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So we got this e-mail in our inbox the other day (e-mail has been edited for length):
Hi FIRECracker and Wanderer,
Well I just saw the article on the Greater Fool and all I can say is… Way to go!!! And Congratulations!
My situation is a little different… My wife and I are 35 years of age and we have two kids (a 3 year old and a 1 years old). We plan on exiting the rat race sometime next year for a new chapter in our lives… we own our home (mortgage free next year) and have ~$350k in a diversified portfolio. We will sell our home (evaluated at $650k) and invest the proceeds. We’ll then have our money working for us!! With a conservative 3% SWR we will have a long life with our portfolio. We will be purchasing an RV and traveling (Canada, US, Mexico, etc…) with our kids full time so we can start living life.
We can’t wait… but mind you we are nervous. Nervous to be quitting two great jobs (incomes, benefits, etc…) selling our home, possessions, everything we’ve worked for. We second guess ourselves but after a long week of working the grind and not being able to spend quality time with our kids make us realize why we want to do this.
Coming from a family who’s philosophy revolves around following the straight line… education, work and work some more it will be very, very difficult to explain our rational. How did that go for you guys?
I am also curious about how your investments are structured as to maximize tax efficiencies? Also, how is your portfolio allocated? We have mine allocated 90% Equities (70% US and 30% International) and 10% Bonds mostly Vanguard ETFs, albeit our work pensions and savings plans which are Blackrock ETFs. I know it is rather aggressive but I “think” we can weather the volatility…
Anyways… again, Congratulations and lets get a Revolution going!
Regards,
NervousReader
Well, NervousReader, first of all, with a $650K home and $350K portfolio, you are doing AMAZINGLY well for your age. Most people don’t even have 100K in the bank by 35, so kudos on all your hard work saving and investing. You are not that far off from where we are. Congrats!
Now, to get down to brass tax, let’s start by answering your questions:
Questions:
1) Coming from a family who’s philosophy revolves around following the straight line… education, work and work some more it will be very, very difficult to explain our rational. How did that go for you guys?
As the child of strict Asian parents, and having lived under a totalitarian government until I was 8, I gotta say, it wasn’t easy. Basically, my parents are STILL mad at me for not buying a house, and to this day, think I’m an unemployed bum. But even with their disapproval, and lots of hate from “friends” and ex-coworkers, I would STILL gladly pick this life over any other. I only have 1 life to live, and I’d rather live my life than someone else’s.
And that’s the entire reason why I started this blog. Society has brainwashed us to believe we must do things a certain way, just because “that’s the way it’s always been done”. And if you’re happy, then great, keeping doing what you’re doing. But if you’re not, don’t let fear or dogma keep you from making a positive change. Life is too short to care about what everyone else thinks, and that’s why the #1 regret of the dying is “I wish I’d had the courage to live a life true to myself, not the life others expected of me.” And having taken the leap, I can honestly say I no longer live with regret.
2) I am also curious about how your investments are structured as to maximize tax efficiencies?
Great question! A full article is needed to properly address this, but from a high-level view, we have:
- Bonds, REITS, US equities in RRSPs (or 401(k) for our American friends)
- Canada and international equities in TFSA (or Roth IRA)
- Preferred shares in non-registered accounts.
Basically, you want the highest taxed securities (ie bonds) in RRSPs and most favorably taxed securities (ie dividends) in non-reg, once you’ve maxed out your RRSPs and TFSAs. US equities go into the RRSPs in order to avoid the US withholding tax.
We will talk about tax minimization strategies in detail in a future post.
3) Also, how is your portfolio allocated?
60% equity, 40% fixed income, with preferred shares, REITs, Real Return Bonds and High Yield Bonds mixed in.
Now that that’s out of they way, let’s see if NervousReader can ACTUALLY retire.
