Growing our wealth while paying expenses and not having a job.

Decumulation is the technical term for spending down one’s assets. It’s the opposite of the accumulation phase of building up those assets.  So typically it’s the point at which you transition from your job income that is both paying your living expenses and allowing you to save money, to where your savings now need to pay for your living expenses.  Your net worth slowly declines as you spend the money you saved.  It’s a stark transition and it’s  psychologically difficult.

I don’t really like the idea of starting to spend down my pool of savings at a relatively young age.  After all the whole point of investing is that your money makes you more money over time, not less.  But if we’re pulling too much from the golden goose, we could end up in trouble.

This is why our plan calls for our net worth to grow in early retirement, even as we spend money while not having jobs.  This is possible because of the magic of investing.

The idea for this post was triggered by other FIRE bloggers who have also been sharing their plans on how they will pay for living expenses once they stop working.  The current (as of end of June) is below.

Anchor: Physician On Fire: Our Drawdown Plan in Early Retirement
Link 1: The Retirement Manifesto: Our Retirement Investment Drawdown Strategy
Link 2: OthalaFehu: Retirement Master Plan
Link 3: Plan.Invest.Escape: Drawdown vs. Wealth Preservation in Early Retirement
Link 4: Freedom Is Groovy: The Groovy Drawdown Strategy
Link 5: The Green Swan:  The Nastiest, Hardest Problem In Finance:  Decumulation
Link 6: My Curiosity Lab:  Show Me The Money: My Retirement Drawdown Plan 
Link 7: Cracking Retirement: Our Drawdown Strategy
Link 8: The Financial Journeyman: Early Retirement Portfolio & Plan 
Link 9: Retire By 40:  Our Unusual Early Retirement Withdrawal Strategy

Link 10: Early Retirement Now: The ERN Family Early Retirement Capital Preservation Plan

I wasn’t planning to join in as we have some specific items that won’t be relevant to most readers.  However, given the diversity of plans being shared, I thought maybe it would be helpful so I thought I’d add my plans for converting savings into income.  I won’t show up on the official list because I’m not on Twitter which seems to be how these are all being linked but I still wanted to add to the contributions here.

I should note that I’m not actually retired at this point yet but I’ve spent a lot of time mapping this out and am confident that what I share here is what I’ll actually do.  The biggest wildcard is whether my wife or I earn additional money that is not in the plan.  I think this is reasonably likely but my plan is built without this in mind to reduce stress.  Any income will simply be extra and require a lower withdrawal from our savings (or allow higher spending) so I’m sure I’ll be able to adjust our plan if it happens.

I’m relatively conservative with the amount of withdrawals I’m planning. Part of this is because my wife and I will retire in our 40’s with young kids and will be using our savings to pay for expenses for many decades.  Part of it is because I like to invest aggressively (nothing too crazy though) and need to have some downside financial protection for my family.  It’s maybe a bit ironic, but I’m building a bigger financial cushion so that I can take more risk in investing.  I fully expect this to pay off in better returns but if it goes south, we’ll still be fine.

So, let’s get to it. Where will our spending money come from?   I have a few different sources of savings that I will use.  The pie chart below shows the main buckets, indicating the % of our annual spending that will come from each source.

 

Bucket 1 – Pension

My wife and I are fortunate to have a nice combined pension from our workplaces. Beyond the fact that we have a pension at all, the great thing about these is that we can take these pensions at any time.  There is no restriction to wait until some later age.  The value continues to increase if we defer these after leaving work but recent IRS rules have reduced the rate at which these build in value during deferral by 25% so deferral is less attractive now.

More importantly, I’m willing to give up some future return in order to give a nice floor of income during the critical “sequence of returns risk” years.  Our pensions are not indexed to inflation so it will be most beneficial during this early retirement time.  Later on, the real value will decline a lot due to inflation.

Another factor is long-term risk to the company.  I’m not too worried about this as we work for a large, stable company and the government will step in and cover a good portion of smaller pension benefits like ours if a firm goes bankrupt.  Still, it’s a much bigger risk to plan on a pension that you won’t start taking for 20 years, versus one that can give you real money now while the company is doing well.  Since I don’t have control of my pension like I do my personal investments, I’d rather use this for spending money and take less from my taxable accounts, allowing them to grow more.

Overall, this will cover about 40% of our annual spending at the start, which is a huge benefit.

