In general, traditional IRAs are attractive for those who believe that their tax rate during their working years will be higher than their tax rate in retirement. This is often the case since it is not unusual to be in a lower tax bracket during retirement. However, this is certainly not the case for all taxpayers and it is possible that all tax brackets could increase in the future.

The following is an excerpt taken from my article written fourteen years ago:

The dire fiscal situation of the United States is likely to lead to much higher taxes in the future, particularly on those who are in higher tax brackets. Recent health care legislation broke precedent by subjecting certain types of investment income to Medicare taxes for higher income taxpayers. While it appears that retirement plan distributions will not be subject to the Medicare tax, this could change in the future. Of course, there is always the risk that the government may try to break its pledge to treat Roth IRA distributions as tax free for higher income taxpayers. However, this seems less likely than moves to tax investment income outside retirement accounts.

One of the great benefits of writing, whether in a personal journal or on a public website, is that we cannot lie to ourselves about what we thought in the distant past. While the overall message of my article holds up well, I was completely wrong about the United States having “much higher taxes in the future, particularly on those who are in higher tax brackets.” I did not foresee the Trump administration’s 2017 tax legislation which cut tax rates across the board. I believe that the fiscal situation is far worse today than it was in 2010, but does it necessarily follow that tax rates will be higher in the future? Past history suggest that we cannot be confident about predicting future taxes.

We live in an era of multi-trillion dollar annual federal deficits, with the shortfall for fiscal 2024 coming it at an astounding $1.8 trillion. The pandemic caused a flurry of spending during 2020 and 2021. Reasonable people can disagree regarding whether this spending was justified in response to the pandemic shutdowns, or whether the shutdowns themselves were justified. It is less reasonable to assert that this high level of spending should become the new baseline, but that is precisely what has happened. The federal government has a spending problem, not a revenue problem, and both parties are to blame for fiscal incontinence. Neither presidential candidate has proposed any credible plan to reduce the tsunami of red ink.

Given that spending will surely not decline to pre-pandemic levels, it would seem reasonable to assume that tax revenues will eventually need to rise. If Vice President Harris wins the Presidency and the Democrats take control of both Houses of Congress, tax rates will certainly rise on higher income earners starting in 2026, but a clean sweep is anything but assured. Republican control of either House of Congress could block higher tax rates, and a second Trump administration will certainly not accept tax increases.

Getting back to the topic of this article, should early retirees consider Roth conversions as a hedge against the possibility of higher tax rates? Obviously, much depends on whether the tax rate that one pays on conversions will be less than the future tax rate that would be owed on traditional IRA distributions. However, the matter is far more complex than simply considering the income tax rate that would apply. This is because required minimum distributions from IRAs could result in higher adjusted gross income (AGI) which is a measure that determines how much seniors must pay for Medicare Part B and Part D premiums. This adjustment, known as IRMAA, can be substantial at surprisingly low levels of income:

It should also be noted that exceeding the income thresholds by even a dollar will result in a higher monthly adjustment. IRMAA is determined based on modified AGI two years earlier. So, the IRMAA adjustment for 2025 will be based on modified AGI in 2023.

Roth IRA distributions are tax free and are not considered “income” for purposes of IRMAA. At least, this is the case under current tax law. While the government could attempt to either tax Roth IRA distributions directly or to include Roth IRA distributions in IRMAA, both of these moves would effectively repudiate the entire premise of the Roth IRA account and would face serious bipartisan opposition. As a result, Roth IRA conversions could be a good way to manage Medicare premiums later in life.

Early retirees often have greater ability to time their taxable income compared to older retirees who may be receiving pension and social security benefits. My case is an extreme example. I left traditional employment in 2009 at the age of thirty-five and the bulk of my assets in taxable accounts were in stocks, including Berkshire Hathaway, that did not pay dividends. Over the years, I have generated cash flow for my living expenses mostly through capital gains and I have complete control over the timing of such income.

In 2009, I moved my traditional 401k account into a traditional IRA. Over the years, I spread out Roth IRA conversions in a manner that never resulted in paying a high tax rate. Today, over half of my retirement assets are in my Roth IRA. While my decisions seemed optimal in any given year, in retrospect I was not aggressive enough with Roth conversions. My IRA assets have compounded at a rate materially higher than my taxable account, most likely due to the freedom I felt to make portfolio changes without incurring immediate tax liabilities. If I had converted my entire traditional IRA to a Roth IRA in 2010, I would have paid substantial taxes, but it would pale in comparison to the deferred tax liability on my traditional IRA today.

But the past is the past.

The question is whether I should be more aggressive with Roth IRA conversions in the future. Marginal tax rates are quite low today by historical standards and seem very unlikely to be lower in the future:

The “sweet spot” in the tax code is currently the 24% tax bracket which includes taxable income up to $191,950 for single filers and $383,901 for married filers. Above those thresholds, the marginal tax rate jumps up sharply to 32%. Former President Trump is likely to resist any tax increases for any bracket while Vice President Harris claims to be opposed to tax increases for “households” earning up to $400,000. This would appear to make the 24% bracket sacrosanct beyond 2025 when the 2017 tax cuts expire, but politicians can never be fully trusted so nothing is certain.

This article would not be complete without mentioning one serious wrinkle to the situation related to the “Affordable Care Act,” also known as Obamacare. The ACA offers substantial subsidies for taxpayers that phase out as adjusted gross income increases. The effect of the reduction of subsidies as income rises is exactly the same as a marginal tax. As a result, anyone who is considering substantial Roth IRA conversions must be willing to accept the loss of all ACA subsidies. I have written about the ACA before, but readers should be aware that subsidies were made far more generous since that article was published in 2017. There is a possibility that ACA subsidies will become less generous after 2025, although I doubt this will be allowed to happen regardless of who wins the Presidency or which party controls Congress.

It is also important to have funds in a regular taxable account available to pay the taxes owed as a result of the conversion. If an individual would have to tap retirement accounts to pay taxes, that would most likely make very little sense, especially for those younger than 59 1/2 years of age since early withdrawal penalties are likely to apply. This would have the effect of increasing the effective tax rate owed on the conversion.

The decision to convert all or part of a Traditional IRA to a Roth IRA is complicated and involves many assumptions in an environment of considerable uncertainty. My current opinion is that tax rates are far more likely to be higher in the future than they are today regardless of what current politicians are promising. However, I made the same precision in 2010 and I was obviously wrong.

I am also concerned that the government might renege on the promise to treat Roth IRA distributions as tax free. Even if Roth IRA distributions are not directly taxed, the government could include Roth IRA distributions in the modified AGI figure used to determine Medicare premiums. However, any move like this will cause a massive outcry and the opposition is likely to be bipartisan.

I would love to convert my entire Traditional IRA to a Roth IRA immediately but this would result in paying the top marginal tax rate, so my approach is likely to involve conversions over a period of several years with the goal of limiting my marginal tax rate to 24%. I am not even certain that I will be that aggressive. I suspect that my “future self” will be thankful if I am more aggressive than my “present self” might prefer.

I could rationalize Roth conversions and payment of current taxes to be a contribution to correcting the federal budget imbalance, but this amounts to a minuscule drop in a vast ocean. Our political climate is not likely to fix the budget until a crisis forces action, and at that point all options could be on the table. Roth IRA accounts, especially owned by “the rich,” could be a tempting target. There is precedent for retroactive changes governing IRA accounts. In 2020, the federal government drastically limited the “stretch” IRA strategy which amounted to reneging on a previous promise and upending many carefully planned estates.

The federal government clearly cannot be trusted. But we still have to make decisions about the future.

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— Warren Buffett

Consider a young man who starts with no wealth at all.

The only way to accumulate the claim checks required to live a decent life is for the young man to trade the only asset he owns, his time and energy, in exchange for claim checks. Young people normally have a great deal of excess time and energy, and directing that time toward earning and accumulating claim checks builds character along with wealth.

At first, the young man will have to exchange a great deal of his time just to scrape by because he can only offer unskilled manual labor. Over time, his skills will develop to the point where each hour of his time is worth more, and he will have the option of exchanging the same amount of his time for more claim checks. Of if he is satisfied with his current income, he could opt to work less in exchange for the same number of claim checks. The choice is his to make.

Every claim check that the young man earns can either be exchanged for goods and services today or saved for the future. If the claim check is saved, it can be invested wisely and the result is that the claim check will earn additional claim checks over time.

If the man is industrious, he might save the majority of his claim checks. This could result in reaching financial independence at a very early age, at which point the man has the choice of continuing to exchange his time for more claim checks or opting to retire when the claim checks generated from his investments are more than enough to buy all the goods and services he desires.

If the man decides to retire, he will have the luxury of never having to sell his time again.

More than enough claim checks keep coming in and, since saving and consumption are two sides of the same coin, it is likely that the same thrift that led to financial independence will result in a surplus of incoming claim checks. The man, who might now be middle aged, will increasingly find his net worth rising over time to the point where he might spend just one or two percent of his assets every year. At this rate, the chances of running out of claim checks drops to virtually zero.

As time goes on, the man will find that the utility of claim checks has serious limits.

While one can exchange claim checks for services, represented by another person’s time, or for a wide array of goods, it is not possible to exchange claim checks for everything one might desire. Claim checks can make it possible to remain healthy for longer, assuming the man has some self-discipline and good habits, but there remain a variety of diseases that cannot be cured with any amount of claim checks. This same reality affects family and friends who the man may wish to help.

Claim checks cannot be used to purchase genuine human relationships. In fact, the possession of claim checks can hinder the formation of human relationships, or at least make the value of these relationships suspect. This is because the presence of wealth is a factor that motivates other human beings and could influence their decision to associate with the man. This is not necessarily a conscious factor in the minds of the man’s newer friends, but could be an underlying factor. The reality is that a man who has great wealth can have great difficulty knowing whether new friendships or romantic relationships are genuine or driven by his possession of claim checks.

There is no doubt that claim checks can purchase companionship, but companionship is not equivalent to friendship. The man might find solace in friends and family who knew him prior to his acquisition of wealth, but he may never be sure whether new people in his life are genuine or not.

A man who owns a significant number of claim checks but consumes a tiny percentage of them annually will naturally see his net worth fluctuate greatly if it is invested in marketable securities. If the man is spending less than two percent of his claim checks annually, there will be plenty of days when market action causes his wealth to rise or fall by more than his annual consumption.

A strange numbing sensation will likely affect the man when market fluctuations cause the value of his accumulated wealth to change by amounts that vastly exceed his annual spending.

While such rises and falls might have had a psychological impact when the man was poorer, they will have little effect at this point. This is particularly true with increases in wealth assuming that there is no desire to increase the use of his claim checks. After all, what is the practical utility of claim checks other than to exchange them for goods and services?

Obviously, Warren Buffett is an extreme example of this phenomenon. Recently, Berkshire Hathaway stock reached all-time highs, and Mr. Buffett’s net worth increased by many billions of dollars. But what practical utility does this increase in wealth have for a man who is nearly ninety-four years old and continues to live a modest lifestyle? The answer is that the utility is close to zero, except as a means of keeping score.

But perhaps claiming that the utility of additional claim checks is “close to zero” overstates the case. We know that Warren Buffett continues to care very much about Berkshire Hathaway which is directly tied to his wealth. This is due to two main reasons. First, he has a fiduciary duty to other shareholders of Berkshire Hathaway who have entrusted him with their capital. Many of those shareholders very much care about the accumulation of claim checks. Second, Mr. Buffett’s claim checks will end up in foundations set up to benefit causes that he cares about.

Not everyone is interested in leaving their claim checks to charitable foundations, but assuming that there is some final destination in mind, the utility of amassing additional claim checks should never fall to zero. It could very well be that there is no longer a motivation to optimize for amassing as many claim checks as possible. But the desire to invest wisely most likely remains for anyone who has in mind heirs who will eventually inherit their wealth.

But now we have come full circle.

We can view the young man who started with no claim checks as disadvantaged because he had to trade his time and energy for claim checks at the start of his life. But we must also acknowledge that his need to do so was a formative experience and, at the very least, made him respect the value of claim checks since he understood what it took to get them in the first place. Those who inherit great wealth will not have such motivations.

The wealth a person accumulates throughout life, after paying taxes, is the cumulative result of countless decisions to work and save and must be respected. It is his to dispose of as he chooses.

I see nothing wrong with passing along wealth to future generations, but the effect on the industry of the recipients should not be ignored. At the very least, passing wealth to young people should be accomplished in the form of a trust that restricts distributions in such a way as to encourage industry and thrift early in life. Inherited wealth at a young age could be destructive, and that would be a terrible legacy of claim checks accumulated over a lifetime.

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— Attributed to Albert Einstein

Albert Einstein probably never referred to compound interest as the eighth wonder of the world, but this is such a good quote! Even if Einstein never uttered these words, the sentiment is certainly true.

Compound interest is merely one example of an exponential function. Human beings have great trouble thinking in exponential terms. It is far easier to think in linear terms and, because this is our natural instinct, most people vastly underestimate the power of investing over a long lifetime. Compounding takes a long period of time to work its magic and we live in a society that prizes instant gratification above all else.

I’ve written a great deal about personal finance over the past fifteen years, so I will not belabor the point. Most of my readers are already likely to be aware of the power of compounding and are capable of thinking in exponential terms. We have all seen the mind boggling graphs that show the effect of investing a lump sum and earning even modest returns over three or four decades. The same is true for dollar cost averaging over a long career. It does not take any heroic investing results to achieve tremendous results if we start early and consistently save and invest over time. Obviously, those mired in true poverty will find this prescription difficult, but this is no excuse for the vast middle class in a very rich country like the United States.

While I do not have much to add about the principle of compounding, I ran into an example of its power this morning and thought it would be interesting for readers. The Social Security Administration sends annual statements to workers who have paid into the system and I just received a report of all of my earnings through the end of 2023. This prompted me to add up my lifetime gross wages and compare it to my current net worth. I knew that the result would look favorable, but I never went through this process before.

The Social Security statement lists all wage and self-employment income subject to Social Security and Medicare taxes. While there is a cap on income subject to Social Security, there has been no cap on wages subject to the Medicare tax since 1993. As a result, I added up all of my lifetime gross wages subject to the Medicare tax. I then compared this figure to my current net worth.

My current net worth is 3.7x the total of all gross wages I have earned over my lifetime.

I find this figure quite remarkable for several reasons. My first wages were earned during the 1980s while I was a teenager with a paper route and after school jobs. I did not earn any substantial wages until 1996, the year after I graduated from college. I then earned solid, albeit unspectacular, wages for the next thirteen years. I retired from regular employment in 2009 and have hardly had any income subject to payroll taxes since then. About 98% of my lifetime wage income was earned between 1996 and 2009.

Throughout my wage earning years, I dramatically underspent my income and invested my savings. I’ve written about some of my early success as an investor, but it should be emphasized that I had no true “home runs” to speak of. My results were basically singles and doubles, with the occasional triple, but sustained over a very long period of time with few permanent losses. My lifetime record has also been enhanced by lucky profits earned on the sale of two homes in California, the first in 2000 and the second in 2002. In both cases, my intention was to live in the home for a long period of time, but relocation for work upended my plans. I benefited from the capital gain exclusion on home sales and reinvested the profits in securities.

Some writers are comfortable sharing specific figures, but I am too private of a person to do that, other than to say that I have certainly reached financial independence and have navigated very early retirement quite well. When I left my last job in 2009, it certainly did not feel like it was an advantageous time to do so. My net worth had been pummeled by the financial crisis and subsequent bear market. But I did not panic and the past fifteen years of returns in stocks have solidified my financial position beyond any question.

I suspect that most readers who have been working in finance for a long period of time would regard my net worth as respectable but nothing special. I will not be flying on NetJets anytime soon and a Manhattan penthouse with a view of Central Park is not in my future. The same mentality that achieved financial independence would preclude any irresponsible spending today. I cannot afford a NetJets share but I could afford to spend far more than the 1.5-2% of my liquid assets that I draw annually. However, doing so would not improve my life. This is not to say that life is perfect, or even satisfactory, but the problems that I have in my life are simply not ones that can be improved by spending more money. However, the fact is that all of my problems would be far worse if I had to trade my time for money and felt financially stressed.

Part of getting older is gaining insight into the reality that living a good life has far more to do with factors such as health and family that simply cannot be purchased with money. However, money is definitely a prerequisite for living a secure life. Since poverty almost always guarantees misery and since anyone in the middle class or higher can easily attain financial independence over a lifetime, there is no excuse to persist in irresponsible spending. Your future self will thank your present self for being prudent and sensible.

The point of writing this article is not to be self-congratulatory and pat myself on the back. I am proud of my accomplishments, but the reality is that they were very ordinary. I had a good job in the software industry and made good income, but anyone in finance would laugh at that income if I revealed it. I simply saved a large percentage of my earnings and invested it reasonably well. Anyone can do this. Nothing I accomplished is beyond the reach of anyone earning a decent income who has a reasonable amount of self-discipline.

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If we invert this advice, the implication is that we should feel free to consume ninety percent of after-tax income. What we are not saving is obviously used for some sort of consumption, whether it is housing, food, clothing, travel, or entertainment.

If an individual has $100,000 of after-tax income and takes the conventional advice to save ten percent, he will save $10,000 and consume $90,000. He will hopefully arrange his life in manner which gets the most “bang for the buck” for that $90,000. After all, no one wants to waste money on things that produce little or no satisfaction. But however the money is spent, it establishes a baseline consumption level.

We can categorize spending into discretionary and non-discretionary buckets, but there are no bright lines in many cases. In the short run, the choices one makes regarding where to live and what type of car to drive represent non-discretionary spending. Other categories, such as food, clothing, and entertainment are subject to greater variability, but it is painful to cut back once a certain lifestyle is established.

Financial independence is reached at the point where one’s accumulated financial assets are capable of safely supporting a certain level of consumption. It obviously takes a smaller investment portfolio to reach financial independence if you are used to consuming $50,000 per year than if you are consuming $90,000 per year.

Perhaps these points are obvious to many readers, but I do not think much of this is understood by the majority of young people. The “you only live once”, or “YOLO”, culture advocates spending now, often for “experiences”, because the future remains unknown and we should enjoy life while we can. It is obvious that no one can be sure of even reaching old age, so there is a kernel of truth in the “YOLO” mentality, but all too often it is extrapolated in dysfunctional ways.

A young person who loves his or her job, intends to work for four or five decades, and is confident that their line of work will continue to exist might end up doing well enough with a ten percent savings rate and a ninety percent consumption rate. This is due to two factors. First, a half century of compounding will prove magical even with relatively small sums. The “snowball” effect will gather steam in the final decades of employment and produce an impressive nest egg in the end. Second, someone who works until seventy or seventy-five will, on average, have a shorter retirement than someone who retires at fifty. A shorter retirement requires a smaller pool of savings.

Sadly, relatively few people love their work to the point where they are content to contemplate four or five decades at the office. The FIRE movement, which stands for “Financially Independent, Retire Early”, has gained a great deal of popularity over the past decade. A growing number of young people wish to escape the rat race early. Not merely at fifty-five or sixty, but often at thirty-five or forty.

If very early retirement is the goal, being aware that savings and consumption are two sides of the same coin becomes absolutely critical, as I wrote about several years ago in Fifteen Years to Financial Independence. As that article showed through contrasting examples, the couple with a low consumption rate (and a high savings rate) was able to achieve financial independence in a short period of time. This was due to two factors: First, the couple’s financial assets obviously grew more quickly given that they were saving over half of their income. Second, and equally important, they had a lower level of consumption spending to replace.

In contrast, a similarly situated couple that saved just ten percent of income would not come anywhere close to reaching financial independence even after three decades, at least not without making drastic cuts in consumption at the point of retirement.

But wait, there’s more … by the time the frugal couple reaches their tenth year of retirement, their portfolio will have grown to the point where they would enjoy a higher level of potential consumption relative to their more profligate peers. While the free spenders are still toiling in employment to support their spending, the frugal couple could now sit on a beach and enjoy that same level of consumption based on their investment portfolio alone.

It is unrealistic, and probably very uncommon, for people to voluntarily reduce their standard of living in any material way. In many cases, they cannot do so even if they want to because they have a lifestyle that, at least in the short run, imposes high fixed costs. The key to financial independence at an early age is to steer clear of high fixed costs and to keep variable costs reasonably low.

When I get to this point in real-world discussions, the objection often turns to a desire to avoid impoverishing oneself in the here-and-now in order to enjoy life later. In my view, the framing of this objection is wrong. It equates a high level of spending with happiness when such spending often merely represents background noise once it is established as a baseline. After the thrill of driving a $80,000 car off the lot subsides, how much more utility does the driver really get compared to someone who bought a $30,000 car? The examples of hedonic adaptation are truly endless.

Obviously, I am writing about individuals who are firmly in the middle class or above and I am not castigating poor people for their low (or non-existent) savings. There is a certain level of spending that is necessary to function well in our society, and certain luxuries do add value. I am sympathetic to the idea of spending on experiences while still young, although I would note that my best experiences, particularly travel, have also been the cheapest. Impoverishment today in order to produce a bounty tomorrow is ultimately a straw-man argument for those at or above the median income.

Perhaps I am preaching to the choir given my audience. However, the two-sided nature of spending and consumption seems to escape the consciousness of many people. Ultimately, we live in a free society and everyone can choose how to balance current consumption, savings, and future financial freedom for themselves. But it is important is to do so with eyes wide open. There is a price to be paid for adopting the unrestrained “YOLO” culture that seems to grow more popular every year.

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— Fred Schwed

Much has changed in the eight decades since Fred Schwed wrote Where Are the Customers’ Yachts. Globalization has reduced cultural differences between regions to the point where much of western society is homogenized, but perhaps the British still have a more enlightened view regarding money. But somehow this seems doubtful.

Morgan Housel hit the nail on the head in his book, The Psychology of Money, when he characterized contemporary attitudes toward wealth:

“When most people say they want to be a millionaire, what they might actually mean is ‘I’d like to spend a million dollars.’ And that is literally the opposite of being a millionaire.”

The vast majority of people regard wealth in a way that almost guarantees the dissipation of wealth rather than its retention.

Viewing what seems like a large lump sum of money as a representation of what that sum can purchase is a good way to return to having little or no wealth at all.

One of the interesting aspects of American consumer culture is the false assumption that retirees, as a group, are poorer than the rest of society. How else can we explain the prevalence of senior discounts? Price breaks for senior citizens appear everywhere if you know where to look. Senior discounts are a competitive tool for private businesses and politicians are eager to provide a reliable voting block with breaks such as the amazing lifetime senior pass for national parks.

If you call it quits at a “normal” age, your coworkers, family, and friends are unlikely to think that you are wealthy. More likely than not, the assumption will be that you have qualified for social security and, far from being wealthy, you probably have a reduced fixed income and might have to actually cut back on spending.

The exact opposite is true for those who retire very early. Society presumes that very early retirement is an indicator of wealth. This social attitude is a particular challenge for the “FIRE” community which stands for “Financially Independent, Retire Early”.

The vast majority of Americans are financially illiterate and spend almost all of their income each year. The FIRE community does the exact opposite. The typical game plan involves a period of aggressively saving a large percentage of income which requires much discipline and resistance to peer pressure. After ten to twenty years, many people in their thirties or forties hit their magic number and are able to leave regular employment with a solid plan to navigate early retirement.

