have to at least partially rely on selling some principal to fund expenses. Which is totally OK because stocks do appreciate on average even after dividends and even after inflation.

A dividend-centered strategy also exposes you to the following catch-22. On the one hand, if I stick with my S&P 500 index funds or U.S. Total Market index funds, I get a 2% annual yield. I think the MSCI Canada has a yield around 2.3%, not much higher. I’m one of the most conservative and cautious commentators on withdrawal rates out there but even I find a withdrawal rate under 3% way too low.

On the other hand, “chasing yields” i.e., replacing broad market indexes with a higher-yielding, more exotic asset mix to push up the dividend yield would have catastrophically backfired in the 2008-2009 bear market. I wrote about that in my SWR Series, in parts 29 through 31. Despite the higher dividends, you did significantly worse than with a boring, run-of-the-mill 60/40 portfolio. The failure during 2007-2019 was due to three factors:

1. Replacing the plain S&P 500 or U.S. Total market with a high dividend ETF had no noticeable effect on performance. The Vanguard VYM (U.S. High-dividend Yield) fund (that you used to own Mark) underperformed the broad index very slightly. The State Street SDY (SPDR U.S. Dividend Fund) did slightly better. It’s a hit or miss!
2. Replacing the U.S. index with international index funds that have higher yields backfired in 2008/2009. Non-US stocks underperformed significantly since 2007! I’m not saying that the high dividend yield caused the underperformance. There were other bear markets where, for example, Australian and U.K. stocks (very high dividend yields!) did really well. I’m merely saying that high dividends don’t fully protect you from sequence of returns risk. Sometimes the high-yielding international stocks do better, sometimes worse. And the under or outperformance is much larger than under item 1 above due to currency risk. It’s a crapshoot!
3. Replacing low-yielding, safe government bond funds with higher-yielding funds (corporate, high-yield bonds, Preferred Shares, etc.) is very detrimental because of the loss of diversification benefits: the higher you move up in the yield the more correlation with the stock market you get!

So, in conclusion Mark, I will stick with my broad index exposure. Of course, people will always claim that they are smarter than everybody else and they can identify the dividend stocks that will do well in the next recession. I’m not convinced. But best of luck!

I had a feeling you’d say that!  I don’t chase high yields though but I fully understand what you are saying even though some of my dividend paying stocks actually never cut their dividends in 2008-2009. This doesn’t mean it can never happen!

So what’s in Karsten’s portfolio? Just indexed funds?

While accumulating assets for retirement, we used almost 100% equity index funds. Very little cash, no emergency fund, as I outlined above! A few years before retirement, though, I started venturing into some other asset classes to smooth out the sequence of return risk a little bit. So, our current asset allocation is significantly less risky.

First, we have a mortgage-free house that’s worth a little less than 10% of our total net worth. I consider a house an investment, and even a pretty good one, because it pays us a stable dividend in the form of the rent we don’t have to pay. Of course, we still have to pay for property taxes, maintenance and repairs, etc. but that’s a lot less than what we’d otherwise pay for rent!

Within the investable portfolio, i.e., assets minus primary residence, we hold the following allocation:

• 51% equities. Almost everything is in equity index funds. Mostly U.S., but also a little bit of international, both developed and emerging for diversification.
• 36% is in an account I use for options trading. By definition, the option trading is done on margin, so I get to put the money in some interest and dividend-paying assets. I hold around 70% of the margin cash in Municipal bond funds (tax-free interest income), 25% in Preferred Shares and 5% in cash. I’ve written about that options strategy here if you like to learn more. It involves selling put options on the S&P 500 index.
• 11% is in real estate, invested in a few private equity funds that hold large multi-family properties. I like real estate as a diversifier for our large equity positions.
• 2% is in money markets and bond funds for immediate cash flow needs.

Sounds very solid to me Karsten.

At FinCon in the U.S., it was a real eye-opener for me that some bloggers/podcasters/vloggers feel they need ~ $2M or even $3M to retire – given healthcare in the U.S. can be such a massive wildcard.  (Some treatments or life-saving procedures can cost hundreds of thousands of dollars without the requisite healthcare insurance.) Do you agree aspiring early retirees really need that much to retire on?  I think investors in Canada should strive to own a $1M portfolio – to retire well.

A million dollars is not what it used to be! What else is new? But seriously, my sense is that there appears to be two camps. Some blogger will tell you that one can retire with a nest egg well below $1 million, probably as low as $500-600k if you do some side gigs, such as blogging or some remote contract work on the side. Others will throw around those $2 million figures or slightly higher. The truth is probably somewhere in the middle. With $1.5 million in the bank, most people will likely have a comfortable and stress-free retirement in most places around the U.S.

Healthcare costs in the U.S. is a wildcard indeed. With Obamacare, we now have a program in place where you can get generous subsidies on your health costs that will keep your insurance premium and out-of-pocket expenses manageable but only if your income stays below certain thresholds. Would I want to rely on that subsidy for the next few decades? Probably not. So, like a lot of U.S. early retirees, we budget $20k a year and more for annual health expenditures.

Seems very smart but I expect nothing less from an economist! On a happier note than U.S. healthcare, what plans do you have in the future Karsten?  Near-term, a few years out?

We just settled down in the Pacific Northwest, outside of Vancouver, Washington. We’ve owned our house for about a year now, but because we traveled so much and we had to do some home renovations in the beginning we didn’t really get to enjoy our new neighborhood very much. So, near-term I’d like to explore the great outdoors opportunities here in the area. I’m also busy with my blog and some other writing projects.

Wrapping up this epic interview, what one or two words of advice do you have for any investor striving to get their financial house in order like you have?

Automate not just your savings but also your investments.

A lot of folks do a great job at curbing consumption and saving money but then never dare to invest the cash for fear of catching the market peak right before the next bear market. I know people who said the S&P 500 was overvalued at 2000 points. Years later and missing out on 50+% returns they are still waiting for a correction!

Thanks for this Karsten.  I hope to have you back on the site in the future.

Lots to learn from this post folks. If you want to find Karsten, visit any of the links above and subscribe to his site and give him a follow on the Twitter machine like I do @ErnRetireNow.

You can find more retirement essays from folks that have successfully “been there, done that” on this Retirement page here. 

What questions might you have for Karsten or myself based on this interview?  Happy to hear them.

Mark