Bucket 2 – Dividends

Another big bucket is dividends from our taxable account. I’m planning on a 2% dividend rate (the current market dividend in the US that you get with a market index fund).  We have consciously saved a lot in our taxable account so we have access to this money long before age 59.5.  It will account for at least 1/3 of our investable net worth by the time we stop working.

Dividends will shift from being reinvested to being disbursed to us for spending once we stop earning an income. This will provide around 30% of our spending depending on how much we end up adding to our taxable account before our incomes stop.  One really nice thing about dividends is the tax advantage that I’ll describe later.

I am not a proponent of investing just for dividends (e.g. dividend aristocrats) so this dividend amount is just the overall dividend yield for the core index funds that we have, which currently is running at about 2%.

Bucket 3 – Deferred Salary

Another bucket is a small amount of deferred salary. I qualified for this due to my position at work and plan to put enough money in that it will cover 15% of our spending for 15 years post-work.  This gets us near the age where we’ll be able to access our retirement accounts.  The benefit of salary deferral is that you can elect not to take some of your salary during high income tax years and have it paid out after you stop working and are in a lower tax bracket.

The only reason I didn’t take more advantage of this option is that it’s a non-qualified plan, meaning that it’s pretty low on the list of creditors for the company and the money here is simply a voluntary IOU from the company instead of a paycheck.  It’s a promise to pay you later in lieu of paying you now.

If the company faces financial difficulties (or simply decides they don’t want to pay), this money can disappear.  In addition, once you set up how the money will be paid, there isn’t much you can do to change this.  So while the tax advantages were significant, I still limited what we put in to under 10% of our total savings.

Bucket 4 – Sale of Stocks

I expect buckets 1-3 to cover at least 85% of our annual spending and maybe 100% depending on where our actual spending lines out after we settle in to our new lifestyle post-retirement.  Any shortfall will be relatively minor and will be covered by selling some stock investments each year.

The amount will be 1% or less of our taxable account.  Combined with the 2% dividend, this is a total 3% withdrawal rate from our taxable account, which is quite conservative.  We will not be touching any of our retirement account assets so our total withdrawal rate is lower than this.

What we’re not doing – using our “retirement” accounts

As many others have written about (MadFIentist covers this well for example) there are many options for getting money out of your retirement accounts early including the rule 72t and traditional to Roth IRA conversions but I don’t plan to use these.

I don’t like the 72t rule of substantially equal periodic withdrawals because I lose too much freedom to make adjustments and I like freedom.  I don’t want to regret getting locked into this if we end up making some money I’m not planning for or find ourselves spending less than we thought.

Taxes

I may take advantage of the traditional to Roth conversion option at some point but it’s a bit of a hassle to manage and I try to keep things simple.  I’ll decide on this later.  There is no rush since we don’t need to do this to generate any spending money.  It would only be to lock in a low 15% tax rate but I need to fully model the effect of a higher AGI on health care subsidies and our overall taxes before deciding this is worthwhile.

Note that while dividends (qualified) and capital gains are taxed at 0% if you’re in the 15% tax bracket, they still count in your AGI calculation.  In other words, our taxable income will be our AGI – qualified dividends – capital gains so while our taxable income will be quite low, our AGI will still be relatively high.

If our AGI exceeds about $75,000, then we will be taxed at 15% on our dividends and capital gains, instead of 0%.  Since around half our spending money will come from dividends and capital gains, I like the idea of getting this at 0%.  It’s not such a big deal if we exceed this since it’s only the amount above $75,000 that is taxed at 15% but it’s still nice to be at zero.

Overall, based on the standard deductions for a family of four, and the preferred tax treatment of dividends and capital gains, our taxable income will be low and our overall tax rate will be below 5%, while still allowing for a relatively high level of annual spending.

This is why it’s worth the complication of optimizing your withdrawal strategy.  Taxes make a big difference.  They are the government equivalent of actively managed fund fees.  When it comes to our withdrawal strategy, we should focus just as much on reducing taxes as we spent trying to minimize investment fees by using index funds instead of actively managed funds.  Over long periods, this tax optimization makes a huge difference.

That’s our main plan

So with these three buckets, a good portion (maybe all) of our planned spending is already covered. If we need a bit more, either for non-recurring expenses like a car replacement, new roof, home improvement, or for higher expenses than we planned (e.g. health care costing more), we can sell some of our stock investments.

We have tracked our expenses carefully over the last ten years, so we know our costs well. We’ll save a lot of money on daycare after at least one of us retires, but health care costs will be higher.  I’m estimating a pretty high health care cost just in case Obamacare disappears but most likely our expenses will end up being about 10% lower than we plan.  On the other hand, we might be having so much fun doing things that some costs go up so estimating slightly higher expenses is not a bad plan.