But there are serious pitfalls ahead.

In his recent article, Rich and Anonymous, Morgan Housel describes the concept of “social debt” and the need to avoid it in order to maximize happiness:

“It’s a realization that once money goes from being a tool you can use to make yourself happy to a symbol of what other people measure you by, you are buried in a kind of social debt that’s hard to measure but has a real impact on your happiness.”

The moment you pull the trigger on FIRE, be prepared for everyone you know to come to the realization that you must have a substantial pool of assets in order to quit normal employment and have control over your time. Depending on the quality of your existing relationships, the effect of this realization can range from people being genuinely happy for you to feeling entitled to part of your hard earned wealth, which is the equivalent of feeling entitled to make a claim on your hard earned freedom.

If you want to avoid being noticed, it is safest to stay safely within the confines of a herd and to do nothing that seems unusual within your peer group. It is not unusual to retire at 62 or 65, but it is unusual to retire at 45 or 50. If you elect to do so, it will be necessary to resist any pressure to view your assets as spendable money rather than as a foundation that can generate income for decades to come, as it must for any retirement that might span four, five, or even six decades.

Social debt is not always a matter of people selfishly seeking a piece of your wealth. In many cases, social debt is something people impose on themselves, and this is not always a bad thing. It is perfectly natural to want to use your wealth to help friends and family who are facing hard times. But when others know that you have financial resources, self-imposed pressure can mount even if no one directly asks for help.

Social debt is a very important reason for early retirees to be extremely conservative when it comes to their withdrawal rate. The vast majority of FIRE articles that I read totally ignore social debt, not to mention the ordinary vicissitudes of life.

If you are an early retiree with financial assets of $2.5 million and a 4% withdrawal rate, you might think of yourself as a middle class person with spending power of $100,000 per year. However, you might be perceived by your peers not as a person with a $100,000 income, but as a multi-millionaire. Social debt can easily upend the apple cart and throw a carefully planned early retirement into disarray.

One obvious way to avoid social debt is to cut ties with people who seek to take advantage of your financial status. Money can buy many things in life but it cannot purchase genuine human relationships whether of a romantic or platonic nature.

Ultimately, wealth clarifies a great deal about human beings. We cannot avoid self-imposed social debt without becoming misers or sociopaths. It is natural to want to use financial independence to help others and this should be encouraged. However, to be in a position to help others without risking hard earned financial independence requires a very large surplus held in reserve. This is yet another reason to use very conservative withdrawal rates that are sustainable in the long run.

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Financial independence is not just about money. It is about control of your time and having the option to stop trading time for money.

A billionaire who is my age has orders of magnitude more wealth than I will ever have. Wealth can purchase trophy homes, private jets, and other luxuries I will never have (and do not want), but it cannot buy substantially more time. Despite the fantasies of many technology billionaires, I am skeptical that vast amounts of wealth will ever make it possible to purchase immortality or even a substantially greater lifespan.

Most people dream about retirement but not necessarily because they dislike work. Having more time to devote to family, recreation, hobbies, and volunteer activities are common motivating factors. Unfortunately, most people fail to achieve financial independence due to the trap of an ever-ratcheting lifestyle. But for those who are motivated, early retirement is within reach even without an unusually high income. It just takes a great deal of discipline and a fiercely independent mindset.

My recent articles, The Role of TIPS in a Fixed Income Portfolio and Hedging Against Inflation Using TIPS and I Bonds, were targeted toward conservative investors who may be in the process of tapping their financial assets for retirement or for other cash flow needs. After writing those articles, it occurred to me that there are several pitfalls and opportunities related to drawdown strategies that deserve a closer look.

Writing about retirement strategies is complicated because of the large number of variables involved and the fact that so much is unknown at the time someone decides to retire. While it is possible to make educated guesses based on health and family history, no one can estimate their own longevity with precision. Healthcare needs later in retirement, including the possibility of nursing care, are also difficult to forecast. The variability of investment returns, inflation, and future tax policy are further complications. All of these uncertainties call for a great deal of conservatism.

Even those who give up employment at sixty-five should plan for at least a quarter century in retirement. Of course, early retirees must plan for a longer retirement, and this is even more true for those who opt for retirement prior to age fifty, the goal of the “FIRE” community which stands for “Financially Independent, Retire Early”. I count myself as a member of this group, although I have become more skeptical about the wisdom of very early retirement. I think that most people in their thirties and forties will be happier in some sort of paid employment that they enjoy.

This article is based on a fictional married couple preparing for retirement at the beginning of 2024 when they both turn fifty-five. The story is meant to illustrate the choices made by one couple and there are a number of simplifying assumptions. The purpose is to illustrate several opportunities and pitfalls in financial planning and the tax code that I have found important to understand in my own journey. By no means is this story an exhaustive treatment of every aspect of early retirement. However, I hope the concepts discussed can help increase awareness of several key issues.

I must stress that nothing in this article is financial or tax advice. Retirement is complicated and heavily influenced by individual circumstances. Only a qualified investment advisor or tax expert can address your specific situation. The scenarios used in this article do not resemble my personal situation and are entirely fictional.

Brenda and Eddie Redux

Brenda and Eddie were still going
Steady in the summer of '75
When they decided the marriage would
Be at the end of July
Everyone said they were crazy
Brenda you know you're much too lazy
Eddie could never afford to live that kind of life
But there we were wavin' Brenda and Eddie goodbye …

— Scenes From an Italian Restaurant

Billy Joel’s story of Brenda and Eddie didn’t end well. They were unfortunate victims of the ratcheting lifestyle trap. No matter how much they consumed and accumulated, it was never close to feeling like they had enough. Money got tight, they started to fight, and they just didn’t count on the tears. They soon got a divorce as a matter of course, but they parted as the closest friends.

The fictional Brenda and Eddie in this article made better choices and have enjoyed a much happier outcome. Approaching their mid-fifties after thirty years of marriage, they are empty nesters now that their youngest child has graduated from college. They recently made the final mortgage payment on the modest home in Austin, Texas that they purchased for $100,000 as newlyweds. To their amazement, similar homes in their neighborhood have recently sold for $500,000.1 They have two cars that were purchased for cash and one will be sold once they no longer commute to work.

In addition to home equity, the couple has the following assets:

• $500,000 in Treasury Inflation Protected Securities (TIPS), with $100,000 maturing in 2024, 2025, 2026, 2027, and 2028.

• $1,500,000 in the Vanguard Total Stock Market Index Fund (Admiral Shares) with a cost basis of $500,000.

• $1,000,000 in a Traditional IRA which is also invested in the Vanguard Total Stock Market Index Fund (Admiral Shares).

• The couple does not have traditional defined benefit pension plans, life insurance, or long-term care insurance policies and they do not anticipate receiving any inheritances in the future.

Brenda and Eddie are debt free and have a net worth of $3.5 million including home equity. Their financial assets total $3 million, of which $2 million is accessible to them without tapping their traditional IRA which would incur early withdrawal penalties if taken prior to the year in which they turn 59 1/2.2

Conventional wisdom suggests that Brenda and Eddie could safely consume four percent of their financial assets annually with minimal risk of running out of money. However, for reasons that I have previously described, I prefer to use a more conservative three percent withdrawal rate especially for early retirees who should plan for a retirement horizon of four decades or more.

Let’s say that Brenda and Eddie agree with the three percent withdrawal rate. Should they apply this rate to their entire net worth? Or to the sum of their financial assets? Or to just the subset of their financial assets that are available to them without incurring early withdrawal penalties from an IRA?

These are some of the questions that I will attempt to answer in this article. I will also assume that Brenda and Eddie plan to retire on January 1, 2024, the month in which they will both celebrate their 55th birthdays, and that their financial asset balances will remain unchanged between now and January 1, 2024.

Key Dates in Retirement

Let’s take a brief detour from Brenda and Eddie’s story to review some key dates to be aware of in retirement planning. While there are exceptions to these general rules, they apply to the majority of people who are currently in their fifties.

• Prior to age 59 1/2, there is generally no access to retirement accounts without paying an early withdrawal penalty so IRA, 401k, and similar accounts should not be tapped. Health insurance will usually be purchased via the Affordable Care Act (ACA), either on the federal exchange or on state exchanges, if available. Most early retirees will be able to qualify for ACA subsidies with proper planning.

• At age 59 1/2, retirees gain full access to retirement accounts. Traditional IRA and 401K plans can be accessed without paying any early withdrawal penalties, although income taxes will be due. Roth IRA plans can be accessed without incurring early withdrawal penalties or taxes, subject to limitations that are usually easy to address. However, retirees who avoid tapping these accounts can continue to enjoy valuable tax deferred compounding for many years to come.

• At age 62, retirees qualify for social security benefits, albeit at a lower benefit level that will remain reduced for life. Unless a retiree faces severe financial difficulties or has strong reason to believe that he or she faces an unusually short life expectancy, it usually makes sense to avoid taking social security at 62.

• At age 65, retirees qualify for Medicare. Most workers will qualify for Medicare Part A (hospital benefits) without paying a premium, but Medicare Part B requires a monthly premium of $164.90 in 2023, with higher premiums for individuals with modified adjusted gross income (MAGI) of over $94,000. Married couples filing jointly begin to incur higher premiums with MAGI over $197,000.3

• At age 67, retirees qualify for “full” social security benefits. However, individuals who opt to defer receiving social security benefits will continue to accrue additional benefits until reaching age 70.

• At age 70, the maximum Social Security benefit is reached and there is no further benefit enhancement for those who defer enrollment. Therefore, retirees should plan to enroll at age 70 if they have not already done so.

• At age 75, retirees must begin to take required minimum distributions (RMDs) from traditional IRAs and 401Ks. Note that for those born prior to 1960, RMDs are required starting at age 73. However, Brenda and Eddie were born in 1969.

Overall Strategy

The day has finally come: Brenda and Eddie call it quits on December 31, 2023 and they are finally retired. With a mortgage-free home and substantial financial assets, the couple feels financially secure, optimistic, and very excited about the future. Even better, Brenda and Eddie both feel like they are in the prime of their lives and have every reason to believe that they will live for many decades to come.

Having lived a frugal life, Brenda and Eddie have saved substantial funds. Aside from servicing their mortgage, which has recently been paid off, they have rarely spent more than $50,000 in any year. But now they wish to spend more freely to travel and enjoy life. After decades of living frugally, they would like to aim for an annual spending rate of $100,000 per year, allowing for substantial discretionary spending.

Given their good health and life expectancy, Brenda and Eddie are planning to wait until age seventy to claim social security benefits in order to maximize the size of the benefit. In addition, they do not plan to tap their traditional IRA accounts until they are required to begin taking required minimum distributions at age seventy-five.

This means that Brenda and Eddie must initially rely on the $2 million of assets in taxable accounts consisting of $500,000 in TIPS and $1,500,000 in the Vanguard Total Stock Market index fund. Since they would like to spend $100,000 per year, this means that they will tap five percent of the $2 million each year. This is above both the conventional four percent rule and my preferred three percent rule. Is this a problem?

There is no problem.

We need to consider Brenda and Eddie’s retirement in phases. They will rely exclusively on their taxable accounts for the next fifteen years until they reach age seventy. At that age, they will begin to draw on social security and at that point they will need to draw less from taxable accounts. At age seventy-five, they will be required to begin taking RMDs from their traditional IRA and, at that point, they anticipate that there will no longer be any need to draw funds from their taxable accounts.

It’s important to note that Brenda and Eddie have significant optionality if things do not go as planned and they need additional funds prior to age seventy. Starting in 2028, they will have the option of drawing from their traditional IRA without paying penalties since they will both turn 59 1/2 years old that year. Starting in 2031, they will have the option to begin taking social security benefits. Brenda and Eddie do not intend to exercise these options, but they can do so if absolutely necessary.

In addition to the optionality of drawing from retirement accounts and taking early social security benefits, if needed, Brenda and Eddie’s cash requirements are highly tilted toward discretionary spending. If needed, they could easily cut their spending down to $50,000 or even less. After all, they are debt free and they have lived a frugal life unaccustomed to luxury, and they both have inexpensive hobbies in Austin that can consume their time if financial setbacks require reducing their spending.

To summarize, we can simplify Brenda and Eddie’s phases of retirement as follows:

• Phase I: 2024 to 2033

  • Age 55 to 64

  • Funds to be drawn exclusively from taxable accounts.

  • Health insurance purchased on the ACA exchange.

• Phase II: 2034 to 2038

  • Age 65 to 69

  • Funds to be drawn exclusively from taxable accounts.

  • Health insurance provided by Medicare.

• Phase III: 2039 to 2043

  • Age 70 to 74

  • Begin taking social security benefits. Taxable accounts will continue to provide for spending in excess of social security benefits.

  • Health insurance provided by Medicare.

• Phase IV: 2044 to ???

  • Age 75 onward

  • Begin taking required minimum distributions from IRAs. When combined with social security, there should no longer be a need to tap taxable accounts.

  • Health insurance provided by Medicare.

With the stage now set, let’s take a look at each of the phases of Brenda and Eddie’s retirement in more detail, with particular attention on how we should look at their financial assets, the sustainability of their spending, and various risks that could arise.

Phase I: 2024 to 2033

The early years of retirement can be exciting, but it is critical to put in place a strong foundation for the years to come. In Brenda and Eddie’s case, they will face two important choices right away. First, they will need to consider how to tap their taxable accounts for cash flow needs. Second, they are now responsible for ensuring that they have appropriate insurance coverage for their healthcare needs.

On January 1, 2024, Brenda and Eddie have the following assets in taxable accounts:

• $500,000 in Treasury Inflation Protected Securities (TIPS), with $100,000 maturing in 2024, 2025, 2026, 2027, and 2028.

• $1,500,000 in the Vanguard Total Stock Market Index Fund (Admiral Shares) with a cost basis of $500,000.

To meet the couple’s goals, they will draw down $100,000 from the $2 million portfolio in 2024. In subsequent years, they will increase their withdrawal based on inflation, as measured by the CPI-U index. Although Brenda and Eddie’s personal cost of living might not track the CPI-U index perfectly, it is a rough proxy that is meant to make it more likely that their standard of living will remain constant over time.

As I wrote in The Role of TIPS in a Fixed Income Portfolio, I like the idea of maintaining a “bond ladder” that covers five years of cash flow needs. It so happens that Brenda and Eddie have a portfolio of TIPS that is sufficient to cover their needs for the next five years. To maintain this TIPS ladder, they will need to purchase a new five year TIPS every year using funds drawn from the Vanguard Total Stock Market index fund.

The presence of the TIPS ladder insulates Brenda and Eddie from feeling compelled to liquidate stocks in a severe bear market. If the couple and their financial advisor feel that stocks should not be sold in any given year, they can forego sales in exchange for shortening the TIPS ladder. At a future date when they feel that stocks are trading at more normal levels, they can re-establish the full five year ladder.

How would the mechanics of this process work?

Cash flow for 2024 will be covered by the first maturing TIPS. Assuming the 2024 TIPS matures in January, Brenda and Eddie will keep part of the $100,000 at their bank and invest the rest in short term treasury bills for spending needs later in 2024.

However, by using the first TIPS for spending needs, the couple now has a four year TIPS ladder rather than a five year ladder. They need to purchase a new five year TIPS that will mature in 2029. How will they fund this new TIPS purchase? They will need to come up with the cash to buy the TIPS from their Vanguard stock index fund.

As of May 31, 2023, the Vanguard Total Stock Market index fund had a dividend yield of 1.55%. Brenda and Eddie will tell Vanguard to no longer reinvest dividends. This will generate approximately $23,000 of cash flow during 2024 based on their $1.5 million account balance. This is not enough to purchase a $100,000 five year TIPS, so they will sell $77,000 worth of shares in the fund.

The alert reader might be wondering if I am ignoring the question of taxes. After all, if Brenda and Eddie receive dividends and sell shares in a taxable account, they need to account for income taxes and cannot count on the full amount to buy a TIPS.

Fortunately, Brenda and Eddie will not pay any income taxes in 2024!

How is this possible? Although Texas has no personal income tax, the couple has been paying substantial federal income taxes and payroll taxes for their entire working lives and they are now multi-millionaires with a net worth of $3.5 million!

The fact is that the current tax code is very friendly to early retirees who are careful when it comes to managing their income. In Brenda and Eddie’s case, substantially all of their dividend income represents “qualified dividends” and all of the capital gains realized from selling shares in the index fund are long term capital gains.4

The federal income tax rate on long term capital gains and qualified dividend income is 0% for couples with taxable income under $89,250 in 2023. This figure is indexed for inflation and will be substantially higher in 2024 based on recent inflation trends.

Brenda and Eddie are likely to have the following gross income in 2024:

• ~ $25,000 in interest and inflation adjustments for the TIPS portfolio. As I explained in Hedging Against Inflation Using TIPS and I Bonds, the IRS considers TIPS inflation adjustments to be income on an annual basis even though the adjusted principal is not received until maturity. This is considered ordinary taxable income. The amount might be higher or lower than $25,000 depending on the rate of inflation in 2024, but $25,000 seems like a reasonable estimate.

• ~ $23,000 of dividend income from the Vanguard Total Stock Market Index mutual fund, which will be almost entirely comprised of qualified dividends eligible for the 0% federal income tax rate.

• ~$51,000 of long term capital gains from the sale of $77,000 of Vanguard Total Stock Market Index mutual fund shares. Recall that the average cost basis of the account is $500,000, representing one-third of the current market value. I assume that the average cost basis method is used to calculate realized capital gains, which will result in a long term capital gain of ~$51,000 in 2024.

The standard deduction for married couples in 2023 is $27,700 and will increase in 2024 based on the rate of inflation this year. The standard deduction will more than fully offset the ~$25,000 of ordinary income from the TIPS portfolio and the small amount of non-qualified dividend income. This will leave the couple with ~$74,000 of combined qualified dividend income and long term capital gains, well below the $89,250 threshold for the 0% tax rate on such income. As a result, it appears that Brenda and Eddie will not owe any federal income tax in 2024. Assuming that tax laws remain unchanged, which is not a certainty, Brenda and Eddie are unlikely to pay any material amount of income taxes during the first fifteen years of their retirement.

But wait, there’s more good news!

Brenda and Eddie used to get health insurance coverage from their jobs, but this ended when they retired. Although many employers allow workers to continue workplace coverage for a period of time at their own expense, Brenda and Eddie are aware of the subsidies available under the Affordable Care Act.

To get an idea of the plans available to Brenda and Eddie, I ran a search on the healthcare.gov website using the Austin zip code of 78704. This will not exactly match the financial situation or plan choices in 2024, but it serves as a good proxy.

The ACA guarantees that Americans can sign up for healthcare plans without medical underwriting, that is, without consideration for any pre-existing conditions. The only questions that must be answered to produce a quote are the ages of the individuals seeking coverage, their smoking status, and their zip code.

Subsidies are determined based on adjusted gross income (AGI). In Brenda and Eddie’s case, all of their income sources count toward AGI. Based on the analysis above, they expect $99,000 of AGI. This entitles the couple to a subsidy of $923 per month toward a health insurance plan of their choice.

My search produced 126 plans ranging in price from $1,120 to $2,655 per month. These plans vary in quality in terms of level of coverage and deductibles. However, the $923 monthly subsidy can cover a large percentage of the vast majority of ACA plans. As a result, Brenda and Eddie’s health insurance expenses should be quite low.

Several of the plans qualify for an annual health savings account (HSA) contribution. In Brenda and Eddie’s case, they would be able to contribute up to $10,300 toward a HSA in 2024. HSA contributions are deducted from both AGI and taxable income. Funds within HSAs grow tax free and withdrawals can be made tax free for qualifying medical expenses, with unspent funds carrying over from year to year.

Is it right that multi-millionaire early retirees like Brenda and Eddie can qualify for very large subsidies under the Affordable Care Act? This is a political question. Obviously, Brenda and Eddie could decline to accept ACA subsidies, but I do not consider it morally wrong to maximize benefits available in the tax code.

Is it possible to project how Brenda and Eddie’s financial situation will develop for Phase I of their retirement? With the important caveat that investment returns will vary considerably from year to year, we can make a rough estimate of the depletion of their taxable funds and the growth of their traditional IRA from 2024 to 2033.

In the exhibit below and throughout this article, all figures are presented in real terms using 2024 dollars. My assumption is that the Vanguard Total Stock Index fund will produce a real return of 4% and that the TIPS portfolio will produce a real return of 0%. I am presenting these figures in real terms because the rate of inflation over the next decade is impossible to predict. Selecting 4% as the real return on stocks is meant to be conservative. From May 1993 to May 2023, the real return on the S&P 500 was 5.1% without including dividends and 7.1% assuming reinvestment of dividends.

Looking at each line of the exhibit, we can see that the real value of the taxable stock portfolio declines as withdrawals are made. For example, the taxable stock portfolio’s projected value for 2025 is calculated by taking the initial value of $1,500,000, subtracting the $100,000 drawdown for 2024, and assuming a 4% real return:

2025 Value = (2024 Value - 2024 Drawdown) * 1.04
2025 Value = (1,500,000 - 100,000) * 1.04 
2025 Value = $1,456,000

The same formula is used for the subsequent nine years of the exhibit. The reason the real value of the taxable portfolio is declining is because the assumed real return is not sufficient to fully offset the rate of withdrawals.

The TIPS portfolio just holds its value in real terms, so why maintain it? As I alluded to earlier in this article and in my previous articles on bond ladders, the presence of the TIPS portfolio is to act as ballast for the couple’s finances during times when stocks are in a bear market. In reality, returns on stocks will not occur in the steady manner shown in the exhibit. Stock returns are volatile. Knowing that the TIPS portfolio is available to tap into for an extended period of time without a fire sale of stocks should provide a psychological benefit as well as a potential financial benefit.

Turning our attention to the last column of the exhibit, we can see that the couple’s total assets in real terms is holding up quite well because the IRA is being left to compound undisturbed for the entire period. The return assumption for the IRA is also a 4% real return since it is invested identically to the taxable stock portfolio.

Assuming that the tax code is not materially changed over the ten year horizon, Brenda and Eddie appear to be on course to enjoy their first decade of retirement drawing a substantial income with minimal income tax liabilities and their health care costs should be well contained assuming that ACA subsidies are not reduced. Better yet, their real net worth should hold fairly steady over this period as well, providing safety and flexibility as they enter the next phase of their journey.

Phase II: 2034 to 2038

Note: All dollar figures in this article are expressed in 2024 dollars.

Starting in 2034, Brenda and Eddie will qualify for enrollment in Medicare, so they will no longer purchase health insurance on the ACA exchange. As we discussed in Phase I, generous ACA subsidies should be available based on projected adjusted gross income during the first ten years of retirement. However, without subsidies, ACA plans can be expensive. At age 55, the cost of an unsubsidized plan for the couple ranges from $1,120 to $2,655 per month and this cost increases with age.

Medicare Part B requires a monthly premium of $164.90 in 2023, with higher premiums for individuals with modified adjusted gross income (MAGI) of over $94,000. Married couples filing jointly begin to incur higher premiums with MAGI over $197,000, so it is important to avoid income spikes in any single year that could result in higher premiums. Those who enroll in traditional Medicare often choose to purchase a “Medigap” plan which helps pay for out-of-pocket costs not covered by insurance. Alternatively, some beneficiaries opt to enroll in a Medicare Advantage “managed care” plan offered by private companies.