To figure this out, we need to do a “ShitHitsTheFan” analysis. Why? Because as engineers, we have an insatiable NEED to care about risk analysis, risk mitigation, and all that boring stuff. In order to make sure everything runs smoothly, we need to have backup plans for the backup plans. That’s just how we roll.
And really that’s the thing about life. Life is full of risks. The point is not to shy away from these risks and live so cautiously that you might as well not have lived at all, but to mitigating the risks, so that when life inevitably kicks you in the ovaries, you have sufficient protection.
So, looking at NervousReader’s situation, I see 5 “ShitHitsTheFan” cases:
SHTF Case #1: Closing Costs for the House
With home values hitting all time highs, many homeowners become so enamored with their gains, they forget about closing costs. And with lawyer, real-estate agent fees, maintenance, and staging costs, it adds up pretty quickly. So if we look at all this in detail:
Real-estate agent fee:
- $32,500 (5% of 650K)
Lawyer fee:
- $500
Home repairs/staging:
- $1000 (or more depending on the upkeep of the home)
Total: $34,000
They can choose to list the property privately without a real-estate agent, but that may significantly decrease their sale value, as some buyers won’t buy a house without an agent.
Also, given that they will not be mortgage free until next year, can we say for sure that their house will be worth 650K by then?
Given the costs above and assuming they can sell the house for the expected value next year, they would be able to net 616K+ 350K (in investments), giving them a portfolio size of $966, 000…just shy of a million.
SHTF Case #2: Kid Costs
Given that NervousReader plans to use a SWR (Safe Withdrawal Rate) of 3%, they would need to live on $28,980K/year. Now, not knowing whether that number is feasible since we don’t have kids of our own, we’ll based our projections on other FI-ers who retired with kids.
- MMM:
• 1 kid
• 25K/year but with a paid off house
- GoCurryCracker:
• 1 kid
• 50K/year while travelling around the world, and making side income from his blog.
- RootofGood:
• 3 kids
• 40K/year but with a paid off house
NervousReader’s case is similar to RootOfGood’s (2 kids versus 3 kids). The difference is that NervousReader won’t have a paid off house, but will have $6000 per child in childcare benefits from the Canadian government.
Since 40K is for a family of 5, we’ll estimate the cost to be 32K for a family of 4. And we’ll need to add rent, which we’ll assume to be around $1200/month, since NervousReader and his family can move to a lower cost location when he and his SO stop working. This gives us a yearly expense of $46,400. However, given that we now have a Liberal government that’s decided to make our childcare benefit progressive rather than flat, and knowing that NervousReader’s income will drop dramatically in retirement, he will have close to the maximum of $6000/year/child benefit. That lowers his expense to $34,400. Yay Liberals!
To support a yearly expense of $34,400, NervousReader would need a portfolio of $860K using the 4% rule. Or to be more conservative, and using a SWR of 3% as he mentioned, he’ll need $1,146,666. So once he sells his house, he’ll be off by about $181K with a SWR of 3%, but right on target with a SWR of 4%.
SHTF Case #3: Portfolio Volatility
With a retirement horizon of 1 year, the equity allocation should be around 0%. Given the low interest environment, this isn’t really possible. To get the yield we need, some equities will inevitably need to be part of the allocation. But how much?
In our opinion, in the accumulation phase, when both partners are working, 90/10 portfolio is perfectly fine, but once you retire, you’ll need more fixed income to weather any future storms. At least in the beginning, we advocate for a more conservative allocation, while you’re still getting your feet wet living off your portfolio.
However, a 90/10 equity weighting can work perfectly fine as long as you can stomach the volatility and not sell when downturns happen. Which brings us to something called “Sequence of Return Risk”. What this means is that for the first 3-5 years of retirement, if you need to withdraw from your portfolio and the market is down, you run a risk of depleting your portfolio because you’re forced to sell when the market is down to fund your living expenses. So the first 3-5 years are the most crucial, and to protect against this risk, you need…
SHTF Case #4: Cash Cushion
Now, that 45K cash cushion is based on the assumption that they will have $966K after selling their house. If you use my estimates of $1,146,666 needed to support $34,400/year at 3% SWR, and $860K at 4% SWR, the cash cushion then becomes $34,400 (3% SWR) and $51,600 (4% SWR).