We also plan to move and most locations we are considering will be lower cost areas than we currently live in so expenses are likely to drop by around 10% but there are a lot of variables so I’m not counting on this.  Our plan calls for purchasing an equivalent cost house somewhere else, plus enough cash to cover selling our house and moving in the first year of retirement.

So we have a number of changes that are planned and many that are still uncertain so it makes it harder to nail down fully. But we’ve built a financially conservative plan that we are comfortable with.  We also plan to work another year or two and might even keep going beyond that.  After all, we’re pretty happy already.  Regardless, we’ll be in even better financial shape when we do pull the plug.

As a last detail, I have a life insurance policy I want to get out of (the subject of another post on professional financial planners and why I now do things myself).  However, I have about $80,000 in gains that will be taxed at my regular income tax rate when I surrender the policy so I am waiting until the year after retirement when income is very low (prior to starting deferred salary and pensions) to do this.  This money will then roll into our taxable account and is already part of the dividend and capital gains buckets I described earlier in our plan.

What we’re not counting as “buckets” we can use for spending money

I’m not counting some assets in our net worth (i.e. part of our safe withdrawal rate numbers) because I don’t plan on using them as income sources.

We are not counting the kids 529 plans. This should cover a good portion and maybe all of their education costs.  If not, we’ll cover any gap from our retirement savings since we should have enough.  They will still need to be reasonable on their college choices.  An ROI analysis is already a common discussion in our household so this won’t be a shock when we do the same thing with college.

I’m also not discussing home equity. Our house is paid off but I’m not planning on using any of this equity to fund our living expenses.  It’s possible we get some equity out in a move and add this to our investments but that is uncertain at this point so our current plan is build around buying a house at an equivalent price point.

One of the big advantages of having a house paid for, is that our income needs are lower.  We don’t need to liquidate more investments to pay the mortage.  Being below an AGI of $75,000 means our dividends and capital gains are tax free and our overall tax rate is very low (not to mention any health care subsidies which are based on your AGI).  This is largely possible becuase we don’t have to pay for a mortgage.  I would rather have a very low tax rate than a high one with a small mortgage interest deduction.

Can we be even more conservative?

You can see that we are pretty conservative already.  We don’t count the 529 plans or home equity.  We won’t touch our tax-sheltered retirement accounts at all.  And we’ll have a 3% or less withdrawal rate from our taxable account.

 

Investment Hedges

In terms of investment modeling, everyone knows that forecast returns for US stocks is low for the next decade because they have gone up so much (although what’s forgotten is that even if it turns out to be true, the average return over the next 30 years should still be quite nice).  Of course when everyone knows something will happen, there is a tendency for it not to happen!

Even so, as I’ve mentioned before, I have a lot more allocated to emerging markets because of relative valuations so my expected returns are higher.  But no one can predict this stuff well so despite this, my plan is built to be successful even with a terrible market return compared to history.  I fully expect things to turn out much better than planned though!

From an investment and withdrawal rate perspective, if stock prices do not increase at all, ever, inflation runs at 2%, and all we get is the 2% dividend yield, our net worth still only declines about 25% by the time we hit age 60 (40% on an inflation-adjusted basis).  So with even this incredibly pessimistic (and extremely unlikely) scenario we still preserve most of our savings while having no job and living a nice lifestyle during the rest of our 40’s and our 50’s.

This scenario is not going to happen but it’s certainly comforting to do the thought exercise with such a long-term financial depression and realize that we will still manage just fine.  Note that if such a scenario does happen, the world would destabilize and the only option will be to build a bunker and hoard canned good and guns.  It’s not something I’m planning around because if we do this, there is a high probability we’d feel like idiots in a few years.

Annual Spending Flexibility

I include our spending increasing at 1-2% rate per year on average in our base plan.  This will be at or slightly below my 2% inflation estimate but many studies show that spending doesn’t actually rise with inflation in retirement, even early retirement (it rises at about half the inflation rate which makes a big difference over time).

This is a major degree of flexibility we all have.  If you combine this flexibility with the 4% (or 3%) withdrawal rule, you basically have a bullet-proof plan.  If there is a stretch of poor market returns, we will either (1) decrease spending or (2) keep it flat and not increase spending with inflation.  This makes a big difference over several years.

If things go well, we will most likely increase spending with inflation even if we could afford to spend even more.  If anything, we’d make larger one-time purchases compared to making more permanent lifestyle spending increases.