A full discussion of the pros and cons of the options available in Medicare enrollment is beyond the scope of this article, but the transition from a subsidized ACA plan to Medicare is likely to be relatively neutral in terms of overall costs.

In terms of drawdown strategy, nothing will change in Phase II. The couple will continue to draw down $100,000 per year from their taxable portfolio since they will opt to defer starting social security and will not draw funds from the traditional IRA.

However, now that social security benefits are on the horizon, it is important to plan for how the composition of the couple’s income will change starting in Phase III. The couple’s social security benefit is likely to be around $36,000. Starting in 2039, they will no longer need to draw down $100,000 from their taxable investment account. Instead, they will only need to draw down $64,000.

As a result, the TIPS ladder can become smaller. Each year during Phase II, Brenda and Eddie will consume the maturing $100,000 TIPS, but they will only invest $64,000 in a new five year TIPS. Over the five years of Phase II, $64,000 will be invested in TIPS maturing in 2039, 2040, 2041, 2042, and 2043. This reduces the amount of stock that the couple must liquidate from their taxable portfolio, thereby resulting in lower realized long-term capital gains. In addition, the smaller TIPS portfolio will produce less taxable income during Phase II.

The following exhibit shows the projected portfolio during Phase II. The assumption of a 4% real return on stocks and a 0% real return on TIPS remains unchanged.

Despite only liquidating $64,000 from the taxable stock portfolio every year rather than the $100,000 liquidation that was required in Phase I, the real value of the portfolio continues to decline. However, the traditional IRA’s value continues to increase since it has been left untapped. Overall, total financial assets remain relatively constant in real terms.

As we reach the end of the first fifteen years of Brenda and Eddie’s retirement, we can see that the taxable stock portfolio’s real value has declined from $1.5 million in 2024 dollars to just over $850,000. The taxable stock portfolio has borne the burden of supporting the couple’s retirement for a decade and a half, but their income situation will change significantly over the next decade, as we will see in the next two phases.

Phase III: 2039 to 2043

Note: All dollar figures in this article are expressed in 2024 dollars.

As Brenda and Eddie blow out the candles on their seventieth birthday cakes, they will celebrate finally being on the receiving end of social security when they start taking benefits. By waiting until seventy, they will enjoy maximum social security benefits, indexed for inflation, for life.5

The couple’s $36,000 social security benefit is not sufficient to fund their desired $100,000 of spending, so they will require funds from their taxable portfolio. Due to their good planning during Phase II, a TIPS will mature every year during Phase III which will provide the necessary $64,000 of cash to supplement social security.

Since Brenda and Eddie are forward looking, they realize that in five years they will have to start taking required minimum distributions (RMDs) from their traditional IRA at the age of 75. Given the large size of the IRA and the formula for RMDs (which will be discussed in more detail in Phase IV), it appears that the combination of the RMD and social security will more than cover the couple’s cash flow needs starting at age 75, meaning that no further funds will be required from the taxable portfolio.

Up to this point, the couple has regularly liquidated stock in their taxable portfolio to purchase a new five year TIPS every year. However, starting in 2039, this will no longer be necessary since RMDs and social security will cover their spending starting in 2044 when they turn 75. As a result, the taxable TIPS portfolio will be allowed to “run off” and no new TIPS will be purchased. This means that no stock will be liquidated in the taxable portfolio and no long term capital gains will be realized.

Although it is likely that part of the couple’s social security income will be taxable, the fact that the TIPS portfolio will be in “run off” mode means that it will produce less taxable income every year and there will be no capital gains since no stock will be sold in the taxable portfolio. As a result, income tax liability should be fairly minimal during Phase III. The couple may choose to realize tax-free capital gains every year and immediately repurchase stocks which will result in a higher cost basis and a lower future income tax burden. However, doing so is entirely optional.

The following exhibit shows the projected portfolio during Phase III. The assumption of a 4% real return on stocks and a 0% real return on TIPS remains unchanged.

We can see that the TIPS portfolio is dwindling down while the lack of liquidations from the taxable stock portfolio means that its real value is now on the upswing. Meanwhile, the traditional IRA continues to grow unimpeded by any withdrawals. Total financial assets are also on the upswing. The couple’s finances are in solid shape at they near age seventy-five and the start of Phase IV.

Phase IV: 2044 to ???

Note: All dollar figures in this article are expressed in 2024 dollars.

At age seventy-five, the days of tax-deferred compounding in the couple’s traditional IRA are drawing to a close. Uncle Sam now wants his share of Brenda and Eddie’s IRA, although he is considerate enough to spread the tax burden over the rest of the couple’s lifetime rather than asking for his take all at once.

Every year starting in 2044, Brenda and Eddie will calculate their RMD based on the value of the traditional IRA on January 1 divided by a life expectancy factor. For example, at age 75, the life expectancy factor is 24.6. This factor declines every year as the couple gets older in recognition of the assumption that they have fewer years left.

As the life expectancy factor declines, the RMD will increase assuming that the account size remains relatively constant with investment returns more or less covering the RMD during the initial years of withdrawals.

Our projection is that the value of the traditional IRA will be approximately $2.2 million on January 1, 2044 resulting in a RMD of approximately $89,000. Combined with social security of $36,000, the couple’s pre-tax income will be approximately $125,000. Unfortunately, the days of paying little or no income tax are now over. The entire IRA distribution is taxable along with most of the social security benefit. Although the couple’s income has increased to $125,000, it is likely that they will not see much of an after-tax increase in spending power due to taxes on the RMD.

The following exhibit shows the projected portfolio during Phase IV. The assumption of a 4% real return on stocks and a 0% real return on TIPS remains unchanged.

I chose to cut off this exhibit at age 85, but the same basic drawdown strategy will continue for the rest of the couple’s lives. I have applied the life expectancy factor for each year based on the couple’s age and the projected balance of the IRA. Over time, the RMD will increase due to declining life expectancy.

We can see that the couple remains in good shape in terms of total income, even after considering likely taxes due on the IRA distributions, although we cannot precisely guess what tax rates will look like in the 2040s. Since the taxable stock portfolio is no longer needed for the couple’s cash flow, its real value starts to increase nicely and total financial assets begin a slow upswing.6

Old Age Contingencies

As the couple reaches their mid-eighties, hopefully they will remain in good health. However, the reality is that eventually old age will impose limitations on their activities and potentially require assistance in tasks of everyday living. This reality is one reason for conservatism earlier in retirement. Due to Brenda and Eddie’s good planning, the real value of their financial assets has remained intact and even increased to a small extent during their first three decades of retirement.

It is common to read criticisms of financial plans that result in a large net worth late in life. After all, shouldn’t people enjoy their wealth while they are young rather than hoarding it for extreme old age or to leave to their heirs?

This is not an invalid question, but the premise is that Brenda and Eddie have deprived themselves of something important in order to remain multi-millionaires in their old age. Recall that the couple never spent more than $50,000 per year prior to retirement and they doubled their consumption to $100,000 per year when they retired. I doubt that they felt deprived of anything, but they certainly could have afforded to spend even more if they really wanted to or if unfortunate events compelled them to.

Although everyone has different priorities, my view is that most people would prefer to remain in their homes and avoid institutional settings. In-home nursing care is extremely expensive, especially if needed on a 24/7/365 basis. It is not unusual for such care to cost $30/hour or more in major urban areas. If serious debility requires constant care, the bill can add up to a quarter million dollars per year. A person requiring that level of care is also likely to have other large medical bills that must be paid for out of pocket. Long-term care insurance is a possibility not explored in this article that could potentially mitigate the need to pay for some costs out-of-pocket.

There are other complexities not discussed in this article and many simplifying assumptions that have been made. In particular, both Brenda and Eddie are the same age and I have not explored strategies related to spousal social security benefits or survivor benefits due to the second to die. As I mentioned at the outset, retirement is a complex topic and individual situations vary widely.

Conclusion

The point of our fictional story is to present a simple scenario that reveals some of the opportunities available to early retirees and key pitfalls to avoid. Obviously, most people in their mid-fifties do not have a $3.5 million net worth and the early retirement plan presented in this article might appear wildly unrealistic. However, I do not believe that it is unrealistic for a couple to accumulate such a net worth provided that they have a decent income and live far below their means, saving a great deal of money and investing it well for many decades.

Several years ago, I wrote Fifteen Years to Financial Independence about a twenty-five year old married couple with a goal of retiring at forty. If that couple continued to work and save for another decade, they would have been in a position similar to Brenda and Eddie in this article. The reality is that few people will elect to make these choices, but that does not make early retirement impossible even if it is uncommon.

To bring our story to a close, if Brenda and Eddie live to be a hundred years old, they should have an estate worth in the neighborhood of $4 million in 2024 dollars based on a continuation of the scenario in Phase IV. Although estate tax law can change, it is highly unlikely that their estate will be subject to tax.7 The value of their stock portfolio will also receive a “step-up” in cost basis, leaving their heirs with a substantial inheritance, something that Brenda and Eddie are happy to provide for their children and grandchildren.

The End

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It is difficult to predict macroeconomic variables such as GDP, wages, productivity, and inflation. Many investors try to do this and routinely fail. Warren Buffett’s advice to Americans is to simply dollar cost average into a broad-based equity index fund during their working years and ignore macroeconomic predictions altogether.

If this is the case, why did I write an article like Death, Taxes, and Inflation last week? The premise of the article is that inflation has become inevitable, on par with death and taxes as certainties in life. I was not attempting to predict the precise level of inflation in the future. Instead, I argued that our experience over many decades suggests that investors cannot ignore the effects of inflation in the years to come.

I followed up with Warren Buffett's Advice on Stocks vs. Bonds and it probably did not surprise most readers to learn that Mr. Buffett has strongly favored investing in stocks over the years. The call he made on the superiority of stocks in 2010 was particularly prescient but is in keeping with his longstanding beliefs. Actions speak louder than words. If Berkshire Hathaway’s small fixed-maturity portfolio is any indication, Mr. Buffett still strongly prefers investments in stocks over bonds.

If stocks provide higher returns than bonds over long periods of time, why own any bonds at all? This is a valid question for a twenty-five year old just starting out, but there are good reasons for most investors to maintain an allocation to bonds.

A bond allocation can soften the volatility of a portfolio and help investors stay in the game for long periods of time rather than reacting in panic during a bear market. I’ve compared bonds to a financial flu shot that can protect against investor panic and I still think this is a valid reason to hold bonds. This is particularly true for investors who rely on their portfolio to cover living expenses. It is hard to stay rational if next month’s mortgage payment depends on selling stocks at a good price this month.

If one accepts the premise that some allocation to bonds is useful for most investors, then the question becomes how to achieve positive inflation-adjusted returns or, at a minimum, to not lose purchasing power over time. During the long years of extremely low interest rates, it was extremely difficult to avoid losing purchasing power in real terms while insisting on safety of principal. However, the situation has changed and there are now reasonable options for investors to consider.

There are many choices for bond investors including treasury securities, municipal bonds, investment grade corporate bonds, high-yield non-investment grade bonds, as well as more esoteric options including bonds denominated in foreign currencies. For purposes of this article, I have focused on treasury securities because they have no credit risk and interest is exempt from state income tax.1 However, interest rate risk, duration risk, and inflation risk remain critical issues when investing in treasury securities, as I described in The Risks of Investing in Bonds earlier this year.

This article describes two options for reducing inflation risk when investing in bonds: I Series United States Savings Bonds (I Bonds) and Treasury Inflation Protected Securities (TIPS). There are no firm rules that dictate whether I Bonds or TIPS are superior at all times. However, we can examine the features of these securities and establish a framework for assessing the relative attractiveness of I Bonds vs. TIPS. I will apply this framework based on conditions in June 2023.

Inflation Expectations

The United States Treasury issues securities that are not inflation protected as well as inflation protected securities (TIPS).  Regular treasuries pay interest in nominal terms while TIPS pay a real rate and principal is adjusted based on actual inflation. Buyers of TIPS are locking in a real return while those who buy regular treasuries are locking in a nominal return and are accepting the risk of inflation eroding principal. 

Before we delve into the intricacies of I Bonds and TIPS, let’s take a brief look at how inflation expectations have evolved in recent years. The following chart displays the ten year breakeven inflation rate which the St. Louis Fed calculates as the difference between the regular ten year treasury note and the ten year TIPS.2

As of June 6, 2023, the ten year breakeven inflation rate stood at 2.2% which is slightly above the Fed’s 2% inflation target. However, we can see that inflation expectations vary significantly over time. During periods of soft economic conditions, inflation expectations tend to decrease precipitously, as we can see in the shaded areas of the graph corresponding to the financial crisis and the pandemic.

We are not restricted to observing inflation expectations for the ten year breakeven since it is possible to compare the yield of regular treasuries and TIPS across the yield curve. The first table below shows the yields available on regular treasury securities and the second table shows the yields available for TIPS in early June 2023:

Regular Treasury Securities:

Treasury Inflation Protected Securities:

Although TIPS can be purchased on the secondary market for shorter maturities, they are only offered at auction for terms of five years and longer. In contrast, regular treasury securities are auctioned for terms as short as one month. From the tables above, we can observe the following embedded inflation expectations as of June 6:

• 5 Years: 3.85% - 1.71% = 2.14%

• 7 Years: 3.78% - 1.59% = 2.19%

• 10 Years: 3.7% - 1.5% = 2.2%

• 20 Years: 4.02% - 1.55% = 2.47%

• 30 Years: 3.87% - 1.64% = 2.23%

We should keep in mind that the Federal Reserve’s stated inflation target is 2%.

For many reasons, discussed in more detail in Death, Taxes, and Inflation, I view 2% as the minimum level of inflation that one can expect over the long run. The market is pricing in somewhat higher inflation, perhaps recognizing that the Fed is not likely to follow a period of high inflation by temporarily lowering their target below 2%.

Despite recent high levels of inflation, the market is not pricing in a large long term failure of the Fed’s stated 2% policy objective. We can see evidence of this by observing that the yield curve is currently “inverted” — that is, short term treasuries are offering higher yields than longer term treasuries. The market is acknowledging that inflation is high in the short run but expects a quick reversion to the 2% target.

The market is buying into the Fed’s narrative that we should experience a period of disinflation in the years to come. Market observers often confuse the term disinflation with deflation. Disinflation refers to a period of a declining, but still positive, rate of inflation. Deflation refers to a period of declining prices. The market expects prices to rise in the future, just at a lower rate than over the past couple of years. The market does not expect there to be a decline in the price level.

At a basic level, investors who expect inflation to be higher than the breakeven levels listed above should favor inflation protected securities over regular treasuries. Investors who believe that the economy will experience inflation lower than breakeven levels should favor regular treasury securities.

If we believe the Fed is serious about generating inflation of at least 2%, it makes sense to favor inflation protected securities to hedge against inflation overshooting the target, as we have seen over the past two years. For example, if inflation averages 4% over the next five years, investors in the five year TIPS should expect an annual return of approximately 5.71% compared to 3.85% in the regular five year treasury note.

Let’s now turn our attention to a more detailed examination of I Bonds and TIPS to determine which option makes the most sense in today’s environment.

Series I Savings Bonds

The United States Treasury introduced I Bonds in 1998 to allow small investors to have access to a relatively simple savings vehicle that promises protection from inflation. Prior to 1998, the Treasury issued several types of savings bonds that did not include explicit inflation protection. In addition to Series I savings bonds, Treasury offers Series EE savings bonds which are not inflation indexed and are not described in this article. I covered Series EE bonds in an article published in December 2020.

Investors must purchase I Bonds electronically from the Treasury via the Treasury Direct website. I Bonds can be purchased in any amount over $25. However, there is a purchase limit of $10,000 per social security number per calendar year. In addition, it is possible to direct up to $5,000 from a tax refund toward I Bonds in paper form. While the calendar year purchase limit is a significant constraint, it can be effectively doubled for a couple and it is possible to purchase bonds as gifts as well.

I Bonds do not make periodic interest payments. Instead, interest accrues on a monthly basis. Every six months, the principal value of the bond is updated by adding the interest earned on the bond during the prior six months. Thereafter, the interest rate on the bond is applied to the new principal value which results in semi-annual compounding. I Bonds do not generate recurring cash flow for investors. To generate cash flow from an I Bond, investors must redeem all or part of the bond.

I Bonds are not marketable securities and cannot be resold to other investors. The bonds cannot be cashed in at all for the first year. Bonds cashed in prior to five years are assessed a penalty of the last three months of interest. I Bonds continue earning interest for up to thirty years. With occasional exceptions, it is best to think of I Bonds as an investment intended to be held for between five and thirty years.3

When an investor purchases an I Bond, it comes with a fixed real interest rate that is held constant for the life of the bond. In addition, there is an inflation adjustment based on the consumer price index for urban consumers, known as the CPI-U. The inflation adjustment resets every six months over the life of the bond.

The fixed rate for newly issued I Bonds varies over time and is reset on May 1 and November 1 of every year. The fixed rate for I Bonds issued between May 2023 and October 2023 is 0.9%. At times, the fixed rate has been 0% but it has never fallen into negative territory. The following exhibit shows how I Bond fixed rates have changed over the past quarter century:

The following exhibit from Treasury Direct shows how the current composite rate for newly issued I Bonds has been calculated. The current inflation adjustment is added to the 0.9% fixed rate and brings the total composite rate for I Bonds to 4.3%. The inflation adjustment will be reset every six months over the life of the bond based on changes in CPI-U but the fixed rate will never change.

What if the economy experiences a period of deflation? Deflation can offset the fixed rate, but the composite rate can never fall below 0%. In other words, if deflation more than fully offsets the fixed rate, the bond’s value will still never decline. This means that I Bonds provide an important hedge against the unlikely prospect of deflation.

Like other treasury securities, I Bonds are exempt from state and local income taxes. Savings bonds can be exempt from federal income taxes as well if used for higher education, subject to income limitations. However, most investors can expect to pay federal income taxes on both the interest and inflation adjustment for I Bonds at the time they are cashed in. Not only does tax deferral simplify annual taxes but it allows the magic of compounding to work in the investor’s favor on a tax deferred basis.

It is not possible to own I Bonds within an individual retirement account. However, it would be undesirable to do so even it was possible because I Bonds already benefit from tax deferral. For example, I purchased I Bonds in October 2001 with a fixed rate of 3% plus the inflation adjustment. I have never paid income taxes on the accrued interest and inflation adjustments for these bonds and will not have to do so until they mature in 2031. Holding these bonds within an IRA would have been redundant.

Investors should purchase I Bonds at the end of a calendar month because interest is credited for the entire month in which a bond is issued, even if it is purchased on the last day of a month. For the same reason, investors should cash in I Bonds toward the beginning of a calendar month to capture interest for the entire month.

The fact that I Bonds are not marketable securities means that they have no interest rate risk. If you purchase an I Bond with a fixed rate of 0.9% today and the fixed rate goes up to 1.9% a year from now, it will be possible to cash in your I Bond for what you paid for it plus accrued interest and inflation adjustments. However, the flip side is that investors cannot benefit from a decline in interest rates. If the fixed rate for new I Bonds falls to 0% a year from now, you cannot sell your I Bond at a premium.

I Bonds offer optionality. You must hold the bond for at least a year but are free to cash it in at any time thereafter, subject to the three month interest penalty if cashed in prior to five years. If new I Bonds offer a higher fixed rate in the future, you are free to cash in your I Bond and invest in a new one, although you will have to pay federal income taxes to do so and will be subject to the $10,000 calendar year purchase limit.

For small investors, I Bonds serve an important purpose by eliminating both credit and interest rate risk. While I Bonds do provide inflation adjustments, I will not go so far as to say they completely eliminate inflation risk since the adjustment is based on the CPI-U index which is constantly revised by the Bureau of Labor Statistics with changes that have tended to lower the reported level of inflation over time.

With these caveats in mind, I have owned I Bonds for decades as part of my bond portfolio. The I Bonds that I purchased in October 2001 with a fixed rate of 3% have compounded at an average annual rate of 5.6% on a tax deferred basis. This trails the returns provided by stocks but came with no market risk and was always available as an emergency fund if needed at any time. I found it easier to cope with market meltdowns in 2009 and 2020 knowing that I held I Bonds as ballast for my portfolio.

Treasury Inflation Protected Securities (TIPS)

The United States Treasury introduced TIPS in January 1997 in response to investor demand for a treasury security with inflation protection. Like regular treasury bills, notes, and bonds, TIPS are marketable securities that are initially sold at auction and then trade on secondary markets which generally offer ample liquidity.

Individual investors can purchase TIPS at auction via Treasury Direct or through brokers such as Fidelity and Vanguard without paying commissions. TIPS held at Treasury Direct cannot be sold unless they are first transferred to a broker, so investors who might sell their bonds prior to maturity should consider buying them through a commission-free broker.

TIPS are offered at auction for five, ten, and thirty year terms but may be purchased in the secondary market if an investor desires a maturity that is not offered at auction. Individual investors may purchase TIPS at auction in $100 increments. While there is a $10 million limit per auction for the non-competitive bids made by individual investors, there is no limit to the total amount of TIPS an investor may accumulate.

In addition to periodic coupon payments, the TIPS principal is adjusted based on the same CPI-U inflation index that is used to adjust the principal of I Bonds. During periods of inflation, the principal value of TIPS will increase. During periods of deflation, the principal value will decrease. However, when TIPS mature, investors will always receive the original principal back at par value even if sustained deflation has pushed the adjusted principal value below the original principal value.4

The inflation adjustment process is considerably more complex for TIPS than for I Bonds. The Treasury publishes detailed CPI Data that allows a bondholder to figure out adjusted principal value on a daily basis. Semi-annual interest payments are made based on the adjusted principal value for TIPS on the day of the interest payment.

To illustrate how the mechanics of auctions, inflation adjustments, interest payments, and price fluctuations work, I will use the example of the five year TIPS maturing on April 15, 2028 which was auctioned on April 20, 2023. I participated in this auction by bidding for $50,000 of bonds at par value and will use my purchase for this example.

The Treasury released the following auction results on April 20:

The coupon rate for the bond was set at 1.25%, but the bonds were sold at 99.904611 which means that I paid $49,952.31 rather than $50,000 and the effective yield was 1.32%. This can be regarded as the real yield on the bond.5

On the original date of issue, the bond will have an “index ratio” of 1.0 and this index ratio will be adjusted upward and downward on a daily basis based on the CPI-U index. For example, on June 6, 2023, the index ratio stands at 1.00714 representing the inflation adjustment from April 15 to June 6. Every month, the treasury will release an updated set of index ratios for all TIPS that have yet to mature.

The first semi-annual interest payment on my bond will occur on October 15, 2023. At this point, we do not know what the index ratio will be on that date, but let’s hypothetically assume that it is 1.025 on that date, representing semi-annual inflation of 2.5%. If this is the case, my first interest payment will be calculated as follows:

Par Value of Bond x Index Ratio = Adjusted Principal
50,000 x 1.025 = $51,250

Adj.Principal x (Interest Rate/2) = Interest Payment
$51,250 x (0.0125/2) = $320.31

The index ratio will continue to reflect changes in the CPI-U index until the bond matures on April 15, 2028 at which time I will receive the adjusted principal value. For example, assume we experience 5% annual inflation over the term of this bond. If that is the case, the index ratio will be approximately 1.276 when the bond matures and the adjusted principal will be $50,000 x 1.276 = $63,800. The final semi-annual interest payment will be $63,800 x (0.0125/2), or $398.75.