I know that some advisors say you don’t need a cash cushion, and just to use a line of credit, but we prefer to have cold hard cash. Again, backup plan for the backup plan.
SHTF Case #5: Inflation
NervousReader is heavily weighted in equities, which is a natural hedge for inflation (as inflation rises, companies raise prices, which benefit shareholders). Something to look into is real return bonds which adjust the interest paid with the CPI (seek professional advice if you’re unsure about how to do this).
Another knob to turn to hedge against inflation is global arbitrage, which is something we’ve found is hella awesome. If inflation in Canada goes up, go live somewhere cheaper. We’ve found by being digital nomads and moving around from country to country, we were able to actually LOWER our cost of living by staying in countries where everything’s just cheaper (Eastern Europe & SE Asia). Given that they have 2 kids, this is slightly more challenging but still doable as we’ve seen couples pull this off (Jeremy from www.gocurrycracker.com is the best example). They’ve told us of expat havens in Mexico like San Miguel that are super cheap yet very livable, so this is totally possible in South America.
After looking at the above 5 ShitHitsTheFan case, I’d say, once they build up a cushion outside the portfolio or adjust their allocation to be a bit more conservative, they should be in good shape. My conservative estimate, using a SWR of 3% and the child costs done above, he would need $1,146,666 +$34,400(cash cushion) = $1,181,066.
If he wants to be less conservative, using the 4% rule, he’ll only need $860,000 +$51,600 (cash cushion) = $911, 600.
Given he’s crazy-saved so well already, NervousReader’s probably only like a year or two away, so by the time the house sells next year, he should be fine (or close enough that you can just save for a few more months). Just make sure your backup plans are in place when you pull the trigger on your job.
Disclaimer: Since we’re not licensed financial advisors, we aren’t legally allowed to recommend individual assets. We are simply describing the investing strategies that got us here. Please consult a professional before implementing any of these strategies.
Retirement Readiness Score: 4/5
And with that, let’s hear from our readers. What do you guys think of NervousReader’s situation?
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You know, it’s funny that when interest rates were high & in the process of falling from historic highs in the early 80s to historic lows today, everyone used the 4% rule. Now that interest rates are rock bottom (and bonds overvalued) but in the process of rising, we now say 3% is the maximum drawdown a portfolio can handle. I have a feeling that the 4% rule will once again be the norm over time (maybe as high as 5%) in the future. ?
We were expecting to use a SWR of 4% after retirement, but surprisingly it’s actually pretty easy to live on 3%. Especially if you build a side income or use global arbitrage. And considering how much your costs drop once you no longer need to work, you actually don’t need as much as you think.
So in my opinion, 3% or 4% are both fine. Most people will want to start some sort of side gig, especially if they’re retiring young.
Another great post btw. Keep posting on the topic of portfolio management & tax strategy!
Thanks! We’ll have another investment post for this upcoming Wednesday.
We are in pretty similar situation like Nervous reader. Same age group and 2 little ones. Little $$$ more in the bank but more mortgage on a similar priced house [I may have to check if it was my wife who sent you email with pseudo name NervousReader ;)]. We are still few years away from our dream of go around the globe. Reason is I have to grow the nest egg over $1.5M and fortunately I am still enjoying my job.
+1 for having extra cash as cushion. You can be FI as long as you stay out of debt. No LOCs. My philosophy is to hope for the best and plan for the worst. Just by using 3 or 4% SWR calculation on excel may not be sufficient. Always have a backup plan. There are more chance of meeting unexpected expenses then receiving windfall. Otherwise Nervousreader congrats on reaching the finishing line. Happy for you
Wow, good for you! I might’ve held out a bit longer if I had liked my job, but as it turns out, we can easily leave off a SWR of 2.4-3% in retirement. So we didn’t need as much as we thought.