Social Security Will Be A Bonus

We are also not counting any social security.  It’s a ways off and a lot could change but despite the financial challenges, I still expect we’ll receive at least 75% of the promised benefits (at 75%, the system is solvent).

Earning Money in “Retirement”

I also expect we’ll end up doing something that earns us money.  But I don’t know what this will be at this point.  I doubt it will be blogging 🙂  Regardless, I don’t want the stress of needing even a small income to make our plan work so we’re not counting on it.

Not Done Working Yet

Finally this is based on current numbers but we’re still working at this point and saving a lot so we’ll have even more cushion when we do actually stop work.  We have not decided when that is at this point since we generally like our jobs still.

As I write this, I’m ready to retire now!  Actually, the main reason we’re not is because we still like working at this point.  It’s not a financially driven decision as you might expect from what I describe here.

But I don’t have a pension or deferred salary – this won’t help me!

I realize we have some opportunities like a pension and deferred salary that are only accessible to a few but hopefully the details here will still help you think about your own plan.

How we’re optimizing our sources of income to minimize taxes is something that anyone can do because of the tax advantages of dividends and capital gains.

A small amount of side income, coupled with dividends and capital gains, would allow anyone to do the same thing we’re doing.  Just substitute our pension and deferred salary amounts with a part-time passion job income.

Or use the traditional to Roth IRA conversions to generate some “income” to supplement your investments (just make sure you understand the details like the 5 year hold period).

Many people have some rental income from real estate investments which would also be treated similar to any income/pension/deferred salary.

A high dividend strategy also takes advantage of the tax benefits of investments I list here.  Many people target higher dividend paying stocks or funds to take advantage of this.  Just be careful about fees.  And valuations since many people have piled into high dividend investments in the search for yield in today’s low-yield world……most of them aren’t cheap right now.

I also have a different view on housing because I want to minimize my cash flow needs so that I don’t need to take more from my investments and increase the taxes I pay.  Many others like carrying a mortgage due the low interest rates but just remember that you’ll need to draw a lot more from your investments to pay that large mortgage.  Make sure you factor the extra taxes this will trigger against any advantage you expect.

I’m also uncomfortable using margin a mortgage to invest in the market at these valuations.  I like the safe return of paying off a mortgage even at today’s low rates.

Regardless, I hope you can find a tidbit or two that helps you think about your own personalized plan.

As always, I wish you success in your own FI journey.

4 thoughts on “Growing our wealth while paying expenses and not having a job.”

  1. Can you explain those IRS rules about pension valuation?

    Surprising how neglected decumulation has been in investment and even retirement research. But academics are studying it more, and already have interesting results, like how market performance in the first 10-15 years pretty much determines your retirement.

    Being older, my challenge is draining pretax accounts prior to RMDs to avoid the Social Security tax torpedo, which hits middle incomes with punishing marginal rates. Especially when trying to stay under ACA subsidy thresholds. One of my hedges is to take both pension and SS as late as possible, assuming markets cooperate. And being closer to traditional retirement age, not averse to spending down principle, just as long as we both expire at about the same time!

    And I completely concur that having no debt, especially mortgage, is best. Imputed rent is much safer than market return, and completely tax free! By far the most valuable benefit of home ownership.

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    1. I can’t seem to find the actual IRS rule change online but my company cited this change when they changed our annual pension value gains when in “deferral”. Prior to the change, our pension benefit would go up about 8% per year if it was deferred instead of taken right away. After the change it was 6%. Most pension plans are still assuming high rates of returns and I assume the IRS rule change forced them to use lower rates in projects, meaning more contributions so their plans were better capitalized. My company used it as an opportunity to reduce benefits in our plan, which is certainly the trend in America.

      It sounds like you have a good plan around managing your income in retirement. It gets pretty complicated but the bottom line is that minimizing your cash flow needs (e.g. no mortgage), allows you to lower your income needed. This has big tax advantages but also opens up things like ACA subsidies. I’m even considering using a larger cash pile to minimize my AGI in early retirement while also having a buffer for sequence of returns risk. I’ll get lower returns on that cash but it looks like the benefits from minimizing income below key thresholds will largely make up for this while allowing me a lower risk portfolio.

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  2. Interesting that your pension deferral was fixed at such a high rate. Mine goes up approx. 6% a year, although not from any publicized rate I heard of. Still a mystery how their formulas work. Anyway, that was a more reliable return than I could probably achieve.

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