As we can see from this example, inflation has the effect of increasing the principal value of the security in addition to increasing the semi-annual interest that is received by the investor. The interest payment can be regarded as the real interest paid on adjusted principal. In other words, the investor can theoretically spend that interest payment without suffering a decline in the purchasing power of the principal.

The complexity of TIPS increases when one considers the role of income taxes. While it is not surprising to learn that semi-annual interest payments are taxable at the federal level, many investors are surprised to learn that adjustments to the principal of TIPS due to inflation are also taxable on an annual basis. This is true even though the investor does not receive the inflation adjustment until the bond matures. Investors sometimes refer to TIPS inflation adjustments as “phantom income” because although it keeps accruing constantly, it is not received until maturity.

Using the same five year TIPS as an example, let’s say that inflation runs at 5% on an annualized basis in 2023 and the index value for my bond is at 1.04 at the end of the year to account for 9.5 months of inflation. In addition to paying income tax on the $320 interest payment received in October 2023, I would also have to pay income tax on the increase in adjusted principal of approximately $2,000.

The need to pay income taxes on “phantom income” is a serious issue that gets worse during periods of high inflation. For this reason, many investors choose to own TIPS within traditional or Roth IRAs. In the case of traditional IRAs, income tax is not due until withdrawals are taken from the account and Roth IRAs are not subject to income taxes upon withdrawal. I personally use TIPS as part of a five year bond ladder, as I described in an article published earlier this year. Unfortunately, this is in a taxable account so I have to deal with the unpleasant reality of taxes on phantom income.

TIPS are securities that I believe are best held to maturity because this guarantees that the investor will receive the adjusted principal as scheduled. However, the fact that TIPS are marketable securities provides the option of selling the bond prior to maturity. While this optionality is valuable, investors must realize that the price of TIPS will vary based on fluctuations in the real interest rate.

To illustrate this point, recall that an earlier exhibit showed that the current real interest rate on five year TIPS is 1.71% which is considerably higher than the 1.25% interest rate on the five year TIPS I purchased less than two months ago. This means that if I sell my five year TIPS in the secondary market today, I can expect to receive less than par value. According to Vanguard, the price I would receive if I sold today is 98.22842 which means that I would realize about $49,114 resulting in a capital loss since my original purchase price was $49,952. On the flip side, if real interest rates decline, I would be able to sell my bond at a premium and realize a capital gain.

My use of TIPS is restricted to the five year maturity since the purpose is to build a five year bond ladder. It is possible to invest in longer term TIPS with maturities extending out to thirty years. Fluctuations in real interest rates will have a greater impact on the price quotations of longer term TIPS compared to shorter term TIPS. This is the law of financial gravity that impacts all fixed-maturity securities which I discussed in more detail in The Risks of Investing in Bonds.

Comparing I Bonds and TIPS in June 2023

How should investors think about the relative attractiveness of I Bonds and TIPS based on conditions that prevail in June 2023?

Investors who purchase I Bonds today will receive a real rate of 0.9%. TIPS investors can lock in a real rate of between 1.5% and 1.7% depending on the duration of the bond. Although the mechanics differ, both I Bonds and TIPS receive inflation adjustments based on the CPI-U index.

While these rates might seem modest, we should recognize that both I Bonds and TIPS offer positive real returns. This is not always the case. I Bonds offered a 0% real rate as recently as 2022 and the real rate on five year TIPS was in negative territory from March 2020 to June 2022. In comparison to conditions that prevailed earlier this decade, investors at least have opportunity for modest positive real returns.

Small investors who would like to minimize complexity and defer taxes outside of a retirement account might want to opt for I Bonds over TIPS despite the lower real rate. I Bonds are a “set it and forget it” type of security. Once purchased via Treasury Direct, you can just forget about them for up to thirty years. There is no record keeping or annual tax consequences to deal with and there is no need to worry about price fluctuations. I Bonds can be part of an emergency fund after the minimum one year holding period is met since they can be liquidated at any time.

For small investors with access to a tax deferred retirement account, TIPS can be relatively simple to deal with since there are no annual taxes due. For those who are very likely to hold the TIPS to maturity, price fluctuations are also a non-issue. It makes sense for small investors to own TIPS within a retirement account to take advantage of the higher real rate.

Larger investors who need to commit funds in excess of the $10,000 annual limit on I Bonds will have to deal with the complexities of TIPS if held in taxable accounts. Many investors might choose to put the maximum amount allowed into I Bonds and then invest the balance in TIPS. This is the approach that I have used in the past for my five year bond ladder. However, I currently favor TIPS over I Bonds due to the higher rate and the fact that I’m used to dealing with the tax complexities of TIPS.

Conclusion

Many investors will argue that the entire premise of this article misses the point if the goal is to preserve wealth in real terms because history shows that a broad based equity index fund does that job very well.

I would not disagree with this argument except to point out that the majority of investors are temperamentally unable to tolerate the volatility of a 100% stock portfolio. For those who rely on their investments for cash flow to cover personal expenses, it is too traumatic to depend on selling equities every month or quarter.

By constructing a five year bond ladder, investors can view the volatility of their stock portfolio with equanimity, knowing that they are not going to be forced sellers in the near term. The only action investors need to take is to periodically reallocate a portion of their stock investments to replenish their bond ladder, and this need not occur during the depths of an equity bear market.

To the extent that owning bonds makes sense, I do not like the idea of taking credit risk or much interest rate risk, and to the extent possible I would like to take inflation off the table as a cause for worry. Under current conditions, both I Bonds and TIPS seem to fit these requirements quite well. These securities will not make anyone rich, but they might provide the ballast required to be more venturesome in the equity portion of the portfolio which does have the potential to build wealth over time.

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Copyright, Disclosures, and Privacy Information

Nothing in this article constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC.  

Your privacy is taken very seriously. No email addresses or any other subscriber information is ever sold or provided to third parties. If you choose to unsubscribe at any time, you will no longer receive any further communications of any kind.

The Rational Walk is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.

— Warren Buffett, October 5, 2010

From our perspective in mid-2023, Warren Buffett’s advice in late 2010 seems obvious, but it was not self-evident at the time. The United States had recently emerged from a financial crisis and it took years for investors to regain confidence. In retrospect, most of the fluctuations that seemed meaningful to us on a day-to-day basis have receded into mere noise when we zoom out and look at markets over a period of many years.

With the benefit of hindsight, Mr. Buffett’s observations nearly thirteen years ago were exactly on target. From October 2010 to May 2023, the S&P 500 posted an annualized return of 10.7%. Those who reinvested dividends would have achieved a 12.7% annualized return over that timeframe. Berkshire Hathaway Class A shares have compounded at an annualized rate of 11.8% since October 4, 2010.

Stocks have done very well indeed, just as Mr. Buffett predicted. How does this compare to the experience of bond investors over the same timeframe?

When I listen to Mr. Buffett comment on bonds, I usually think of treasury securities because Berkshire Hathaway tends to concentrate its fixed maturity investments in treasuries rather than accept credit risk. The occasional drama over the debt ceiling notwithstanding, treasury securities are considered very safe when it comes to credit risk. This lack of credit risk usually comes at the cost of relatively low returns.

On October 5, 2010, the following yields were available on treasury securities:

Although no one knew it at the time, treasuries were at the beginning of a very long period of extremely low returns. In 2010, the Federal Reserve did not yet have an explicit inflation target, but Chairman Ben Bernanke would soon announce a 2% target. Investing at the short end of the yield curve was a near guarantee of loss of purchasing power of time. A yield in excess of inflation expectations at the time could be obtained in treasuries, but only by purchasing a maturity of ten years or more which involves taking considerable duration risk.

In 2010, fixed income investors might have waited on the sidelines in short term treasury bills expecting that long term treasuries would eventually provide more attractive yields as the economy recovered. While the ten year treasury did offer better yields occasionally, the story of the past thirteen years has been one of consistently low long term yields, as we can see from the chart of the ten year treasury note:

According to the inflation calculator provided by the Bureau of Labor Statistics, the consumer price index compounded at approximately 2.7% from October 2010 to April 2023. Investors in the S&P 500 or Berkshire Hathaway have compounded their wealth far in excess of inflation while an investor in longer term treasury securities would have been lucky to achieve any real return after inflation and taxes.

What if a skittish investor worried about the risk of investing in stocks but found the yields offered on ordinary treasuries unappealing because of the risk of inflation?

Since 1997, the United States Treasury has offered Treasury Inflation Protected Securities (TIPS) which are meant to provide investors with a real return adjusted for inflation. Just as we have a yield curve for regular treasury securities, we also have a yield curve for TIPS. This is what TIPS yields looked like on October 5, 2010:

Unlike regular treasury securities, TIPS are only offered as longer term securities at auction, although one can purchase TIPS on the secondary market for shorter maturities. For purposes of this discussion, I have displayed TIPS yields for five to thirty year maturities in the chart above. Note that the yields are expressed in real terms. In addition to the real yield, investors receive an adjustment for inflation.

At the time, the yield curve was upward sloping for TIPS, with the five year offering a real yield of negative 0.19% and the thirty year security offering a real yield of 1.54%.

It is interesting to note the difference between the yield on the regular ten year treasury of 2.5% and the yield on the ten year TIPS of 0.65% which implies that the market expected the inflation rate to be approximately 1.85% over the ten year period. This means that the choice of investing in the regular ten year treasury or the ten year TIPS would depend on the investor’s expectation of inflation. The investor who expected inflation higher than 1.85% would opt for the TIPS over the regular treasury.

Just as the interest rate for regular treasury securities fluctuates over time, TIPS real yields also fluctuate. The following chart shows how the real yield on the ten year TIPS has varied over the past thirteen years:

We should note that the real yield on longer term TIPS can become negative, as we can see from the exhibit above. This happened early in the thirteen year period and, in a more extreme way, during the period following the pandemic. As of mid-2023, real yields on TIPS are back in positive territory again.

The other option for risk averse small investors in October 2010 would have been to buy I Series U.S. Savings Bonds, also known as I Bonds. However, at the time, the I Bond offered a real yield of 0%, lower than the yields available on TIPS.

The bottom line is that unless an investor in October 2010 was willing to take credit risk in bonds and had a high degree of skill, it is almost certain that stocks provided far higher returns. A long-term investor who took Warren Buffett’s advice to heart would have achieved returns well in excess of inflation. In the bond world, an investor would have struggled to keep his head above water in real purchasing power terms.

This raises the question of whether it ever makes sense to invest in bonds over long periods of time, especially during periods of inflation. The answer depends on the yields offered on bonds, the likely level of inflation in the future, and the current valuation of a broad-based index of U.S. stocks.

I recently wrote an article about the role of TIPS in a fixed income portfolio, but this was in the context of a five year cash flow ladder rather than a long term investment. However, the fact is that the majority of investors will want to allocate a portion of their assets to bonds, especially those who are approaching their retirement years. A bond allocation usually provides a baseline level of perceived stability which permits many investors to view stock price fluctuations with greater equanimity, avoiding panic during the inevitable periods when stocks are declining.

For U.S. based investors who are unwilling to take credit risk, it makes sense to focus on securities backed by the United States government. Both marketable treasury securities and savings bonds have no credit risk, although all marketable securities, including regular treasuries and TIPS, have duration risk if sold prior to maturity.

Anyone investing in bonds needs to be aware of the risk of inflation, the topic of an article published yesterday. TIPS and I Bonds are both viable options that can provide limited inflation protection. In my next article, I will provide a detailed comparison of how TIPS and I Bonds work along with my opinion on how they might be used for various investment goals based on the interest rates that currently prevail.

Note to readers: This is the second article in a three-part series about inflation, TIPS, and I Bonds. The first article in the series, Death, Taxes, and Inflation, was published yesterday. Early next week, I will publish an article about investing in TIPS and I Bonds in today’s economic environment.

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Copyright, Disclosures, and Privacy Information

Nothing in this newsletter constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC.  

Your privacy is taken very seriously. No email addresses or any other subscriber information is ever sold or provided to third parties. If you choose to unsubscribe at any time, you will no longer receive any further communications of any kind.

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Dividend paying stocks can be intelligent investments, but there is no contractual right to dividends on common stocks. One can easily identify and invest in companies that have paid rising dividends over many decades. Most companies with such records will try hard to maintain the dividend, sometimes even making questionable overall capital allocation decisions to do so. Ultimately, dividend paying stocks cannot be considered a perfect, or even a close, substitute for bonds.

Investors sticking with bonds for their income needs must be aware of the risks of fixed maturity investments, a topic that I discussed in detail last month. Additional yield can usually be obtained by purchasing longer term bonds, but this comes at the cost of accepting the risk of a decline in the bond’s price if interest rates increase and the bond is sold prior to maturity. Real purchasing power can also be lost to inflation.

Bonds issued by riskier companies can offer greater returns which, unlike dividends, are backed by contractual terms. However, defaults can occur and the investor in a riskier bond could end up owning equity in a restructured company or, in more extreme cases, losing the entire investment. In my opinion, investing in such bonds requires analysis that is almost identical to evaluating the company’s common stock. The investor must understand the business and his place in the capital structure.

Several years ago, I wrote about bond ladders and compared the strategy to a “financial flu shot”. As the article explains, a bond ladder is a way of constructing a fixed income portfolio that will generate cash flow to match an investor’s needs. The article used an example of an investor who requires $40,000 of cash per year and purchased investments in that amount timed to mature over the following five years.

Why did I compare a bond ladder to a “flu shot”? The answer has to do with investor psychology. I prefer to attempt to build wealth with investments in common stocks and allocate the vast majority of my portfolio accordingly. However, common stocks are notoriously volatile. The reason I was able to stay sane during the bear markets of 2008-2009 and early 2020 is because I knew that I had absolutely no need to sell my stocks anytime soon. This was only possible because I have always maintained an allocation to ultra-safe investments in the form of cash and treasury securities. This psychological ballast is why I compare a bond ladder to an immunization.

Did I take my own advice and maintain a bond ladder after writing the article in late 2017? I intended to do so, but interest rates soon dropped back to extremely low levels. The real rate offered on five year Treasury Inflation Protected Securities went into negative territory. I could not justify moving out on the yield curve beyond six month treasury bills. After the Fed cut rates to zero at the onset of the pandemic in early 2020, I sought refuge in some higher yielding FDIC insured bank accounts.

In late 2020, I pointed out that United States Savings Bonds offered attractive yields. Over the past two years, I Bonds turned out to be a good way to obtain some protection from inflation by owning a very secure asset. However, at the time of my article, the real return on I Bonds was 0%, so the only return was the CPI adjustment. The real return was eventually increased but still stands at a modest 0.4%.

In recent months, Treasury Inflation Protected Securities (TIPS) have offered returns that compare favorably to I Bonds. Unlike I Bonds, TIPS are marketable securities that are purchased either at a Treasury auction or on the secondary market. TIPS can fluctuate in price prior to maturity and, when held in a taxable account, produce taxable “phantom interest” representing the inflation adjustment that is added to the principal of the bond but is not actually received by the investor until the bond matures. TreasuryDirect provides a useful comparison between I Bonds and TIPS.

The following exhibit shows recent real rates of TIPS of various maturities. The real rate fluctuates on a daily basis as the TIPS are traded in the secondary market:

As we can see, the real rate on the five year TIPS was recently 1.36%. Extending the maturity out to seven or ten years does not result in additional yield, while going out to twenty or thirty years only results in a modest incremental yield.

In my “flu shot” article, I suggest using five year TIPS as the vehicle for building up a bond ladder over time. The idea is that, once such a ladder is constructed, the investor only needs to take one action every year by purchasing a new five year TIPS at a Treasury auction to replace the five year TIPS that matures and provides the desired cash flow. The investor would obtain the funds required to purchase the five year TIPS by liquidating other investments, likely equity securities, but this can be done without the pressure of being a forced seller who needs to fund current consumption. If stocks are deep in a bear market, the investor can always choose to defer purchasing a new TIPS temporarily. There is no need to be a forced seller.

Although TIPS can be purchased on the secondary market (that is, from another investor), it generally better to purchase the security directly from the government at auction. The Treasury publishes an auction schedule on a regular basis. A portion of the current schedule appears below:

As we can see, there is an auction for a five year TIPS on Thursday, April 20. The Treasury provides further information regarding the terms of the security, a portion of which is displayed below:

Since this is a marketable security, the interest rate will be determined at auction but, typically, the rate will not be dramatically different from one day to the next unless there are major market dislocations (such as the bank failures last month which caused significant volatility in interest rates).

I would recommend reading TreasuryDirect’s comparison of TIPS and I Bonds carefully before deciding to buy TIPS, especially the information related to tax consequences if the bond is being purchased in a taxable account. I would emphasize the fact that TIPS are marketable securities and, if sold prior to maturity, might result in a loss. If real interest rates increase, the bond price will decline just like any other fixed maturity investment. In contrast, one cannot lose principal on an I Bond, although it is not possible to sell an I Bond for one year after purchase. TIPS can be sold at any time on the secondary market.

I Bonds can only be purchased using TreasuryDirect. TIPS can be purchased using TreasuryDirect as well as through most brokerage firms. I personally prefer to purchase Treasury securities at auction from a brokerage firm. Both Fidelity and Vanguard charge no fees for buying these securities at auction and you receive the same terms as you would when using TreasuryDirect. In addition to offering a more user friendly website, holding the security at a brokerage provides the option of selling it prior to maturity if absolutely needed. TreasuryDirect does not permit sales and it is complicated to transfer securities from TreasuryDirect to a brokerage.

It is possible that the real interest rate on I Bonds will increase from 0.4% to something a bit closer to the real rate on the five year TIPS. The I Bond rate will reset on May 1. However, I suspect that any increase in the I Bond real rate will be modest and will not approach the current rate on the five year TIPS. Furthermore, the $10,000 annual limit on I Bond purchases is an important limitation to consider. There is no limit to the amount of TIPS an investor can own, although there is a $10 million limit for noncompetitive bids via TreasuryDirect.

Should you build a bond ladder and, if so, use TIPS? That is a question that each investor must answer based on his or her financial situation.

In my opinion, a bond ladder using TIPS makes sense for a retiree or anyone counting on cash flow from an investment portfolio. While the inflation protection is far from perfect, having an option to put aside funds today that are at least somewhat protected from the ravages of inflation over the next five years seems like a good hedge. This is ballast for a portfolio that will never make you rich but might provide peace of mind and the fortitude to view price fluctuations in stocks with equanimity.

Further Reading:

The Financial Flu Shot: Using Bond Ladders, December 27, 2017 (The Rational Walk)

The Case for U.S. Savings Bonds, December 23, 2020 (The Rational Walk)

Earnings a Risk Free 7% Return in I Bonds, November 2, 2021 (The Rational Walk)

The Risks of Investing in Bonds, March 15, 2023 (The Rational Walk)

Comparison of TIPS and Series I Savings Bonds (Treasury Direct)

Upcoming Treasury Auctions (Treasury Direct)

Tentative Auction Schedule of U.S. Treasury Securities (United States Treasury)

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The social media chatter surrounding the bailout of Silicon Valley Bank and Signature Bank has made it painfully apparent that many market observers lack an elementary understanding of the risks assumed by investors who own fixed maturity securities.

It is not surprising that most people lack a full understanding of the risks, but I have been shocked by many comments on social media made by individuals who should know better. This article might be too basic for many readers, but I have made a point of trying to explain basic personal finance topics in the past and this article is another contribution to that effort.

There are many types of fixed maturity securities of varying complexity. I will not address hybrid securities such as convertibles and I do not address bonds that have inflation protection, such as Treasury Inflation Protected Securities. I have attempted to simplify the discussion as much as possible consistent with conveying basic points.

Types of Risk

At an elementary level, a bond investor provides cash to the bond issuer in exchange for a promise from the issuer to pay interest on a fixed schedule for a certain period of time and to pay back the principal when the bond matures. For example, an investor might agree to pay $1 million for a ten year bond paying 4% interest semiannually. Every six months, the investor can expect to receive $20,000 and at the end of the ten year period, the investor expects the return of his $1 million.

This investor faces the following risks:

• Credit Risk. The issuer of the bond might fail to pay the bondholder $20,000 every six months and might not return the $1 million in ten years.

• Interest Rate Risk. If the investor needs to sell the bond to another investor prior to maturity, he may not be able to find a buyer who will pay $1 million. If interest rates are higher than 4% when the investor tries to sell the bond, he will have trouble finding a buyer willing to pay $1 million.

• Inflation Risk. Even if the bond issuer faithfully pays the bondholder his $20,000 of interest every six months and returns the $1 million in ten years, the purchasing power of those payments might be eroded by high inflation.

Let’s say that the investor is a retiree who is depending on investment income to fund part of his expenses over the next decade. He may not want to take any credit risk whatsoever, even if taking credit risk would result in obtaining a higher interest rate. This is simple to accomplish. The investor can purchase bonds from the United States government and will be assured of receiving timely interest payments and a return of the principal at the end of the ten year period.1

The investor can now sleep well at night knowing that $20,000 is going to land in his bank account every six months for the next decade and that he will receive $1 million of principal when the bond matures. He can “take that to the bank”. The bond is “risk free” in the sense that interest and principal payments will be made on schedule.

Unfortunately, the investor has not eliminated interest rate risk or inflation risk. It is easy to understand why inflation risk has not been eliminated. The bond is going to pay $20,000 every six months for the next decade and $1 million when the bond matures. If prices accelerate faster than expected, that money will not go as far. If the investor is counting on the funds to pay for ordinary expenses of daily life, a high rate of inflation will not be a pleasant experience. This is why you hear people complain about being on a “fixed income” when inflation rears its ugly head.

Understanding interest rate risk is a bit more complicated. If the investor holds the bond to maturity, he will receive par value for the bond, meaning that he will receive the full $1 million back from the government. However, if unexpected events occur over the course of the coming decade and the investor needs his $1 million back early, he cannot simply go to the government and ask for the money to be returned. He will need to find another investor to purchase the bond, and if interest rates are higher than 4%, he will not be able to find an investor willing to pay $1 million.

A Real World Example

Rather than continuing with the scenario described so far, it is more useful to take a real life example since we can observe actual market prices in action.

On May 15, 2020, the Treasury announced the results of an auction for a ten year note:

This security represents a commitment by the government to pay a semi-annual coupon of 0.625% for ten years.2 At the end of the ten years, the government will return the principal. When a treasury security is purchased directly from the government, the price is based on a competitive auction. An individual investor who purchased this security via Treasury Direct would have paid a price of 99.276869, the price that was set at auction making the effective yield 0.7%.3

Our investor would have paid $992,768.69 for a bond that promises to pay $3,125 every six months and will receive $1 million when the bond matures. The following exhibit shows the cash flow starting with the initial purchase for the bond on May 15, 2020 and concluding with its maturity on May 15, 2030. As expected, the 0.7% internal rate of return (IRR) for these cash flows corresponds to the yield in the auction result.