Congrats on saving so much! You’re only a few years away from your world trip and it’s going to be awesome!
It warms my nerdy heart to read bloggers write about sequence of return risk, probably the most important piece of advice for people actually trying to retire early.
We’re planning on actually having a rising glide path in early retirement, and selling our super conservative bonds early on in the early retirement, allowing the equities to become a larger percentage of our portfolio as we age. But that’s just us, and how we’re trying to tackle the sequencing problem.
Good stuff as always!
Talking about sequence of return risk always gives me a girl boner. #InvestmentsAreSexy #NerdsUnite
“selling our super conservative bonds early on in the early retirement, allowing the equities to become a larger percentage of our portfolio as we age.”
I’ve read about “The glide path” from Wade Pfau and Michael Kitces. It sounds counter intuitive, but we’re considering it as well. Especially since we’re making a side income from coding.
Before we set off sailing at age 31/32 we had found and still follow this blog today: http://www.bumfuzzle.com/adventure/ They have been travelling for over 10 years by land and sea and recently wrapped up a family RV adventure. Best part is they share their costs and we found our sailing lifestyle and costs compared well with theirs so we were really glad to have found it before we set off. ‘Nervous Reader’ could check out a few posts and try and figure out if they will eat out more or less, do more or fewer repairs themselves etc to adjust the expectations accordingly.
In our experience for sailing, it costs what you have. We have met cruisers spending way more than us that could never imagine our life, and we have met others living on much less that probably think we are excessively extravagant.
When we set off we also had a 90/10 mix (equities/REIT & Prefs), but we had 2 years living expenses set aside as retained earnings in my SO’s corporation to dividend out in a low tax bracket to cover our expenses. 2 years later I have 75% equities, 15% short term bonds and 10% REITs/Prefs and a margin credit facility (those dang Cdn Prefs are a lot more correlated in recent years with the TSX that some would like to admit) . Once we set off we no longer had an income that produced savings to deploy when the equity market corrected to facilitate buying low, so we added some bonds and upgraded our taxable account to a margin account to improve flexibility in market corrections.
“2 years later I have 75% equities, 15% short term bonds and 10% REITs/Prefs and a margin credit facility”
– going from 90/10 to 75/25 makes sense to get a higher yield and have more flexibility to rebalance.
– I’m curious about how you mitigate call risk if you’re using margin to rebalance. Because our fear is that when markets tank, and you use margin to buy, if the market plummets further, it might cause the bank to call the shares at a loss. What do you do in that case?
I’m very conservative with the margin I use right now. I don’t extend my margin beyond what my ‘buying power’ would be if if the holdings in the account dropped by 50% and I don’t go trying to make an opportunity just of the sake of doing so. It also has only represented 5-8% of the total portfolio, so in the event of a complete screw up it would sting but life would go on.
So far this past January is the only time I’ve used it anywhere close to my rule. In future I am looking at using long calls on indexes such as the S&P or Nasdaq if I feel a market correction is overblown as this would cap the downside risk, put less capital on the line for the same potential outcome, but at the risk of needing to be right on the direction of the impending move and the timeframe.
I’ll admit it is not something I necessarily recommend to others and my risk appetite is increasing now as I know I’m returning to work to finish off the journey to financial freedom.
Yeah, we definitely don’t have the risk appetite for it, but in your case, if you’re going back to work, you can afford to take more risk.
Preferred shares and REITS are owned for generating a fixed income and not for capital appreciation, so we consider them Fixed Income.
” If I consider them as Fixed Income, if I replace, Bonds with Pref + REIT => how risky is that?”