It is painfully obvious that this real world example resulted in far less generous payments than would have been the case with a 4% bond. The prevailing interest rate for treasury securities in May 2020 was extremely low. A retiree with a million dollars to invest would receive a pittance in exchange for a ten year commitment. However, there is no doubt that the government would make timely interest payments and the investor is certain to receive $1 million in 2030 when the security matures.

Fast forward to March 15, 2023. Let’s say that our retiree has unexpected expenses and needs to sell the treasury note. At this point, he has received the first five coupon payments. There are still fifteen coupons left before the security matures.

Unfortunately, the retiree cannot just go to Uncle Sam and say, “I’d like my $1 million back today, please.” The government will not redeem the security before maturity. If the investor needs the funds today, he has to find a willing buyer.

Unfortunately, Treasury Direct has no facility to sell securities, so the investor will have to transfer the treasury note to a brokerage firm. Let’s say that he makes the transfer to Fidelity and then tries to sell it to another investor. Here is the screen that the investor will see when he goes to sell the security:

Fortunately, there are investors who are willing to buy the treasury note. Treasury securities are among the most liquid fixed maturity investments in the world and there is always going to be a market if an investor needs to sell. That’s the good news. The bad news is that the bid for this security is 80.455.

I hope our investor is sitting down when he realizes that the treasury note will only bring him $804,550, not his original investment of $992,768.69 and not the face value of the bond of $1 million that he was expecting to receive at maturity.

The problem is that interest rates have dramatically increased since May 15, 2020. Let’s take a look at the recent market rates for treasury securities:

Although the original maturity of the treasury note was for ten years, only seven years and two months remain, so we need to look at the current market yield for a seven year note which is around 3 3/4%. That is about the rate a buyer of the bond will demand from our unfortunate investor who must sell the security. In order to achieve a market return, the buyer is only willing to pay $804,550, not $1 million. It is easy to understand why this is the case by looking at the economics of the transaction:

The buyer of the treasury note will benefit from fifteen coupon payments of $3,125 each and will receive $1 million at maturity. The coupon payment remains fixed at 0.625%. In order to earn today’s market rate, the buyer can only pay $804,550 for the security, not $1 million.

If the original investor demands $1 million for this bond, he will not find anyone willing to purchase it because the market interest rate is now around 3.75% for a seven year bond, not 0.625%. There is no reason for any buyer to offer full (par) value for the bond under present conditions.

The bottom line is that the original investor can gain liquidity if he needs it today, but he will take a loss of nearly $200,000!

This loss is incurred because of interest rate risk, not because the government failed to fulfill the promise that was made in May 2020 when the bond was issued.

There is still no credit risk. The government is still willing and able to make the interest payments it promised to the investor and the government will still pay back the $1 million when the security matures. The government is holding up its end of the bargain that the investor agreed to in 2020.

The loss occurs because the original investor cannot find a buyer for his bond who is willing to accept the original terms offered by the government because interest rates are much higher today and it is possible to purchase a brand new treasury note offering much higher interest.

If an investor can buy a brand new seven year treasury note yielding around 3.75%, that is the return you will demand if purchasing a ten year note with around seven years left until maturity.

Conclusion

It is important for investors to understand that there are risks associated with investing in fixed maturity securities. While it is possible to eliminate credit risk by purchasing treasury securities, this does not relieve the investor of interest rate risk.

The degree of interest rate risk that an investor takes is greater for securities that mature in the distant future. If the investor in our example had purchased a three year treasury note instead of a ten year treasury note, it would be maturing soon and he would receive all of his principal back. There would be no need to sell the note to another investor because the government will soon return the principal at par value.

The trouble is that the investor purchased a ten year bond and then needed to sell it after just three years. This required the investor to find another investor to take his place — and in a free market, he could not find someone to pay par value for the security since interest rates have increased substantially. If it is any consolation for the investor, the situation would be far worse if he had purchased a thirty year treasury rather than a ten year treasury.

There is more complexity involved in the bond market than I have outlined in this article, but hopefully the example illustrates the reason for the inverse relationship between bond prices and interest rates and why investors who sell a bond prior to maturity cannot be assured of receiving par value and could suffer substantial losses.

While it is understandable that ordinary people might not be familiar with this topic, it is inexplicable for professional investors, bankers, and financial officers of companies to be ignorant of risks. Loading up on long duration fixed maturity investments carries a great deal of risk, especially when interest rates are low. In a market economy, investors who take such risks must bear the consequences.

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TerraUSD was not backed by U.S. dollars, but by an algorithm tied to the Luna cryptocurrency. It didn’t work as planned:

“Here is how it was supposed to work: If TerraUSD fell below $1, traders could buy the coin and convert it into $1 of Luna, earning arbitrage profits. That would dry up supply of TerraUSD and push its price back to $1. But the mechanism only worked if traders saw value in Luna. When TerraUSD started wobbling this month, Luna went into free fall.”

When the music stopped, TerraUSD went into a free fall and is now “worth” 3 cents.

The article goes on to describe the steep losses taken by ordinary individuals, some of whom have lost the majority of their life savings. You have to wonder how people could have fallen into the trap of thinking that it was possible to earn double digit yields on an asset devoid of risk of loss.

My reaction to these types of articles is always the same. I cannot believe how people fall into what seem to be “obvious” speculative traps. However, we should keep in mind that many of these people are not stupid. One of the individuals profiled in the article is a surgeon. The irony is that it is often highly educated people who fall into speculative traps in financial markets.

I think that there is something hard-wired in our psychology that often leads to speculation, especially among people who have achieved a great deal in other fields. A surgeon, for example, cannot fake his skills. Incompetence would quickly reveal itself and result in an exit from the field of medicine. The same is not true in the field of investing, but many people don’t realize that.

The financial “experts” on television are usually empty suits, and even those who appear to have skill might just be lucky. It takes a decade or more to demonstrate real skill in the investing arena. If you are a surgeon, you might assume that an investment expert is just like you, except in another field, and then listen to some very bad advice.

This brings me to the point where I’m obligated to share a personal story about speculation. In February 2001, I purchased 100 shares of Level 3 Communications for $2,870, including a $20 commission.

A year earlier, I made my first investment in Berkshire Hathaway which had done very well, especially compared to market averages. During that year, I started to participate on the Berkshire Hathaway Yahoo! group where a number of Berkshire shareholders wrote about investing in Level 3. The Berkshire connection was that Walter Scott Jr. was Chairman of Level 3. Many very smart Berkshire shareholders decided to invest in Level 3. I simply followed them into the stock even though I had no understanding of the business and did almost no due diligence.

In November 2001, I sold my shares of Level 3 Communications for $327, again paying a $20 commission. The total loss was $2,543, or 89%. I thought I was investing, but I was really blindly speculating, and I paid for it with nearly a total loss. I read about the idea on a message board, but the fault was mine, and mine alone.

There was no excuse for speculating in Level 3 Communications. Aside from my finance degree, I had spent years studying Benjamin Graham and Warren Buffett and my investment in Berkshire Hathaway the prior year was a legitimate investment made after much due diligence and effort.

Intellectually, I should have been immune to speculation, but clearly I was not.

Long before the development of safe vaccines for dreaded diseases like smallpox, a risky procedure known as variolation was used to provide some protection. Although the methods varied by region and changed over time, the general idea was to purposely expose a person to smallpox in a controlled way that would hopefully result in a mild case of the disease and provide durable immunity in future outbreaks.

Although some people died after the variolation procedure, there is no doubt that it saved many lives. We might cringe at the idea of purposely infecting ourselves with a deadly disease in order to gain immunity today, but it was useful in its time.

If reading Benjamin Graham and Warren Buffett’s writings represents vaccination against speculation, then perhaps having a small “mad money” account at an early age used for speculation could be a form of variolation. If we cannot learn the perils of speculation vicariously through the experience and wisdom of others, maybe we need to learn by direct experience.

The key thing, however, is to learn our lesson through experience that burns but doesn’t kill us. It is one thing to learn not to speculate by losing a couple thousand dollars, and quite another for a surgeon in his 40s to lose 90% of his life savings speculating in cryptocurrencies.

My experience in Level 3 Communications has offered durable protection against speculation over the past two decades. Although I have certainly made investing mistakes, I have not outright speculated since 2001, and I have no desire to do so. Witnessing other people get rich (usually temporarily) through speculation does not tempt me to join them.

I know that the $2,500 loss in 2001 easily represents $15,000 today given that I also owned Berkshire Hathaway at the time and could have invested that sum in Berkshire instead of speculating. Losing $2,500 in 2001 burned but didn’t change my life, and while having $15,000 more today would be nice, it also wouldn’t change my life.

For most people, I doubt that reading books or making pretend trades in a test account will cure the urge to speculate. However, actually losing money that is meaningful but not ruinous might represent a cure. It is best to learn this lesson at a young age with small sums at stake.

PS: This is a longer version of a Twitter thread I posted last week, before I decided to stop using the platform.

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“Like Warren, I had a considerable passion to get rich, not because I wanted Ferraris — I wanted the independence. I desperately wanted it.”

— Charlie Munger

Trial by Fire

One of the things that I disliked about my job was public speaking.

Unfortunately, delivering a speech at a conference was simply an unavoidable part of my job during the weekend of September 13-14, 2008. As I went over my presentation for the hundredth time during that weekend in Chicago, I was oblivious of the events taking place on Wall Street leading up the Lehman Brothers bankruptcy. I was too focused on doing well, or at least not looking foolish, during my speech on Sunday.

A couple of weeks earlier, I had made the decision to end my career in software and pursue investing on a full-time basis, something I had wanted to do for over a decade.

The combination of making a decent income over thirteen years in the software industry coupled with a very high savings rate and some good investments allowed me to reach my “magic number”, the point at which I felt comfortable going without a paycheck permanently. I had never ratcheted my lifestyle at a pace commensurate with my income growth and my ongoing income needs were modest.

I had a key role in a small company, so I provided six months of notice which put my “retirement” date around the end of the first quarter of 2009.

Little did I know that my net worth would be cut in half, at least on paper, between the day I made the decision to quit and when the decision would ultimately take effect in March 2009. To put it mildly, this was an uncomfortable experience.

I was starting my FIRE experience with what seemed like a trial by fire.

Time is the Currency of Life

The FIRE movement, which stands for “Financially Independent, Retire Early”, has gained a great deal of popularity over the past decade. When people in the FIRE movement refer to “early”, they are not talking about retiring at the age of 55 or 60. Many FIRE devotees aim to retire much earlier — typically in their 30s or 40s.

Financial independence always appealed to me because, like Charlie Munger, I desperately wanted the independence that it would bring. The freedom to know that your basic economic needs are already taken care of means that you have the ability to fully control your most valuable asset: Time.

Not having financial independence means that you must sell your time for money.

You might enjoy your job, or you might hate it. But regardless of how you feel about your job, the requirement to work in order to pay for food and shelter means that you do not fully control your time, and if you cannot fully control your time, then you are not in full control of your life.

The “Financially Independent” part of FIRE has great appeal and I think it is certainly possible for those who are willing to put in the effort and have the right mindset. In as little as fifteen years, I believe it should be possible for many people to reach financial independence. I reached that point at the age of thirty-five after a thirteen year career.

The goal of being financially independent at a relatively young age is one that nearly everyone should have. There really is no controversy in my mind regarding the “FI” part of the FIRE movement. Independence provides optionality, and having optionality is almost always a good thing.

Almost always.

What’s Next?

Today, there are countless blogs, websites, discussion forums, and other online communities that are devoted to the FIRE movement. I am not sure if the FIRE movement existed in any form back in 2008, but if it did I was not aware of it. In fact, I never thought of what I was doing as pursuing “early retirement” at all.

My education had been in finance, but I switched to software after college because I was able to earn far more on contract jobs in the Silicon Valley than I could ever hope to earn in an entry level finance job. I didn’t hate writing code, but I didn’t love it either. I did enjoy the intellectual aspect of writing algorithms to solve problems. But mostly, work was just a means to an end, a way of earning (and saving) money.

After a few years, I began managing a team of engineers and started writing less code. The pay was higher, but the work was not as intellectually interesting. I fulfilled my need for intellectual activity by saving as much money as I could and working on investments in the evenings and on weekends. I typically worked at least sixty hours per week at my job and another twenty hours per week on my investments.

By the middle of the ‘00s, financial independence was clearly in sight. I had a clear idea of what was next.

It wasn’t “retirement”.

Yes, I was planning to take the time to go on several trips that I had deferred numerous time due to my work schedule. But my goal was to study investments on a full-time basis and compound the value of my portfolio.

When I look at many of the FIRE blogs, websites, discussion forums, and other communities, I often see that people fail to fully consider how they will spend their time after reaching financial independence. Everyone typically agrees on the rough contours of how to reach financial independence, but relatively little attention is spent on the question that is far more important:

What’s next?

If you have been working non-stop for years or decades, especially if you dislike your job, it is easy to dismiss this question. You dislike your occupation intensely and wish to escape from it. There’s nothing wrong with that motivation. No one wants to spend their days doing work they dislike and feeling trapped.

But it is important to understand that removing a source of misery does not automatically lead to happiness.

Victor Frankl spent nearly three years during World War II in a concentration camp. His memoir, Man’s Search for Meaning, is an important record of his awful experiences, but also a profound philosophical work.

In a postscript to his book, written in 1984, Frankl stated that the ultimate goal for many people — happiness — is not one that can be directly pursued. Instead, it must ensue. If a person has a reason to become happy, he or she will achieve happiness. And the reason to become happy is invariably the achievement of one’s purpose in life.

I think that Frankl’s observation is obviously true, and it is really true at any age. Whether you leave the workforce at the age of thirty-five or sixty-five, you need to be able to answer the question: What’s next?

Having the financial resources needed to remove a source of misery or discomfort from your life can lead to the conditions required for you to pursue happiness, but it cannot deliver happiness itself. I realize that this is a counterintuitive idea, but I assure you that it is true for almost everyone.

Every general statement risks falling into stereotypes. There certainly are people in the FIRE community who have plans for what they are going to do with their lives. Many people plan to focus more on their family, pursue other types of work that are potentially lower paid but more fulfilling, volunteer for unpaid work, or go into business for themselves. But a very large number seem to think that endless travel and recreation will make them happy. I am not saying that this won’t work for some people, but I think that it is more rare than generally believed.

When I say that optionality is almost always a good thing, what I mean is that you have to have an answer for the question of “what’s next?” or that optionality can become a path to aimlessness rather than happiness. And an aimless life can eventually lead to misery just as easily as a life full of work that you dislike.

Are You Really Financially Independent?

It might seem odd that I put this section after “What’s Next”, but I did it because there is no point in really delving into the question of whether you can quit your job and retire until you determine for yourself whether you should do so.

But let’s say that you do have a solid plan for what you will do with your time and are really to pull the trigger on FIRE. Are you really ready to do so?

How confident are you that you are truly financially independent? If you are very young, say in your 30s or 40s, are you confident that you truly have enough money to last for five, six, or even seven decades?

One of the major issues I have with the FIRE community is the almost religious belief in what is called “the four percent rule”. The rule is very simple which is part of its appeal. The idea is that you can safely consume four percent of your portfolio every year, adjusting this annual consumption for inflation, and be very confident that you will not run out of money.1

For example, let’s say that you estimate that you will need $70,000 per year, which is about the median household income, to fund your retirement goals. The four percent rule says that you would need a starting portfolio of $70,000/0.04 = $1,750,000. You would consume $70,000 during the first year and adjust each subsequent annual withdrawal for inflation.

While this rule is simple, there are several problems with it especially for people who are retiring at a very young age, which I list here in order of importance:

1. The four percent rule posits that one can follow this strategy for up to thirty years with a very low probability of running out of money. If you are retiring very early, your time horizon is longer than thirty years, and probably much longer. At thirty-five, I estimated that I was likely to live another five or six decades, twice as long as the four percent rule was tested for. 2

2. The four percent rule, like all other studies, is necessarily backward looking. The rule was originally developed in 1994 at a time of much higher interest rates on bonds and lower equity valuations. There is no assurance that this rule will work in the future even for people retiring at normal retirement age who might actually only have a three decade horizon to plan for.

3. Sequence of return risk could quickly decimate a portfolio if an early retiree is unlucky enough to leave the workforce right before a major bear market. If you retire with the idea of taking four percent withdrawals but your portfolio declines significantly early in retirement, you will either end up taking withdrawals much higher than four percent, be forced to cut spending, or re-enter the workforce.

Many argue that the four percent rule is conservative enough and using a lower withdrawal rate brings about the “risk” of dying with a large estate. However, there are many reasons to err on the side of caution when retiring at a very young age because any of the following events could occur over the next five or six decades:

1. Your family situation might change. You could get married, get divorced, or have children. If you’re retiring at an early age, it is perhaps more likely than not that one of these major family events will occur and result in major changes to required annual income.

2. Your health could deteriorate. Leaving the workforce means buying private health insurance, most likely on the ACA exchanges in the United States. My premium for health insurance today is four times as expensive as it was in 2009. However, the real risk is encountering a dreaded disease and seeking specialized treatment outside your health network.

3. Your friends and family might encounter financial difficulties. It is only human to want to help family and close friends. Are you going to be able to say no to requests for help that might arise when you have what would seem like a high net worth, even though that high net worth is only producing a modest “safe” annual withdrawal?

4. Your interests might change. You might be happy going hiking or playing cards for recreation today, but what if you want to take up golf or skydiving in the future? Many people assume that spending in retirement will decrease due to lack of commuting costs and not having to purchase work clothes. But for early retirees, these factors can easily be overwhelmed by new expenses. New expenses can easily come up, especially if you are directionless and bored in retirement because you have no discernible goals in life. Spending money to alleviate boredom is similar to taking drugs to alleviate boredom. It can seem to work for a while and become addictive.

The fact that financial markets have performed well over the period during which FIRE became very popular might make concerns over the four percent rule seem silly. But not every decade provides equity returns like the 2010s. The 2000s were far less generous, and the 2020s might be as well.3

I am not going to suggest a rigid alternative to the four percent rule, but I will say that in a world of low returns on bonds and high equity valuations, it would be prudent to consider a withdrawal rate of three percent or less. If the worst thing that happens is you have a larger portfolio in a couple of decades, is that really such a bad thing?

Conservatism has a cost. The difference between using a four percent and three percent rule is significant. If you need $70,000 of income per year, the four percent rule says you need a portfolio of $1.75 million to retire while the three percent rule calls for a portfolio worth over $2.3 million.

Regrets?

I have now been “retired” for thirteen years which is the same length as my working career. Do I have fundamental regrets about making that key decision?

The answer is no.

I do not wish that I was still working a management job in the software industry. I do not miss the work. I never have to make speeches. I do not miss the constraints on my schedule. I highly value the freedom I have to set my own schedule. I have full control of my time and I would not wish to go back to the way things were before.

However, the path has not been smooth.

As I mentioned before, my net worth on paper was cut in half between the time I decided to pull the trigger on FIRE in September 2008 and when I actually “retired” in March 2009.

March 2009 turned out to be the bottom of the bear market, but I did not know that!

No one did.

However, a few things saved me from excessive mental turmoil.

1. I had confidence in the value of my investments and the eventual recovery of market prices. There was no need to panic.

2. My planned withdrawal rate was lower than four percent. Even with the large drop in my net worth, I felt that I was on firm ground.

3. During the six months of constant market declines between September 2008 and March 2009, I was still working. I saved cash like a madman and built up an even larger cash reserve. I also received a cash payout for unused vacation time. I had no need to sell investments in the near term to fund my expenses.

4. I knew that I could return to the software industry for at least the first few years of my “retirement”. I made a conscious effort to keep up to date with relevant technology until I was certain I would not need to return. Fortunately, I never had to.

Although I have no regrets in terms of the fundamental decision to “retire”, I found that I did miss certain aspects of having a job.

1. I missed my daily commute. This might sound crazy, but many people need to have a beginning, middle, and end to each day. Coffee shops replaced the office on many days to simulate a commute.

2. I missed daily interaction with coworkers. I did not enjoy my work, but I did enjoy interacting with coworkers. I had built a team of intelligent and high performing coworkers who were (mostly) pleasant to interact with.

3. I missed the “external scorecard” provided by a job. There are limits to an inner scorecard. I started doing stock research but had no colleagues to share my work with. This was the primary reason for starting The Rational Walk website in 2009. Over time, my need for external input decreased to almost zero, but initially I wrote new posts almost every day for two years.

I think that most people will find that they miss certain aspects of a traditional job. The only way to find out what those things are is to actually stop working. You might even hate “retirement” so much that you choose to voluntarily go back to your old job.

Financial independence represents the option to no longer work for a paycheck.

It is not a mandate to stop working.

You might want to work even after you have no financial need to do so. So, you should stay current with your skills until you’re sure that you will not want to go back to work.

Conclusion

A Twitter thread can only say so much and leaves room for misunderstanding.

I broadly agree with the goals of the FIRE movement when it comes to “Financial Independence”. But I do think that the community has certain blind spots when it comes to “Retire Early”.

Hopefully this article does a better job of explaining where I think the FIRE movement falls short and potentially help some people think about what their early retirement goals are really all about.

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On Tuesday, bitcoin rose 1.7% to $42,407. Most observers say the $40,000 level for bitcoin is a line in the sand for the bulls, and they expect a churning trade in this range. “The price action of bitcoin is still likely to remain volatile as a result of a hawkish Fed,” said AvaTrade analyst Naeem Aslam.

Why is $40,000 a critical level?

Perhaps that level is cited because it is a round number and because bitcoin has not traded below $40,000 in about six months. However, it is not as if the cryptocurrency hasn’t traded well below $40,000 in the recent past — it traded below that level for several months during 2021.

For whatever reason, $40,000 is a “line in the sand” for many observers who either plan to step in with buy orders at that level or expect other investors to do so. They have mentally anchored to $40,000 as a significant level for bitcoin.

Does this make any sense?

When looking at anything that seems irrational at first glance, we need to recognize that the world is an incredibly complex place and that it is not possible for most human beings to function without resorting to heuristics.

Modernity has brought enormous material benefits to society but has also increased complexity exponentially over the years. Perhaps even more importantly, our perception of complexity has dramatically increased due to constant exposure to information flowing at the rate of a fully open firehose.

It is impossible to deal with the complexity of the world without adopting heuristics, which are approaches to solving common problems based on short-cuts. If we attempt to solve every problem we encounter by resorting to first principles, the quality of our decision making might improve but the velocity of the world would guarantee that we will fall hopelessly behind when it comes to getting anything done. As a result, we consciously or subconsciously adopt heuristics that might not be perfect but are usually good enough for our purposes.

One of the most common heuristics people adopt is the practice of anchoring to a well-known and easily accessible reference point.

Anchoring is very evident in consumer behavior. When you arrive at a car dealership, the salesman wants you to anchor on the manufacturer’s suggested retail price of a car, not the true market value based on what customers are actually paying in negotiated transactions. Once you are anchored to the sticker price, the salesman can offer discounts that make the car seem like a great deal. In this scenario, technology has caused more and more customers to anchor on true market value because it can be easily found online. What was once hidden from view is now exposed for all but the laziest consumers to discover. This is great news for consumers but not a welcome development for car salesmen.

There are a number of different types of heuristics that I won’t go into (the Wikipedia article on the subject is actually quite good). My point in bringing up the subject is to recognize that heuristics and both essential and dangerous. In situations where the risk of being wrong is low, using heuristics can save a lot of time especially when you encounter the situation repeatedly. But we must be wary when it comes to using mental short-cuts for any decision that has significant consequences.

It is natural for the owner of any asset to wonder what it might be worth if it is sold. In the case of business ownership, a stark contrast exists between the mentality of an owner of a privately held business and the owner of shares of stock that are actively traded in financial markets.

If you own a small business, you probably have only a vague sense of what it is worth, and your perception of value is almost certain to be based on how much money you have been able to make over time. If you own a restaurant and experience a few slow weekends, you are not likely to mentally change your vague estimate of what it is worth. But if business is slow for a year and shows no sign of turning around, you will start to slowly update the number that you have in mind. The same is true when business is booming — you will only slowly adjust your assessment of business value.

But the situation is completely different with actively traded securities. The owner of a share of common stock knows precisely what his or her shares are worth at any moment in time when markets are open, down to the penny. The vast majority of owners of common stock or any other financial asset will constantly update their mental model of the value of their investment purely based on the quotation provided by financial markets.

Does this make any sense?

It is obvious that the intrinsic value of a business cannot possibly change on a minute-to-minute basis and that security prices fluctuate far more dramatically than the underlying value of a business.

Intellectually, most investors will acknowledge that this is the case and that it makes no sense whatsoever to anchor on quotations.

But the vast majority of them will anchor on stock prices anyway.

This is because anchoring is a powerful heuristic that is very useful in many contexts outside investing. Since heuristics are useful in general, they can easily be misapplied in situations where it makes no intellectual sense to do so. The fear of losing money and the thrill of making money are powerful forces to reckon with and with stock prices being so readily available, the mental short-cut of conflating price and value is taken by almost everyone.

In March 2020, stock prices plummeted as investors came to terms with the reality of the pandemic and the dire implications for business. In early March, I attempted to take a 30,000 foot view of the correction then underway to assess the actual impact of a temporary lock-down on business values.

The point isn’t that I was right about forecasting the future course of the pandemic (no one was) but to emphasize that even though we need to anchor on something, we have the ability to choose what it is we will anchor to.

I was not willing to use market quotes as an anchor point and determined to anchor on some logical assessment of business value. Coping with market meltdowns is impossible if you anchor to market quotes with no further context. This is almost always a recipe for panic selling, not rational behavior.

My largest investment at the time was (and remains) Berkshire Hathaway stock which was being pummeled by late March. I was getting poorer and poorer by the day based on market quotations, but was it necessary to anchor to quotes? Or was there a better way to measure the actual damage?

It is important to not bury your head in the sand when it comes to investing and it was clear toward late March that the world was not going back to normal anytime soon. Rather than anchoring on the quotation of Berkshire Hathaway, I attempted to examine how each of its major businesses would be impacted.

Did the intrinsic value of my stake in Berkshire Hathaway take a hit in early 2020 due to the pandemic?

Of course it did because the pandemic had a major impact on the business results of the company’s investees as well as its wholly owned subsidiaries. But I came away from the analysis comforted by my assessment that operating earnings were unlikely to be negative or consume cash for extended periods of time:

Despite the inability to be precise, it seems to me that it is highly unlikely for Berkshire’s operating earnings to be negative or operations, in aggregate, to consume cash for any length of time. If there are quarters in which there are operating losses for the group as a whole, Berkshire certainly has ample cash resources to avoid any kind of financial distress.

Like everyone else, I had to anchor to something during that period of great uncertainty. I did not have the option of just not thinking about it, nor did I have the option of pretending that nothing had changed.

The only recourse was to find something logical to anchor to.

Anchoring to daily quotations not only makes little sense logically but would be self-imposed mental tyranny and allow random fluctuations to dictate my state of mind. I had to find an alternative, so I did the research needed to write that article much more for my own sanity than for the benefit of my readers.

Since I started this article with bitcoin, I should come back to the subject of cryptocurrencies and how investors are anchoring to price.

Bitcoin owners are doing what investors in stocks have always done, so in that way their mental model of anchoring is nothing unusual. The difference is that, unlike a business, bitcoin has no underlying fundamentals that can be used to arrive at an estimate of intrinsic value outside of the immediate supply and demand dynamics setting today’s price.

To be more precise, bitcoin has no fundamentals that I can personally understand well enough to estimate a value independent of its quotation.

The risk of making a statement like this is that it might attract angry comments from cryptocurrency investors who insist that there are fundamentals at work that I am glossing over.

Fair enough. What are those fundamentals?

Bitcoin owners would likely state that the supply of bitcoin is capped at 21 million and that this amount can never be exceeded. If bitcoin continues to gain acceptance as “digital gold”, incremental demand as it goes mainstream will hit up against a firm supply limitation driving up the price. In contrast, the supply of nearly anything else can increase, including the number of shares outstanding of a popular common stock.

Bitcoin owners also often compare the market capitalization of bitcoin to gold and further note that, unlike bitcoin, gold’s future supply is not fixed. Gold is regularly mined, and a rising gold price is an inducement for more mines to produce more supply. If the price of gold gets high enough, people may even melt down jewelry further increasing supply. But no matter how high the price of bitcoin gets, there will never be more than 21 million coins in circulation in the future assuming the technology works as promised and cannot be hacked or otherwise compromised.

While these points might be valid, it is notable that the argument is still based on supply and demand dynamics, just taking a longer-term outlook. There is still no measure that is independent of supply and demand in the marketplace that we can use to estimate the intrinsic value of bitcoin. I can use the earnings and free cash flow of a business to estimate its intrinsic value. There is no parallel to earnings and cash flow for an asset like bitcoin.

While I have tried to understand these perspectives and to keep an open mind, I remain unconvinced regarding the value of bitcoin and other crypto assets that have no cash flow or other independent means of assessing intrinsic value.

But my lack of belief is only ancillary to the point I am trying to make:

In order to hold any asset, my mind demands that I anchor to something.

I need to form an opinion regarding the value of what I am buying and what I own. In the case of some businesses, I can develop an estimate of intrinsic value which will be updated over time based on criteria that is entirely independent of the stock price itself. I can anchor to that estimate rather than daily stock price fluctuations.

I have no such option when it comes to bitcoin or other cryptocurrencies. If I owned bitcoin, whether I like it or not, my mind would anchor to its daily price. If the stake was enough to be meaningful to my net worth, anchoring to the daily price of bitcoin would impact my daily state of mind. This is not my idea of a good way to live my life.

I am not excluding the possibility that other investors might own assets like bitcoin and be able to develop an investment thesis that allows their mind to anchor to an estimate of value that is independent of the price itself.

Bill Miller, who has fifty percent of his personal portfolio in bitcoin, is not someone who is blindly anchoring to its quotation. He must have some independent idea of the value of bitcoin that he is anchoring to. I am sure that he is not mentally tortured when bitcoin’s price fluctuates against him because he has formed an independent assessment of its value.

But it is not wise to outsource your thinking when it comes to investing if you are picking securities yourself, nor can you achieve personal conviction or staying power by coat-tailing another investor, regardless of who that investor is.

When it comes to investing, the world is full of assets to own, and it is important to be cognizant of your own capabilities and psychology. What I think is universal, however, is that almost all human beings will anchor to something when it comes to the value of what they own.

But we get to decide what to own and what metrics to anchor to.

If we are disciplined, adopt the right mindset, and only own assets where the fundamentals are personally well understood, we can then choose what we will anchor to rather than looking only at market quotations.

Anchoring on market quotations exclusively is a recipe for stress, misery, panic selling, and financial loss and therefore should be avoided at all costs. So, it seems logical that we should select investments where an anchor independent of market quotes is possible. This will vary for each investor based on their temperament, background, and analytical skills.

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Your privacy is taken very seriously. No email addresses or any other subscriber information is ever sold or provided to third parties. If you choose to unsubscribe at any time, you will no longer receive any further communications of any kind.

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The uptick of inflation in recent months has captured the attention of the news media and it is now a rare day when we do not see articles in the Wall Street Journal and elsewhere describing inflationary pressures. Whether the inflation is “transitory”, as the Federal Reserve claims, or will prove to be more persistent is a debate that I will not enter at this point other than to say that in the here-and-now, inflation seems very evident in day-to-day transactions, not to mention levitating prices for real estate and financial assets of the most speculative variety.

If consumers felt that they have access to some viable and safe means of protecting their hard-earned money from inflation, they might be less inclined to spend the money or to “invest” it in the latest cryptocurrency craze. Unfortunately, savings accounts yield next to nothing and the treasury yield curve continues to offer microscopic yields, with next to nothing on offer for short term treasuries that act as cash substitutes.

For reasons that I do not fully understand, personal finance articles on savings alternatives routinely either ignore or gloss over the option of United States Savings Bonds. As I wrote late last year, there is a solid case to be made for consumers to take full advantage of these instruments as cash substitutes. Readers unfamiliar with how savings bonds work can find more information in that article, linked above, so I will not repeat the basics here.

On November 1, the Treasury announced that new Series I savings bonds will offer a composite yield of 7.12% for the next six months. This yield is comprised of a 0% real rate combined with a 7.12% inflation adjustment. Understanding how the composite yield is calculated is relatively straightforward. Every six months, the Treasury sets the real rate, which has been 0% for some time. In addition, the semi-annual inflation rate, as measured by the CPI-U index, is multiplied by two and added to the real rate. Since the semi-annual increase in the CPI-U was 3.56%, the composite rate is double of that at 7.12%.

So, for new I Series Bonds purchased today, the yield will be 7.12% for the next six months. After that, the yield will depend on the increase of the CPI-U over the prior six months multiplied by two.

There are a few caveats regarding using savings bonds to park cash. One cannot redeem these bonds for any reason for the first year. Additionally, any bond redeemed before the first five years will incur a three-month interest penalty. Finally, one cannot purchase more than $10,000 of these bonds in any given calendar year.

Despite these limitations, I think that I Series bonds represent a cash alternative that is too good to ignore. At a time when the one-year treasury bill yields 0.15%, the I Series bond is a no-brainer even if one cashes it in after a year and takes the three month interest penalty. Additionally, the $10,000 purchase limit applies to one individual. A family of four could purchase $40,000 of these bonds every year. And since it is late in the year, such a family could purchase $40,000 of the bonds in 2021 and another $40,000 in early 2022. It is also possible to purchase an additional $5,000 using the proceeds of a tax refund. The cherry on top is that savings bonds are free of state income tax liability and the federal income tax liability is deferred until you cash in the bonds.

I have never made specific investment recommendations in over twelve years of writing about investments, and this post isn’t advice either. But I would be remiss to not mention the possibility of earning a risk-free return that is multiples of what is offered through savings accounts and treasury bills.

Small investors who want to go out and binge on consumer products this holiday season or gamble on the latest crypto craze are, of course, free to do so. But no one can say that there is no viable risk-free investment that can protect at least some purchasing power for the vast majority of American savers.

Autumn Scenery

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I know that is probably your reaction to the title of this article and I can’t really blame you. 

There is nothing exciting about savings bonds and you’ll never get rich by investing in them. In fact, you may not even keep up with the cost of living. For most people, there are normally far better alternatives for long-term investments. Yet as we approach the end of 2020, a case can be made to use these mind numbingly boring savings vehicles. Individuals who find themselves in certain common situations could conclude that savings bonds represent the “least bad” alternative. 

Bear with me and you might find that savings bonds could be a useful tool in your situation.

The Basics

Except in the case of electing to receive savings bonds through tax refunds, all bonds have been issued in electronic form for several years.  TreasuryDirect offers an easy way for investors to purchase savings bonds as well as other treasury securities. Unlike treasury bills and notes, savings bonds are not marketable securities, meaning that the purchaser cannot sell these bonds to other investors. Instead, savings bonds are held by the investor until they are redeemed or reach maturity after thirty years. Savings bonds are not redeemable at all during the first year of ownership and bonds redeemed prior to five years incur a three month interest penalty. The government intends savings bonds to be a medium to long-term investment vehicle for small investors. 

Savings bonds offer important tax advantages. They are free of state income tax and while you will be liable for federal income tax, the tax is only due when you redeem the bond or it matures after thirty years. This means that savings bonds offer tax deferral, a rare feature outside of retirement accounts. 

There are two types of savings bonds currently offered by the government: Series EE and Series I. One can purchase up to $10,000 of each series every year. Let’s take a quick look at how the two series differ:

Series EE savings bonds earn a fixed rate of interest for the life of the bond. The current interest rate is a minuscule 0.1 percent. Why am I reading this, you might ask? Who in the world would sign up for a bond paying 0.1 percent for thirty years when the Federal Reserve has a 2 percent inflation target? Well, an important but often overlooked feature of the Series EE savings bond is that the government guarantees that the value of the bond will double if, and only if, you hold it for at least twenty years. A doubling of value over twenty years implies a 3.5 percent interest rate. But that is only the case for bonds held at least twenty years. 

Series I savings bonds are intended to offer investors inflation protection. These bonds pay a fixed “real” return plus they earn the equivalent of the rate of increase of the consumer price index for urban consumers (CPI-U). Currently, the fixed “real” rate is 0 percent. That’s right, when you purchase a Series I bond, you are agreeing that you will receive no real return whatsoever. Your return will be comprised of only the rate of inflation as measured by CPI-U. In the unlikely event of deflation, the government guarantees that you will never receive less than the purchase price of the bond. Unlike Series EE bonds, there is no guarantee that Series I bonds will double over twenty years. The rate of return is entirely unknown at the time of purchase because the rate of increase of the CPI-U is unknown. 

The government also offers Treasury Inflation Protected Securities (TIPS) but TIPS are not savings bonds. TIPS are marketable securities and have complexities that are beyond the scope of this article. However, I should note that the real return on TIPS is currently negative as of late December 2020, which makes the Series I fixed rate of 0 percent superior to TIPS at the time of this writing.

Now that we have a basic understanding of the two types of savings bonds, let’s consider how an investor might use each series.

The Case for Series EE Savings Bonds

There’s no doubt about it – the 0.1 percent fixed rate currently offered for Series EE bonds is pathetically low and inferior to many online savings accounts. There would be no reason whatsoever to purchase EE bonds for an intended holding period under twenty years unless you are expecting significant deflation and the imposition of negative interest rates on bank deposits. In such a situation, Series EE bonds could offer protection from negative rates.

So unless you are expecting deflation, why consider EE bonds? 

Most small investors do not think in terms of matching the duration of their assets and liabilities. Insurance companies, for example, think of duration matching when they construct their portfolios. A life insurance company might have a high degree of confidence, from an actuarial perspective, that they will have to pay out a certain amount of nominal dollars twenty years from now. Many insurance companies will seek to match the duration of their investment portfolio to the duration of their expected liabilities. 

Consider that mortgage rates are at historic lows in December 2020 with thirty year fixed rate mortgages available as low as 2.5 percent. Let’s say that Michael and Elizabeth, a newly married couple, just purchased a home for $475,000. They were able to make a 20 percent down payment of $95,000. The monthly payment on the $380,000 fixed rate 30 year mortgage works out to just over $1,500.

Michael and Elizabeth are both 35 and plan to retire in twenty years at the age of 55. This isn’t a starter home for them — they plan to live in it for decades to come and have a high degree of confidence that they will not be forced to relocate. Having a 2.5 percent mortgage for 30 years is very cheap money but they don’t like the fact that mortgage payments will continue beyond their retirement date.

The risk of inflation is a huge problem because most future expenses can and will rise as the cost of living rises. However, Michael and Elizabeth’s mortgage payment is fixed for the life of the loan. It will be $1,500 per month or $18,000 per year during the first year and all subsequent years. 

If the newlyweds want to provide for the mortgage payment during years 21 through 30 of the mortgage, when they will be retired, using Series EE savings bonds could be a perfect way to achieve this objective. By investing $10,000 per year in Series EE bonds for the next ten years, they know that they will have $20,000 per year during years 21 through 30 of the mortgage. Although they will have to pay income taxes when the bonds are redeemed, the proceeds should still be enough to pay the vast majority of the $18,000 annual mortgage service. The risk of inflation is not relevant in this situation because they duration matched the asset with the liability they know they need to service. And they are better off for doing so because the interest rate on the EE bonds will work out to 3.5 percent which is a full percent greater than the 2.5 percent rate on their mortgage.

Granted, this isn’t so exciting and the couple would very likely do better invested in an equity index over two decades. But few things in life are guaranteed. Using EE bonds to fund a fixed payment obligation bearing an interest rate lower than the EE bond rate is an option worth considering. Of course, there are risks. If Michael and Elizabeth cash those EE bonds even a month before reaching the twenty year mark, they will not earn 3.5 percent annually, but the miserable 0.1 percent fixed rate that would apply in the absence of the twenty year doubling guarantee. This is not an insignificant risk.

The Case for Series I Savings Bonds

The case for using Series I savings bonds differs from the Series EE scenario in terms of the duration of the commitment. Unlike Series EE bonds, Series I bonds are not guaranteed to double over twenty years. All you will ever receive from these bonds, at today’s 0 percent fixed rate, is the rate at which the CPI-U increases. This rate is reset twice a year and is currently 1.68 percent. 

With online savings accounts paying only 0.5 percent as of December 2020, an investor could do better with Series I savings bonds even if the bond is held the bare minimum of one year. Sacrificing three months of interest would still result in a return of over 1.2 percent, more than double the rate offered by the highest yielding online savings accounts. Of course, if the CPI-U resets to a lower level in six months, the return the investor will get will be lower than 1.68 percent, but it seems unlikely that we are going to have disinflation or outright deflation in the United States given that the Federal Reserve is determined to create inflation of 2 percent, and perhaps more than that as the economy recovers from the COVID pandemic in 2021. 

The idea of using Series I bonds as a substitute for one year treasury bills is also attractive given that the one year treasury yields just 0.09 percent as of late December 2020. 

A significant limitation is that you cannot invest more than $10,000 per year in each savings bond series. However, the new year will soon be upon us. There is no reason that you cannot invest $10,000 in the remaining days of 2020 and another $10,000 in January 2021. In addition, you could direct the IRS to invest up to $5,000 of a tax refund in savings bonds. There is nothing prohibiting a taxpayer from overpaying 2020 taxes and directing the refund in early 2021 toward $5,000 of additional savings bonds. So, an investor could put around $25,000 into Series I Bonds in this manner over the coming weeks. 

Picking Up Crumbs

Yes, this is all quite boring but we find ourselves in a very low return world and sometimes eking out just a small additional return can be worthwhile. 

I have purchased I Bonds in recent days and will be doing so again in early 2021 with the intent of using these bonds as part of my bond ladder. In my case, I will likely hold these bonds for five years in order to avoid the three month interest penalty for cashing out sooner than five years. The five year treasury note currently yields 0.37 percent and it is hard to see the Series I bond returning less than that between now and 2025. 

I am under no illusions that Series I bonds represent a good investment. They just seem to be the “least bad” alternative at the moment for funds that I plan to need within the next several years. For longer term commitments, owning well run businesses, either directly or via stocks, offers the prospect of better long term returns, but the key words here are “long term”. Anything can and will happen in equity markets over short periods of time. Having a bond ladder might be boring but it helps me sleep at night and prevents forced sales of stock at distressed prices.

Obviously, everyone has a different financial situation and these ideas may not make sense in your situation. As always, this isn’t tax or investment advice but hopefully the article was at least a little less boring than you thought it would be.

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Dear Readers,

Over the weekend, I spent some time revisiting Warren Buffett’s Ground Rules, a book that I reviewed in 2016. The purpose was to refresh my memory regarding Warren Buffett’s attitude toward taxes during the partnership years. His stated goal was not to minimize taxes but to maximize the rate of after-tax compounding, a very sensible proposition. It even seemed like a good idea for an article, but I had a sense of déjà vu and realized that I wrote about a very similar topic a few years ago. Since this was not an article distributed to subscribers at the time, I figured that I should do so now.

Rational thinking regarding taxes extends beyond the willingness to realized taxable gains when warranted. We should also explicitly understand that holdings with embedded unrealized capital gains cannot simply be added to our net worth without deducting deferred taxes. While companies must explicitly account for deferred tax liabilities on the balance sheet, few individuals do this. I have found that explicitly acknowledging that a portion of my appreciated securities do not belong to me allows for more rational thinking. Rather than feeling like I am incurring a large amount of taxes all at once, it feels more like extinguishing part of a balance sheet liability that has existed for some time. This can be an important psychological difference.

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The Irrational Tax Trap

Originally published on July 7, 2020

“Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.”

— Benjamin Franklin

Oliver Wendall Holmes famously said that “taxes are what we pay for a civilized society.” As a widely admired Supreme Court Justice, such words carried a great deal of weight for many citizens and his statement is frequently quoted to this day.

Holmes was not a mere virtue signaler when it came to the necessity of funding the government. He voluntarily paid a very high “tax rate” when he left his estate to the United States upon his death in 1935.

There is no doubt that Holmes was correct regarding the fact that some level of taxation is required for government to function and that some level of government is required for any large and complex civilization to flourish.

But the devil is in the details.

It might be possible to get over ninety percent of the people to agree that some level of taxation is necessary. But it is difficult to get even a bare majority to agree on the overall level of taxation that is appropriate to say nothing of which level of government — federal, state, or local — should be levying the tax. Even if you can achieve a consensus regarding the overall level of taxation and at what level to levy the tax, the question of who should pay the bulk of the taxes will be controversial.

Taxes are inherently emotional for many people and it is very easy to make serious errors in a state of mind that is not grounded in facts and reason. Those who generally disapprove of the size and scope of government are more likely to view taxes negatively and to seek ways to minimize their personal tax burden. However, even people who approve of a strong and forceful government rarely enjoy paying taxes themselves and will usually not pass up opportunities to reduce their payments. It is important to note that I am referring to legal methods of tax planning here rather than tax evasion.

Regardless of your views regarding the role of government, the level of taxation, or who should bear the brunt of the tax burden, it seems clear that viewing the subject of taxation in a rational manner is desirable. When it comes to making investment decisions, it is critical to keep the issue of taxes in mind but to not allow taxes to be the primary driver of decisions.

The old Wall Street quip that one should not let the “tax tail wag the investment dog” is worth keeping in mind because it is all too common for tax driven decision making to lead to serious errors in the long run. Taxes should be viewed as just one of many factors feeding into a coherent decision making process.

The Proof is in the Pudding

As an investor, are you making rational decisions when it comes to taxes?

Everyone obviously likes to think that they are rational, but it is quite likely that tax considerations have hurt your results over time. However, hindsight bias and a human tendency to remember triumphs while relegating errors to the deep recesses of memory makes it likely that we have forgotten cases where tax considerations hurt us.

So, forget about theory and take a look at your results.

If you are like many investors based in the United States, you probably have accounts that enjoy tax free or tax deferred status along with accounts that are fully subject to current income taxes. In my case, I have both traditional and Roth IRA accounts as well as my taxable investment account. Both the traditional and Roth IRA do not incur any current-year tax based on decisions to buy or sell securities, or decisions to invest in securities that pay dividends. The Roth IRA has the additional benefit of offering tax free distributions for people over the age of 59 1/2. My regular investment account has no such tax benefit. Dividends, interest, and capital gains taxes are due on an annual basis.