– Well, not all fixed income is created equal. While bonds are anti-correlated with equities, Pref and REITS are uncorrelated. That means, they may help in minimizing volatility but they won’t be as effective as bonds. They are RISKIER than bonds, so in our case, we are taking additional risk to get a higher yield. In any case, we didn’t abandon bonds completely. We still own some to cushion the volatility.
RESPs are great in that your investment timeframe is well defined. If your kid is a newborn, you know you need the money in 18 years, which would suggest based on the S&P500’s historical returns, you should be heavy in equities and then backing off gradually as the kid gets older.
However, because of Ontario’s regulatory regime, I’m not allowed to approve/disprove your portfolio. May I suggest a meeting with the Great Bearded One?
Um…what?
I would love to see a future post on tax minimization!
I read about how only US-listed US equities would skip the withholding tax. The Norbert’s gambit seems a bit complex to me and also more time consuming. I’ve been using VXC and that certainly isn’t tax efficient, but it’s what I can stick to.
Do you think it matters if VXC is used rather than a split of US/international/emerging indexes? The couch potato site had recommended that as the simplest for beginners.
Was also wondering, where did you place your international equities? (Don’t see it mentioned in your post?)
Thanks for sharing; hope I get to retire as early as you.
“US-listed US equities would skip the withholding tax”
– Yes. That’s why we put our US-listed US equities into an RRSP to skip the withholding tax. Canadian-based mutual funds/ETFs that track US indexes have no withholding tax. We will break all this down in detail in our future tax minimization post.
“Do you think it matters if VXC is used rather than a split of US/international/emerging indexes?”
-A split of US/international/emerging indexes gives you the control to allocate as you see fit (eg,if you think US is going to do better, you can change up the allocation to be more US weighted). With the VXC, it’s not obvious how it’s balanced between US, EAFE, etc, so you have less control and transparency. Again, as a disclaimer: this is just our opinion, and we are not certified financial advisors, so please seek advice from a professional before making any changes.
“Was also wondering, where did you place your international equities? (Don’t see it mentioned in your post?)”
– Good catch. Our international equities are in TFSA, just like our CAD equities. They are not subjected to the withholding tax like US-listed US equities.
“Thanks for sharing; hope I get to retire as early as you.”
It’s really great that you are interested in investing. What we did was nothing crazy or special. As long as you are tracking where your money is going and investing wisely, you should be able to reproduce what we did.
For bonds, we are similarly invested in XRB (20%), with the rest split between XSB (short bonds) and XCB (corporate). I’d agree with your assessment that short is better for any government bond exposure as interest rates have nowhere to go but up (though interest rate hikes might be put on hold with this whole Brexit mess).
How about health care costs? Would love to do this with 2 kids and we are in a good place to, but that is a worry with my husband. We live in the US – maybe it’s not as big of an issue with Canadians because of government sponsored healthcare? I didn’t see anything mentioned in the other dozen or so posts that I’ve binge read today so thought I would ask your opinion.
Love the blog, keep it up – people need to see that this is possible. Thanks!
Well thanks to your Kenyan-born POTUS, you Americans now have Obamacare, which as we’ve written about here, is extremely friendly to early retirees.
Since in retirement your earned income drops to zero, you end up qualifying for all those sweet sweet Federal Subsidies the Republicans keep bitching about, meaning your health care premiums will be covered by the government.
Thanks for the link! That was on my list of posts to read this afternoon…I just hadn’t made it there yet.
Like your blog! When I retire early I will certainly take advantage of available government subsidies, but I do feel that subsidies paid for by the taxes of hard working people shouldn’t be going to pay for the early retirement of people like you and me who don’t need it. Just doesn’t seem fair to me.
Yeah, I hear you. Think of it this way, though. You did pay into those system while working, so you are not exactly taking money from other tax payers. Also, you getting the child subsidy doesn’t exclude other families from getting it. It’s not a zero sum game.
There are also many ways to give back once you’re retired. You have lots of time to volunteer, as well as donate the money you earn from your passion projects. There are many more opportunities to help the world once you are retired.