If my decision making is rational with respect to taxes, then it would follow that the pre-tax results of my IRA accounts and my regular taxable account should not be very different. However, to my surprise, a few years ago when I examined my returns based on the tax status of the account, I found that my IRA accounts had significantly outperformed my taxable account on a pre-tax basis! The difference was not insignificant and because my taxable account is significantly larger than my IRAs, the aggregate lag in dollar terms was very large.

A thorough examination of my transaction activity revealed that I was more likely to sell securities in my IRA accounts than in my taxable account. Although turnover in the IRA accounts was not particularly high, it was materially higher than in my taxable account. I was far more willing to take capital gains in my IRA accounts knowing that I could reinvest the full proceeds of the sale in a new investment without facing the prospect of paying the capital gains tax. As a result, when securities held within my IRA accounts approached my assessment of intrinsic value, I was more likely to at least trim back on the position or sell it entirely when more attractive opportunities existed for reinvestment.

In contrast, a review of my taxable account revealed that I would tend to hold securities in that account even as they approached or exceeded my assessment of intrinsic value. Make no mistake about it, a buy-and-hold approach is usually a good one provided that the companies in a portfolio are steadily growing intrinsic value over time. Owning a security that trades at intrinsic value, or even slightly above it, can be perfectly fine if the intrinsic value of the security is also growing at a nice clip. But the fact is that not all companies fall into this category and usually there are opportunities to reinvest capital in undervalued opportunities. The requirement to take advantage of such opportunities, when fully invested, is to sell a security that is trading at or above intrinsic value. But you have to be willing to do it even if it involves paying taxes.

The Lure of Tax Deferred Compounding

Let us step back for a minute to consider the power of tax deferred compounding and why the prospect of it lures so many investors into making poor decisions.

In a taxable account, a legitimate goal should be to hold securities that will successfully compound intrinsic value over long periods of time, preferably without paying out much in the way of taxable dividends. If you can find a company that can compound capital internally at an attractive rate, your results will be superior to what you would get if you had to identify a different company offering the same rate of return every year. In addition to not having to pay capital gains taxes until you eventually sell, holding a stock for a long period of time relieves the investor of making multiple decisions and the work required to do so successfully.

A simple example should illustrate this point. Investing in a company that can compound intrinsic value at 8 percent per year for twenty years will result in turning a $100,000 investment into over $466,000 prior to paying taxes. If the capital gains tax is 20 percent at the end of this period, the investor will be left with nearly $373,000 after paying the tax.

In contrast, if an investor must change companies every year to earn a 8 percent return, paying a 20 percent capital gains tax along the way, the effective rate of compounding is reduced from 8 percent to 6.4 percent. This investor’s initial $100,000 investment will turn into just under $346,000 at the end of twenty years. In this example, we assume that each of the twenty investments were held for at least one year to qualify for long term capital gains tax treatment. If the holding period was under a year, the lag would be worse.

So, identifying a “compounding machine” that allows for a twenty year holding period produces a difference in the ending balance of $27,000 which is not an insignificant sum relative to the initial $100,000 investment. However, the key caveat is that the single stock must be able to deliver performance over a long period of time. Additionally, the investor would have to forego opportunities to sell and reinvest in better opportunities along the way.

Have I Learned Anything?

In my case, the reason my IRA accounts outperformed my taxable accounts is because I stubbornly refused to sell securities in my taxable account that would incur current year capital gains taxes. I often held the same securities in my IRAs and did sell those shares in order to reinvest in more attractive opportunities. My refusal to pay capital gains taxes resulted in long term underperformance of my taxable account relative to what I know my investment skill was capable of producing, as shown in the results of my IRAs. I would have been far better off making identical decisions in my taxable account and my IRAs, paying the taxes, and reinvesting.

I conducted this analysis of my accounts a few years ago. Have I learned anything from my mistakes?

Apparently I have not learned much given my behavior early this year.

I had held shares of a company in both my IRA and taxable accounts since 2018 that appreciated sharply during the course of 2019. By February 2020, the shares traded materially above my assessment of intrinsic value. I sold the shares that were held in my IRA accounts and redeployed the funds. But in my taxable account, I stubbornly refused to sell more than a token number of shares because doing so would have resulted in a very steep capital gains tax and the loss of other tax benefits.

Fast forward to April 2020. The COVID-19 crisis not only brought the shares of the company in question down to earth, but the fundamental business conditions facing that company had deteriorated to the point where my intrinsic value estimate had declined significantly and the level of risk involved had increased. The range of potential outcomes for the business widened to the point where I was no longer comfortable that a reasonable margin of safety existed. I sold the shares in my taxable account. I still realized a gain on my sale but the large amount of outperformance relative to the S&P 500 that I would have locked in back in February was almost entirely given up. My IRA again outperformed my taxable account due to aversion to realizing taxable income.

Combatting Psychological Pitfalls

It is not possible to change the past and self-recriminations serve no useful purpose. However, we should always try to learn from past mistakes and avoid repeating these errors in the future. The irrational aversion to taxes is a problem facing many investors but perhaps there are ways to frame the problem in a way that is likely to lead to better decisions.

One approach is to reframe how we think about taxes. Those of us who believe that the government wastes a great deal of money are prone to dislike paying taxes because we believe that our money will be wasted. Rather than thinking about our tax money as going into a large void, however, we can reframe the situation. Let’s say that you have realized a $100,000 capital gain and now face a $20,000 federal tax as a result. Rather than framing that $20,000 as going into the government’s general fund, there is no reason that we cannot think of it as funding a specific relative’s social security or Medicare benefits for the year. Alternatively, you can pick any other program and think of your money as funding that program.

If that idea sounds naive, and it might be a stretch for many people to think of taxes in that way, consider a change to how you track your net worth. The reality is that when we refuse to sell an appreciated security to avoid paying current-year taxes, we are not avoiding the eventual tax on the gain. We are only deferring it. If a company, such as Berkshire Hathaway, holds appreciated securities, accounting statements are required to account for a deferred tax liability that recognizes the amount of tax that would be due on the security if the gain was realized immediately.

Individuals should be doing the same for their holdings and recognizing deferred tax liabilities. If you purchased a security years ago for $100,000 and today it is worth $1 million, I am sorry to tell you that you have a silent partner and that entire $1 million is not yours. You have a $900,000 capital gain. And your “partner”, Uncle Sam, “owns” about $180,000 of that $1 million position. You should be carrying a $180,000 deferred tax liability against that $1 million position.

From a mental accounting perspective, if you are carrying a deferred tax liability and thinking of your net worth net of that liability, you are far more likely to be willing to recognize the capital gain and actually pay the tax than if you pretend that the liability does not exist. It is easier from a psychological perspective and leads to more rational decision making outcomes.

Conclusion

Investors should attempt to find companies that are capable of compounding intrinsic value at satisfactory rates for long periods of time without paying taxable distributions to shareholders. Finding such companies, however, is difficult because it is rare for a company to be able to redeploy capital at a high incremental return on equity unless they have and maintain significant moats. Every investor is looking for companies with moats that will protect attractive returns from being competed away. So the valuation of companies that have obvious reinvestment opportunities tends to be high.

If we take Warren Buffett’s approach to heart and view owning shares of a company as owning an interest in the underlying business, we should not have a hair trigger when it comes to selling. The instinct to buy and hold securities of great companies is a good one, but we need to face up to the fact that holding even a great business through periods of significant overvaluation can result in unsatisfactory returns.

When a company gets significantly overvalued, it makes sense to take profits if there are other opportunities that offer brighter prospects going forward. Even Warren Buffett expressed regret in his 2004 letter to shareholders regarding his decision to not sell shares of stock he considered overvalued during the bubble years of the late 1990s.

Those of us who have made serious errors related to irrational tax aversion can take some comfort in knowing that the greatest investor of the past seventy years has grappled with the same problem.

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Nothing in this article constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC.  

Your privacy is taken very seriously. No email addresses or any other subscriber information is ever sold or provided to third parties. If you choose to unsubscribe at any time, you will no longer receive any further communications of any kind.

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Our lives are brief and transitory and our most precious resource is our limited time. Wealth can purchase many things, including better health and longevity, but no millionaire or billionaire has yet been able to purchase immortality. However, what wealth can do is to provide us with control over how we spend our limited time by relieving us of having to trade our time for income unless we choose to do so for non-monetary reasons.

The goal of financial independence is best viewed as a means to an end rather than an end in itself. Simply defined, financial independence is achieved when a person can generate a stream of cash flows from accumulated assets that exceeds his or her spending needs. It is easy to see that there are two sides to this equation and that there is no specific “magic number” that translates into independence for everyone. The level of wealth that implies independence for a person of modest needs could be $1 million or less while a person of very expensive tastes could require tens of millions of dollars and still not find it to be enough.

If you ask most Americans how much they need in order to achieve financial independence, the response will almost always be given in terms of the level of wealth that they aspire to accumulate. However, thinking about the problem in this manner has a number of deficiencies. The primary issue is that it is not the level of wealth that matters as much as the cash flow that can be safely drawn from that wealth every year.

When aiming to achieve a goal, it is important to focus on what the goal actually is, and that goal is not being able to look at a net worth figure but to fund expenses and to be relieved of having to trade precious time for income.

In Where Are the Customers’ Yachts, which I reviewed last month, Fred Schwed makes an interesting observation regarding the difference between American and British attitudes regarding wealth:

Have you ever noticed that when you ask a Britisher about a man’s wealth you get an answer quite different from that an American gives you? The American says, “I wouldn’t be surprised if he’s worth close to a million dollars.” The Englishman says, “I fancy he has five thousand pounds a year.” The Englishman’s habitual way of speaking and thinking about wealth is of course much closer to the nub of the matter. A man’s true wealth is his income, not his bank balance.

WHERE ARE THE CUSTOMERS’ YACHTS, P. 149-150

I find the British manner of thinking about wealth much more satisfactory for several reasons that are worth exploring in greater depth.

Focus on Spending

The simple fact is that financial independence is more attainable for someone with modest needs who avoids the ratcheting lifestyle trap. Especially during the early years of accumulating capital, the most important factor facing a younger person is how quickly to ramp up spending as his or her income increases. The standard approach taken by almost everyone is to consume the vast majority of income and to increase spending as income increases.

Most personal finance articles urge people to save a certain percentage of their income. In recent decades, personal savings has been pitifully low and rarely has approached ten percent.2 Generally, saving 10-20 percent of income is considered a healthy level. The problem is that this implies a consumption rate of 80-90 percent of income and also implies that it is acceptable to increase consumption as income rises. This is not a path to financial independence.

A few years ago, I wrote an article proposing that a married couple earning $100,000 per year could theoretically achieve financial independence within fifteen years starting with no savings at all. What was the catch? The after-tax savings rate for the couple would need to be around 55 percent, which is obviously far in excess of what is considered normal. What about a 10 percent savings rate? The couple would not be anywhere close to financial independence even after thirty years!

Obviously, the amount saved at a 10 percent savings rate will be far lower but the other side of the equation is that the level of spending the couple needs to replace is much higher. The gulf between spending and passive income is simply too large to overcome.

Avoid Fixed Magic Numbers

Let’s say that a person decides that he needs $2 million to be financially independent based on his desire to spend $60,000 per year and his belief that drawing down 3 percent of his portfolio annually can be done safely on a long term basis. Should he mentally anchor to the $2 million or to the $60,000?

Anchoring to the fixed $2 million number is not helpful for a number of reasons. Perhaps most importantly, the $60,000 income requirement will not remain static over time simply due to the rising cost of living. The Federal Reserve has explicitly stated that their inflation target is 2 percent and it is certainly possible that inflation will run much higher than that over time. Ten years from now, the income requirement will be over $73,000 to maintain the same purchasing power as $60,000 today assuming that inflation runs at 2 percent.

The prospect for returns on financial assets also changes over time. For a long time, many financial advisors advocated a “4 percent rule” — that is, conventional wisdom was that an investor could draw down 4 percent of a balanced portfolio of stocks and fixed income securities indefinitely without having to worry about running out of money. With interest rates on fixed income securities plummeting in recent years and stock valuations at elevated levels, it may no longer be conservative to draw more than 3 percent per year. This may change in the future. If a safe withdrawal level returns to 4 percent in the future, the investor may need less than the $2 million number. If the safe withdrawal level declines to 2 percent, on the other hand, more than $2 million will be required.

Sustaining the Long Term Effort

Going back to the couple earning $100,000, the pursuit of financial independence over fifteen years would be a long term effort and maintaining a very high savings rate for a long period of time is not psychologically easy. There is a risk that as the couple’s portfolio value increases past various milestones, they will feel “wealthy” and be tempted to increase spending.

During the accumulation phase, it is very helpful to not think in terms of net worth milestones. For example, reaching the six figure savings milestone is a major event for most people. $100,000 still represents a very significant amount of money and, while it isn’t a huge amount of wealth, it can make someone feel relatively well off.

Instead of thinking of having $100,000, the couple should instead think of having $3,000 of untapped passive income potential, assuming that they are targeting a 3 percent withdrawal rate. Viewed in this way, the $100,000 is really not a huge amount relative to the income needs that the couple aspires to fund. They are still at an early stage of their accumulation phase.

Rather than going out and buying a $40,000 car, the couple might instead spend $100 on a nice dinner to celebrate the milestone and keep focusing on the long term target of financial independence.

Conclusion

Money can be an emotional topic full of psychological pitfalls. Much of the battle when it comes to achieving financial independence is really an adult version of the famous “marshmallow test” in which children are given the choice of consuming one marshmallow immediately or waiting a short period to be able to consume two marshmallows.

There are some people who are relatively immune to the impulse of ratcheting up their spending as income increases but most people will succumb to the temptation. A check on that temptation will exist if we think about financial independence in terms of being able to generate an adequate passive income sufficient to fund the spending that we are accustomed to.

The fact is that a person who ratchets up his or her lifestyle and goes from needing $50,000 to $100,000 per year has dramatically lengthened the time required to achieve financial independence. This is not to say that all spending is ill advised or unjustified. We should just be sure that when we ratchet up our spending, we fully understand the implications of financial independence being further out on the horizon as a result.

Copyright, Disclosures, and Privacy Information

Nothing in this article constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC.  

Your privacy is taken very seriously. No email addresses or any other subscriber information is ever sold or provided to third parties. If you choose to unsubscribe at any time, you will no longer receive any further communications of any kind.

The Rational Walk is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.

Living on the Edge

According to a recent report, 66 million Americans have absolutely no savings available to cover a financial emergency.  This shocking figure is nearly one-third of the roughly 206 million Americans between the ages of 15 and 64 which makes up the age group most likely to lack a safety net to deal with emergencies.  A survey published by Standard & Poor’s revealed that only 57 percent of Americans are financially literate.  Although it isn’t a good idea to unfairly stereotype individuals in large groups, it seems very likely that the Americans lacking savings also have a general lack of understanding of basic personal finance.

Why is this the case and what can be done about it?

One of the problems is that human beings do not seem to naturally understand non-linear systems, and this deficiency prevents us from automatically understanding what is perhaps the most important topic in personal finance:  compound interest.

Here is one of the questions asked in the financial literacy survey:

Suppose you had $100 in a savings account and the bank adds 10% per year to the account. How much money would you have in the account after five years if you did not remove any money from the account: more than $150, exactly $150 or less than $150?

It is likely that most people would understand that 10 percent of $100 is $10 which represents the first year of interest.  The account will be open for five years, so many people will be tempted to simply multiply the $10 by 5 and come up with $50 in total interest which is added to the initial $100 balance for a total of $150.  However, this ignores the fact that you earn interest on interest which is the essence of compounding.  Assuming annual compounding, the balance of the account would look like this over the five year span:

A simple formula can be used to determine the ending result of a sum invested at a certain rate over a certain period of time:

Ending Balance = Starting Balance * (1 + Periodic Interest Rate) ^ Number of Periods

The formula can be applied to this example as follows:

$161.05 = $100 * (1 + 0.1) ^ 5

Compound interest is an example of an exponential equation and the results do not neatly fit our natural intuitions.  It is much more intuitive to think that the $100 deposit will earn $50 over five years than to figure out the actual result which is significantly more than $50.  However, it is important to realize that this particular exponential function is very simple and should be understandable to the vast majority of people if explained clearly as part of a basic education.

The Longer View

To make the effect of compound interest more clear, let’s extend the period of time that the $100 is kept on deposit at a rate of 10%.  Rather than assuming five years, let’s assume that the money is left alone for fifty years instead.  If we apply the same “gut instinct” (but incorrect) logic that would have led someone to believe that the $100 deposit would only earn $50 over five years to this longer example, the answer would be that the fifty year deposit should earn a total of $500, which is 50 years multiplied by $10 per year.

Let’s see what the correct result is:

Ending Balance = Starting Balance * (1 + Periodic Interest Rate) ^ Number of Periods

This formula can be applied to this example as follows:

$11,739.09= $100 * (1 + 0.1) ^ 50

Instead of earning the $500 that “gut instinct” might have led us to believe, the $100 deposit earns a shocking $11,639.09 in interest!

This unintuitive result is due to the exponential nature of compound interest, as we can see from the graph below:

We can see that progress is slow at first, which we already knew based on the first five years of the investment.  However, over time, earning interest on interest becomes the driving force behind the overall value of the account and we can really see the line start to explode upward over the second twenty-five year period.

What Applies to Savings Also Applies to Debt

How many people truly understand the horrible compounding effects of credit card debt?  Although paying 15 to 20 percent interest on a $1,000 sofa might seem like an annoyance over the first year, making minimum monthly payments while taking on additional debt will cause the problem to snowball over time in just the same way that savings multiplied like crazy in the previous example.  Actually, the snowball will be much worse. Compounding at 15 to 20 percent results in a much, much larger snowball than compounding at 10 percent.

Although credit card disclosure requirements have improved over the past several years and people are now clearly told how long it will take to retire debt based on minimum monthly payments, few people are going to pay much attention to the details on a credit card statement or stop using the credit card while paying it down.

Low Interest Rates Make Compounding Less Obvious

The example in the survey uses a rate of 10 percent for a savings account which is obviously unrealistic in today’s world of minuscule savings rates.  However, low interest rates are probably not going to be a permanent phenomenon over the long run.  The problem is that people have been trained to not appreciate the power of compound interest over the past several years because it is even less apparent than it otherwise would be.

Using a rate of 1 percent, which one would have been fortunate to get on a savings account over the past several years, the $100 deposit would have grown to only $105.10 over five years.  In this case, the “intuitive” answer of believing that the total interest would be only $5 is hardly different from the correct answer of $5.10.  In fact, it is so trivial that if we used the 1 percent rate in an example, people would laugh if we tried to claim that compound interest is actually important!

Multi-Disciplinary Education

Financial education is severely lacking in the United States and the fact that over half of Americans lack basic financial literacy is a national disgrace.  The place to remedy the problem has to be the public school system.  Ideally, parents would educate their children on personal finance but too many adults are financially illiterate themselves and we do not want to have a society where this perpetuates through multiple generations.

It should not be difficult to incorporate an appreciation for compound interest into the public school system.  Basic exponential functions are routinely taught at the middle school level and, if not, certainly as part of a high school curriculum.  Rather than using esoteric examples that students might not relate to, teachers could incorporate compound interest directly into basic math education covering exponential functions.

But is it the job of math teachers to cover personal finance?  The better question is why not?

There need not be a special course in personal finance (although such an offering has obvious merits as well).  Disciplines like mathematics should incorporate subject matter from other disciplines, particularly when doing so reinforces the math that is being taught.  All young people are concerned with having enough money to spend.  They might be too impulsive to care about long term growth of savings, but if they are at least aware of the potential of compound interest, that might prevent the accumulation of unwise debt in college or when starting out in the workforce.

Parents who are fully aware of the power of compound interest might try bypassing today’s low interest rate environment by setting up a family “bank” where their children can make “deposits” at rates that are far above market and possibly compound at a more frequent pace.  For example, parents could offer their children an “account” that compounds at a rate of 5 percent every quarter.  At that rate, a $100 deposit would grow to almost $150 over two years, well within the time frame that a teenager should appreciate.

Not a Panacea, But a Start

Even if every American left high school with a solid understanding of compound interest, we will still have people who fail to save because they lack self-control or fall into really hard times through no fault of their own.  However, it is hard to believe that wide dissemination of this very basic principle would not dramatically reduce human misery.  Not being able to cover the cost of a broken refrigerator, a tire blow-out, or a traffic ticket should be preventable for almost everyone.

There are enough truly difficult problems in life that do not lend themselves to simple solutions, so we should adopt simple ideas that have little or no downside such as teaching students about compound interest as part of their existing math programs.  It might be overly optimistic to hope that all Americans will automatically think in terms of exponential functions rather than using their linear intuitions in everyday life.  But when faced with major life decisions, the default should be to think in terms of compound interest when it comes to spending and saving money.

This is the fundamental question that everyone must eventually answer in the context of their own “retirement”.  I put “retirement” in quotes because what we are really talking about is not necessarily retirement in the conventional sense. Instead, the goal might be better stated as attaining the level of financial independence that is needed to make a regular paycheck optional.  You might like your job and have great relations with your boss today, but that could always change tomorrow or next month.  A recession could result in layoffs and you might find yourself involuntarily out of work.  Illness has been the cause of many premature exits from the workforce.

At what point are you immune from having to worry about drawing a paycheck?

Nassim Nicholas Taleb should be credited with the concept of “F*** You Money” that he developed in The Black Swan and has elaborated on numerous times since the book was published.  To state the obvious, not everyone works for a pointy-headed boss and hates their job as much as Dilbert and Wally, and plenty of people actually love their job and enjoy the people they work with.  Whether or not you like the language used by Scott Adams, Nassim Taleb, or John Goodman, the point is obvious:  When can you declare independence from paid employment if you choose to do so?

At the risk of stating the obvious, there are two major factors that we need to look at:

1. How much money is needed to fund your lifestyle every year?  The answer is not as simple as looking at what you are currently spending every year.  There will almost certainly be expenses related to work that will entirely disappear from your budget if you choose to leave paid employment.  You will no longer have to commute to work so the cost of driving or public transit will disappear.  Maybe you can even give up your car entirely.  It will be unnecessary to purchase clothing specifically for work.  If you aren’t packing a lunch for work almost every day, you are probably spending a lot of money on eating out and that could be eliminated as well.  This list isn’t exhaustive.  On the other side of the equation, you will incur new expenses in “retirement” such as the cost of health insurance, which is likely to be the largest new big ticket item.  Also, you will have more time to travel and pursue recreational activities.  You could very well end up spending more money in “retirement”!

2. How much money have you saved?  This is obviously simpler to answer but I don’t think that it can be distilled into a single number.  Most importantly, it is critical to differentiate between assets that are accessible and assets that are locked up for an extended period of time.  If you are 40 years old and contemplating giving up your paycheck, what matters for the foreseeable future is the amount of liquid assets that you have in non-retirement accounts.  You do not want to even contemplate touching retirement funds in a 401(k) or IRA because early withdrawal penalties are significant for anyone who is younger than 59 1/2 years of age.  You also do not want to consider any form of home equity as a source of liquidity unless you are planning to downsize to a smaller home in retirement.

If you read enough personal finance articles, you probably have already come across discussions of “safe withdrawal levels”.  The idea of a safe withdrawal level is to calculate the amount of money that can be withdrawn from an investment portfolio on an inflation adjusted basis over a specific period of time without running a significant risk of depleting all of your assets.  There are usually a number of embedded assumptions that are made in studies of safe withdrawal levels, such as the percentage of assets invested in stocks versus bonds and whether the stocks are invested in an index fund.  Typically, safe withdrawal levels are contingent upon a certain stock/bond mix and broad diversification of a portfolio.

The Four Percent Rule

Over the past two decades, the idea of the “Four Percent Rule” has spread quite widely.  The idea is that one can withdraw four percent of an investment portfolio in the first year of retirement and subsequently withdraw the same amount adjusted for inflation every year.  The inverse of the four percent rule is that one needs to have savings equivalent to 25 times annual spending requirements in order to safely retire.  So, if you have calculated that you need to have $50,000 available for spending in the first year of retirement, you would need to have an investment portfolio of $1,250,000 to support that level of withdrawal in a “safe” manner.

When I first started thinking about the concept of early “retirement”, I spent quite a bit of time researching the topic of safe withdrawal rates and came upon a study that went quite a bit deeper than the four percent rule.  I am not going to link to the study because it has not been updated since 2001 and generated some subsequent controversy regarding the methodology that was used.  However, at the time it was the most comprehensive look at safe withdrawal levels that I had come across.  The study looked at financial market returns from 1871 to 2000 and projected the safe withdrawal level for various payout periods based on past history.  A reader could pick their projected payout period and find the optimal mix of stocks versus bonds that would generate a “100% safe” withdrawal level.

The payout periods ranged from ten years, which would only be appropriate for someone who is either already very old or in poor health, to sixty years which was more appropriate in my situation since I was in my thirties at the time.  I found that the safe withdrawal rate for a sixty year payout was 3.24 percent with a 85%/15% split between stocks and bonds.

The study examined 70 periods from 1871 to 2000 in order to come to the conclusion that a 3.24 percent withdrawal level could be safely sustained for sixty years, with withdrawals rising each year with inflation.  In the vast majority of cases, there would be a very substantial portfolio left at the end of the sixty years. In fact, the median result was that every $1,000 of value in the initial portfolio would end up being worth nearly $43,000 after 60 years assuming a yearly withdrawal of 3.24 percent of the initial portfolio rising each year with inflation.  The worst possible result was that the portfolio would be effectively depleted.

But the main problem with safe withdrawal level studies is that they are backward looking.

It is a major logical fallacy to assume that the next sixty years will look like the period that spanned 1871 to 2000, or anything like it at all!  This is obvious, but it is tempting to look at an overly precise number like “3.24 percent” and assign it with more certainty than it deserves.

No one has any idea what the future will bring or what investment returns will look like, but if we want to make any kind of estimate regarding financial independence, we have no choice but to at least try.  This exercise calls for a great deal of conservatism.  I am not comfortable with the four percent rule, and not really comfortable with the 3.24 percent figure that came out of the study.  Part of this is because of the fact that interest rates have been at an unusually depressed level in recent years.  In addition, the level of the stock market implies an “earnings yield” that is below average.  In a world of savings deposits earning next to nothing, a ten year treasury note yielding just 2.7 percent, and stocks trading at high valuations relative to the past, is it really conservative to look at a four percent withdrawal rate as a sure thing?  Would you bet your financial future on it?

The Three Percent Rule

I am not going to propose any specific rule for readers to follow, but I will say that I am comfortable with a three percent withdrawal rate and that is the rate that I initially used when considering my own financial independence, although my present withdrawal rate is far lower.  This rule implies that you would need to save a little bit over 33 years of annual expenses in order to consider yourself financially independent.  That’s obviously more than the 25 years that is implied by the four percent rule, but it is much more conservative.

Many people would criticize this approach as far too conservative, but is that such a bad thing?  Sure, you might have to save for a longer period of time to achieve independence, but once you do, the level of stress over withdrawal rates will be much lower.  Also, I’ve read criticism of low withdrawal rates along the lines of ending up with “too much” savings at the end of the withdrawal period.  This line of criticism is based on the idea that something big is being given up by under-spending for many years and that ending up with a large account balance in old age is a negative.  I think this is somewhat absurd for a number of reasons.  First, old age involves facing vicissitudes that younger people might not think of, especially when it comes to nursing care.  Having a pile of cash available to make life comfortable would hardly be unwelcome.  Second, most people want to leave some kind of legacy to family members and providing financial security to others in old age is hardly a negative.  Finally, you can always give away money.  There’s value in generosity and the knowledge that one’s savings can generate benefits beyond personal consumption.

The Bottom Line

The subject of safe withdrawal levels has not been a personal concern for quite some time as the level of my annual spending has declined well below any plausible “danger zone” as a percentage of my available investment assets.  I would suggest that using a three percent initial withdrawal level is far more reasonable than the much more commonly advocated four percent level and this would imply setting a target of about 33 times annual expenses as a goal for financial independence.

The other factor that should be noted here is that the lower your annual spending requirements, the sooner you can reach financial independence.  Perhaps that is obvious, but it might not be widely understood.  Too many people think about financial independence in terms of replicating their current income in retirement.  This is the wrong way to look at it.  For example, let’s say that you earn $150,000 per year but are only consuming $40,000 per year, which you expect to remain relatively constant in retirement.  You do not need to replicate a $150,000 income in retirement.  You only need to ensure that you can safely withdraw $40,000 per year from your portfolio, and that you can increase this figure each year at the rate of inflation.  Using a three percent rule, this would imply a required portfolio of a little over $1.3 million, which is less than nine times your current $150,000 annual income.

Obviously, no one want to live some horribly restrictive lifestyle either while employed or in retirement, but what is “horribly restrictive” for one person might represent luxurious living for another. Even for those who enjoy their paid employment and plan to continue working for others for decades could benefit greatly from financial independence and the peace of mind that makes work optional.

In late 2017, you probably feel pretty good about it if you have diligently saved over the years and participated in the long bull market that has propelled financial assets upward since the end of the 2008-09 financial crisis.

Now take the balance and divide it by two.  Actually write it down on a piece of paper.  Suppose that a year from now, this will be the new value of your portfolio.  How do you feel now?

For nearly everyone, the answer is obvious.  You will probably feel rotten and suffer from a sense of loss and regret.  Why didn’t you see it coming and take actions to prevent the damage!  These are natural gut-level reactions to a sudden shock.

But are you in a state of panic as well?

Individuals will react differently to market fluctuations and it is impossible to predict how someone will react until faced with adversity.  Establishing a portfolio “on paper” and pretending that it has declined is completely useless when it comes to understanding your own psychology.  Even reading about psychology is not adequate preparation.  Some things must be directly experienced to be understood.

Know Yourself

For those of us who have experienced financial market declines, it is possible to have a direct understanding of how we would react to a severe correction in security prices.  The most recent period of sustained declines was, of course, the 2008-09 financial crisis.  To say that this period was stressful would be an understatement but two factors kept me from descending into a state of panic and “selling everything” at depressed prices.  First and most importantly, I had a significant reserve of cash and would not be in a position to need to sell securities in order to fund expenses for several years.  Second, as a full time investor, I was excited about the opportunity to deploy funds in stocks that were trading at very depressed valuations.  I also understood what I owned and had a sense of the value of these businesses independent from momentary changes in stock prices.

The situation would have been far different if I had been in the position of needing to liquidate stocks in order to fund expenses the next month.  In such a situation, anyone would probably go into a state of panic and sell at any price in order to ensure that enough money was available to pay the ongoing expenses of daily life including housing, food, utilities, and so on.

For those of us who rely on investment returns to fund ongoing expenses, it is vital for our mental and financial health to have a strategy in place that does not subject the need for ongoing cash flow to the vagaries of short term financial market fluctuations.  This article covers strategies that will help to ensure adequate cash flow and prevent panic in the event of a financial market meltdown.

The Three Percent Rule

Let’s take a step back and consider how much of a portfolio can be safely tapped for income each year.  In a previous article, I outlined a number of concepts related to financial independence and suggested that one should be very conservative when drawing down a portfolio in today’s environment.  For many years, it was conventional wisdom that one could withdraw about four percent of a portfolio’s value and be confident in not running out of money.  However, this advice was formulated at a time when interest rates were at higher levels and it was easy to purchase high quality bonds with nominal yields in the mid-single digits.  With the ten year treasury note yielding around 2.5 percent as of December 2017 and the Federal Reserve dead set on devaluing the U.S. dollar by 2 percent per year, there are scant returns to be found in the safest investment choices.  In addition, stock valuations are historically high as one can see from the Shiller PE ratio in the chart below:

No one can accurately predict stock prices or interest rates over the next year, despite the many charlatans who claim to be able to do so.  However, it is quite apparent that today’s environment is one in which caution should be exercised especially when it comes to decisions that could prematurely deplete an investment portfolio.  For this reason, I would be hesitant to deplete a portfolio by four percent per year.  Even three percent might be considered a little too aggressive but by choosing a withdrawal rate that is far too low, it is possible that you may not enjoy the fruits of your work and savings sufficiently.  Running out of money is a major risk but so is living so far below your means that you forego things that you want to do for no good reason.

The Financial Flu Shot

The question of how to construct your portfolio during retirement is important but can be complex.  The proportion of assets invested in various asset classes, such as stocks, bonds, and real estate, will drive the majority of returns for most investors.  The decision regarding whether one should invest in broad based index funds, in funds run by managers seeking better than average returns, or through direct investment in securities will also have a major impact on results.

Rather than discussing overall investment strategies for retirement, I would like to emphasize the need to “immunize” yourself against the psychological perils associated with fluctuating financial markets.  The price of longer term financial assets, such as stocks and longer term bonds, can move around a great deal in short periods of time.  It can be more than mildly disconcerting for most people to watch these types of fluctuations.  More accurately, people do not mind upward fluctuations in price but become concerned and can even panic when fluctuations are negative, as they inevitably will be from time to time.

What is needed is the equivalent of a financial flu shot.  Like an annual shot to help prevent influenza, a financial flu shot may not be 100 percent effective but can go a long way toward limiting risk.

Essentially, a financial flu shot requires an investor to ensure that a significant amount of money is held in assets not subject to significant market price fluctuations.

These funds will likely earn only small returns but will prevent the individual from entering a state of panic if his or her other assets decline in price.  Some people may panic anyway and act irrationally, such as selling all stocks after a steep market decline, but for most people, having a significant amount of solid assets that do not fluctuate greatly in price will have a calming effect.

Using Bond Ladders

Over long periods of time, investing in high quality businesses via the stock market will almost always exceed returns available from investing in high quality bonds.  However, in the short run, bonds are a more reliable option for those seeking regular income.  A “bond ladder” involves purchasing bonds at maturity dates that coincide with a need for funds.  In the context of retirement, an individual might decide to establish a ladder consisting of equal amounts maturing 1, 2, 3, 4, and 5 years from now.  This five year ladder will ensure that funds are available when they are needed, assuming of course that the bond issuer does not default.  The risk of default can be effectively eliminated by using only United States Treasury obligations.

Let’s say that an individual requires $40,000 per year in cash flow to consider herself financially independent and has accumulated a portfolio of $1,350,000.  This implies a withdrawal rate of just under 3 percent (40,000/1,350,000).  Establishing a five year bond ladder would involve buying bonds with the following maturity profile:

This also assumes that approximately $40,000 in cash is available to fund expenses between now and the maturity of the first bond a year from now, in January 2019.  By having this portfolio of bonds that are solely dedicated to funding expenses for the following year, there is no rational reason to panic if longer term assets, such as stocks, suffer a major decline.  One can rest easy knowing that funds will be available in due course to pay for ongoing expenses for up to half a decade.

Of course, holding $40,000 in cash plus $200,000 in the bond ladder comes at a cost.  These funds are no longer available for longer term growth and will likely earn very low returns.  But is this a major problem?  In the context of a $1,350,000 portfolio, holding $240,000 in low return assets is less than 18 percent of the overall portfolio.  This leaves 82 percent to be invested in assets that could potentially earn higher returns over the long run, although at the risk of potentially suffering short term declines in value.

A bond ladder is easy to maintain over time.  The only task is that every year a new five year bond must be purchased to replace the one that is maturing.  In January 2019, a bond will mature and will be used to fund ongoing cash expenses in 2019.  However, if a new bond is not purchased, what is now a five year bond ladder will become a four year ladder.  The fifth year of the ladder must be replenished by purchasing a new five year bond.  Unless security prices are massively depressed (such as in early 2009), the task is to simply liquidate $40,000 worth of securities and purchase a new five year bond.  However, the individual does not need to do so immediately if markets are in the midst of a panic driven sell off.  In such a case, it would be acceptable to simply wait because there are still four years of cash expenses available in the ladder. Obviously, this cannot be taken too far because eventually the four year ladder will shrink to three, then two, and then one year if it is never replenished but the point is that a five year ladder leaves quite a bit of room for intelligent action if markets have declined temporarily.

Selecting Bonds for the Ladder

Assuming that the concept of a five year bond ladder makes sense, the next question is what bonds to select for the ladder.  My view is that this part of an investor’s portfolio should not attempt to do anything heroic in terms of squeezing out a small amount of additional returns.  Safety should be paramount and that means using United States Treasury securities to build the ladder.  Despite occasional reports of government shutdowns and potential debt defaults, the reality is that the federal government is not going to default on its debt.  The U.S. dollar is a fiat currency that also serves as the world’s most important reserve currency.  A sovereign state that controls the supply of its own currency is not likely to default on its debt, although inflation could very well be a concern.  For our purposes, we can consider treasury obligations to be “risk free” in terms of risk of default.

Treasury Notes

The next question involves what type of U.S. Treasury obligations to use for the ladder.  The most straight forward option involves using treasury notes.  The U.S. Treasury holds weekly auctions for a variety of treasury bills, notes, and bonds.  These instruments can be purchased by anyone at auction either through Treasury Direct or any discount or full service brokerage.  Using Treasury Direct is free of charge and could be a good option for many people. However, large brokerages such as Fidelity and Vanguard offer clients the ability to participate in treasury auctions at no charge.  For those who have existing brokerage accounts, it is worth checking whether it is possible to purchase treasuries at auction with no commissions. Although the design of a bond ladder assumes that bonds will be held to maturity, the ability to easily sell bonds through a brokerage is a distinct advantage.  Treasury Direct no longer facilitates the sale of treasuries.

The Treasury publishes a listing of upcoming auctions.  Let’s take a look at the auctions that are coming up for the month of January 2018:

From this schedule, we can see that it is possible to purchase the following securities for four of the steps of the ladder:

• Purchase $40,000 of the 52 week Treasury Bill at auction on January 30.

• Purchase $40,000 of the 2 year Treasury Note at auction on January 23.

• Purchase $40,000 of the 3 year Treasury Note at auction on January 9.

• Purchase $40,000 of the 5 year Treasury Note at auction on January 24.

We are missing a four year note because the Treasury does not directly offer four year notes.  However, one can easily purchase a Treasury Note with four years left until maturity by purchasing in the secondary market (that is, from another investor).  Treasury notes are extremely liquid securities and there is a large secondary market.

What are the yields one can expect by investing in this ladder?  The Treasury publishes what is known as a “yield curve” at the close of trading every day.  The exhibit below shows the yield for various maturities over the course of December 2017:

If rates are approximately the same as they are today when the securities in the ladder are purchased in January, one can expect to earn from 1.75 percent on the 52 week Treasury Bill to 2.25 percent on the five year Treasury Note.  During normal conditions, the longer a bond’s maturity, the greater the yield will be.  In today’s low rate environment, these yields will barely cover expected annual inflation.  The Federal Reserve has a stated goal to devalue the U.S. dollar by 2 percent annually.  If we’re very lucky, the pre-tax yield from the bond ladder will just cover inflation.

A few words on mechanics:  Treasury bills are purchased at a discount to par value of 100.  If current rates hold, the $40,000 52 week bill will cost the investor around $39,300 when it is purchased at auction.  It will mature one year later at $40,000 with the $700 difference representing the interest.  The 2, 3, 4, and 5 year Treasury Notes pay interest semi-annually.  Taking the three year note as an example, one would pay close to $40,000 at the auction and receive payment of approximately $400 twice a year.  Note that these funds should not be spent but kept in cash or a short term Treasury Bill since the funds barely make up for inflation.  The $40,000 drawdown in Year 5 will really need to be somewhat more than $44,000 in 2023 dollars if the Federal Reserve keeps its promise to devalue the currency by 2 percent annually.

Treasury Inflation Protected Securities

The U.S. Treasury has been offering Treasury Inflation Protected Securities (TIPS) for over two decades.  The purpose of these securities is to generate a “real return” – that is, a return in excess of whatever inflation proves to be over the term of the security.  However, do not get too excited.  The real yields are very small as shown in the real yield curve table below:

We can see that the real yields range from just under 0.5 percent all the way up to a whopping 0.83 percent.  Real yields have been depressed in recent years, as The Wall Street Journal noted in a recent article.  Before the financial crisis, real yields on longer term TIPS were often in the 2 percent range.  On the bright side, at least real yields are in positive territory again after dipping below 0 percent earlier this decade.  The chart below, from the Wall Street Journal’s article, shows how low real yields are today:

The mechanics of building a bond ladder using TIPS is slightly more complicated than using regular Treasury Notes because the shortest term TIPS is five years.  One can build a TIPS ladder in the secondary market (buying from other investors) at any time or slowly over time by using regular Treasury Notes initially but purchasing a 5 year TIPS at auction every subsequent year.  Eventually this will result in TIPS with remaining maturity of 1, 2, 3, 4, and 5 years but it will take four years to get there.

The mechanics of TIPS work differently from regular Treasury Notes.  The U.S. Treasury’s full explanation is required reading for anyone seriously considering these securities.  The short version is that returns from TIPS are provided in two “buckets”.  First, one receives interest payments based on the “real” yield – these are the yields shown in the table above.  Second, the value of the TIPS principal is adjusted periodically based on fluctuations in inflation.  

When the note matures, you will receive the principal adjusted for reported inflation.  One catch is that investors holding TIPS in taxable accounts must pay annual income taxes on both the actual cash received from interest payments and increases in the value of the TIPS due to inflation.  In other words, you will be required to pay tax on cash that you will not see until the TIPS actually matures.  This is probably only a minor annoyance for most investors and a non-issue for those holding TIPS inside a tax deferred account such as an IRA.

Regular Treasury Notes vs TIPS

Should you use regular Treasury Notes or TIPS to form your bond ladder?  The question boils down to inflation expectations.  Ignoring tax issues, if you purchase a five year TIPS with a real yield of 0.5 percent instead of a regular 5 year Treasury Note yielding 2.25 percent, you are implicitly saying that you expect inflation to exceed 1.75 percent.  If inflation stays below 1.75 percent over the next five years, you would have done better by purchasing a regular Treasury Note.  If inflation exceeds 1.75 percent, the TIPS will be the better choice.  Remember that the Federal Reserve has a stated goal of causing inflation of 2 percent annually.  Clearly the market does not believe that the Fed will achieve this goal, but remember that the Fed directly controls short term interest rates and the money supply.  “If there’s a will, there’s a way” comes to mind.

My view is that taking the inflation protection offered by TIPS is worth the slightly more difficult process of building a five year bond ladder and dealing with the tax quirks.  Remember that the goal of the bond ladder is to supply yourself with cash for ongoing expenses for the next five years.  What you should care about is purchasing power.  As long as the TIPS offer some real yield (above 0 percent), at least in theory the $40,000 our fictional investor puts into a 5 year TIPS today should hold its purchasing power when the note matures in 2023.  There are all sorts of reasons to doubt official inflation statistics, but that’s beyond the scope of this article and there isn’t much an investor building a bond ladder can do about it.  If you insist on total safety, you simply have to choose between Treasury Notes and TIPS.

Price Fluctuations

Treasury Notes are not immune from price fluctuations but these should be steadfastly ignored by an investor who is using these instruments to build a bond ladder.  The only thing the investor should care about is that the note will mature and pay 100 cents on the dollar at maturity.  If interest rates suddenly shoot up between now and when the note matures, the market value of the note will temporarily decline.  However, it will still pay out 100 cents on the dollar at maturity.  By investing in TIPS rather than regular Treasury Notes, the investor would also gain some level of protection if interest rates jumped up due to much higher than anticipated inflation.  My recommendation is to not even check the market value of the bond ladder.  Simply ignore all price fluctuations.

This Is Too Complicated!

Although setting up the ladder might seem a little complicated, it is important to note that once it is set up, there is only one step that needs to be taken annually:  purchase a new five year Treasury Note (or TIPS) using the proceeds from selling securities in your longer term investment portfolio.  This can be handled in a mechanical way by simply selling down everything you own in your longer term portfolio in equal proportions or selecting securities to sell that seem overvalued.  If market prices are severely depressed, like in early 2009, it is possible to just skip buying the new 5 year note for a few months or even a year since there will still be four years of bonds in the ladder.

However, if this still seems too complicated, you may want to consider using mutual funds rather than individual bonds.  Mutual funds do not “mature” so you would not purchase five mutual funds.  Instead, you would most likely purchase just one short term bond fund.  You would still have to replenish this fund annually by selling down securities in your longer term portfolio but you would not have to identify a specific bond to purchase.

There are two problems with mutual funds that one must consider.  First, even the cheapest mutual funds charge management fees.  This will be a drag on your returns especially given how low interest rates are today.  Second, a bond mutual fund never matures.  If interest rates increase, the price of the mutual fund will decline and you cannot deal with this psychologically by knowing that the fund will mature at a specific date.  It is true that the mutual fund will benefit from purchasing new bonds at higher rates and, in the long run, the fact that a fund doesn’t mature should not be a major issue.  Still, some investors might be more comfortable in individual bonds with set maturity dates.

For those interested in bond funds, the Vanguard Short-Term Treasury Fund has an average duration of 2.4 years and has an expense ratio of 0.2 percent.  Those who are investing over $50,000 can purchase the admiral class of this fund which carries an expense ratio of 0.1 percent.  If TIPS seem more compelling to you but you want a fund rather than individual bonds, consider the Vanguard Short-Term Inflation-Protected Securities Index Fund which has an average duration of 2.5 years and an expense ratio of 0.16 percent.  Those who are investing over $10,000 can purchase the admiral class of this fund which carries an expense ratio of 0.07 percent.

Conclusion

If you have never experienced a severe bear market, it is not possible to know in advance how you will react.  You may react with equanimity or you may panic.  The odds of acting in a rational manner will increase if you are not relying on the longer term portion of your portfolio to fund your living expenses next month.  By keeping a significant amount of money in cash and a bond ladder, you can stack the odds in your favor.  You are more likely to stay the course in your investment portfolio and avoid costly mistakes such as selling everything at the low point of a bear market.

Even those with more experience who have navigated past bear markets well do not know with certainty how they will react in the future.  Bond ladders will provide some level of protection but the concept is not a panacea.  Just like a flu shot might be only 60 or 70 percent effective, a bond ladder will only stack the odds in your favor.