Author Topic: Never touch the principal?  (Read 9524 times)

Mister Fancypants

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Never touch the principal?
« on: July 30, 2014, 10:31:28 AM »
I am curious how many people here agree with that statement and to what extent. From a lot of what I read about peoples FIRE goals and the 4% SWFs and living expenses they plan to incur during ER that a large portion of this group intends to touch the principal when they FIRE with the assumption that the SWF will allow the money to not run out.

My wife and I both grew up in families that grew their wealth following that precept and have done exceptionally well for it, the reason we are frugal and conservative in our financial decisions is because of more old school financial wisdom. FIRE is a fairly new concept from a generationally perspective; it was not something easily achievable or even desired by pre-Baby-Boomer generations.

A portfolio size of $1m is needed for a 4% SWR to get $40k in annual spending and assume you have set up your portfolio to be tax free either Roth or you are below in the 0% capital gains/dividends tax. In NY where I live if you were to have a taxable portfolio of the Triple Tax Free iShares Muni ETF NYF currently yielding 2.92% you would need a portfolio size of $1,369,863. Both portfolios give you $40k to spend, you pay no taxes but to never touch the principal you need over 30% more in principal.

So I am curious who thinks its worth it?  How many of you think touching the principal is ok? If so when and how to access will your principal? If so how much principal is ok?

-Mister FancyPants

neo von retorch

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Re: Never touch the principal?
« Reply #1 on: July 30, 2014, 10:37:20 AM »
I just saw another discussion about how "principal" is really whatever money you have in your investments. That is to say that if your investments grow 7% in a given year, and you take out 4%, the money you started with is still there, plus another 3%. But perhaps in the following year, the investments only grow 1% and you take out 4%. Now you're dipping into the money you used to have in there (even though some of it was from previous year growth.) Ultimately the idea with a "safe" withdraw rate is that over a long time period, you tend to get more growth than you skim of the top.

So your question might be more about where you get the growth from - investment gains or dividends. Most would say "whichever has a better long-term outcome." Generally dividends are a "lower risk, lower reward" option compared to growth (correct me if I'm wrong.)

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Re: Never touch the principal?
« Reply #2 on: July 30, 2014, 10:45:12 AM »
I am curious how many people here agree with that statement and to what extent. From a lot of what I read about peoples FIRE goals and the 4% SWFs and living expenses they plan to incur during ER that a large portion of this group intends to touch the principal when they FIRE with the assumption that the SWF will allow the money to not run out.

My wife and I both grew up in families that grew their wealth following that precept and have done exceptionally well for it, the reason we are frugal and conservative in our financial decisions is because of more old school financial wisdom. FIRE is a fairly new concept from a generationally perspective; it was not something easily achievable or even desired by pre-Baby-Boomer generations.

A portfolio size of $1m is needed for a 4% SWR to get $40k in annual spending and assume you have set up your portfolio to be tax free either Roth or you are below in the 0% capital gains/dividends tax. In NY where I live if you were to have a taxable portfolio of the Triple Tax Free iShares Muni ETF NYF currently yielding 2.92% you would need a portfolio size of $1,369,863. Both portfolios give you $40k to spend, you pay no taxes but to never touch the principal you need over 30% more in principal.

So I am curious who thinks its worth it?  How many of you think touching the principal is ok? If so when and how to access will your principal? If so how much principal is ok?

-Mister FancyPants

in an ideal world, the 'principal' would be invested in something that pays a coupon/dividend but the absolute value of the principal would increase with inflation; equities and real estate are the best examples, as well as TIPS (before the Fed's ZIRP made yields negative)

I think the effect of inflation on muni principal is underestimated - so in essence even if you get the principal back in x years time the purchasing power is dramatically less - not really any different than having a fixed x% SWR on a portfolio that might be drawn down over time

Mister Fancypants

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Re: Never touch the principal?
« Reply #3 on: July 30, 2014, 10:54:47 AM »
I just saw another discussion about how "principal" is really whatever money you have in your investments. That is to say that if your investments grow 7% in a given year, and you take out 4%, the money you started with is still there, plus another 3%. But perhaps in the following year, the investments only grow 1% and you take out 4%. Now you're dipping into the money you used to have in there (even though some of it was from previous year growth.) Ultimately the idea with a "safe" withdraw rate is that over a long time period, you tend to get more growth than you skim of the top.

So your question might be more about where you get the growth from - investment gains or dividends. Most would say "whichever has a better long-term outcome." Generally dividends are a "lower risk, lower reward" option compared to growth (correct me if I'm wrong.)

In the 4% SWR portfolio there would be some combination of dividends and asset sales and asset growth/decline and at the beginning of year 2 your principal would obviously have a new value, and the same thing is true of the Muni ETF portfolio the dividends would be spent and the portfolio value would grow/decline with the market and year 2 would be a new principal value so the exact amounts would fluctuate... However if you look at the record for the Muni fund it's payouts are fairly consistent over time so the income would be fairly stable

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Re: Never touch the principal?
« Reply #4 on: July 30, 2014, 11:01:26 AM »
This is one of the reasons to own higher yielding real estate.  I am not a fan of the SWR and assets are not fungible.  Leverage your way into higher yielding assets that have tax benefits and buy some solid companies for their dividends and growth.  You won't be staring at your net worth spreadsheets and five retirement income calculators when the market corrects to see if you can eat for the following 30 years if you do that.

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Re: Never touch the principal?
« Reply #5 on: July 30, 2014, 11:03:34 AM »
A portfolio size of $1m is needed for a 4% SWR to get $40k in annual spending and assume you have set up your portfolio to be tax free either Roth or you are below in the 0% capital gains/dividends tax. In NY where I live if you were to have a taxable portfolio of the Triple Tax Free iShares Muni ETF NYF currently yielding 2.92% you would need a portfolio size of $1,369,863. Both portfolios give you $40k to spend, you pay no taxes but to never touch the principal you need over 30% more in principal.

What you're really asking here is if you should work longer for 2.92% WR instead of a 4% WR.  Obviously, a 2.92%WR is safer by definition, but only you can decide if it's worth it or if you're comfortable with a less conservative draw.

Mister Fancypants

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Re: Never touch the principal?
« Reply #6 on: July 30, 2014, 11:03:42 AM »
in an ideal world, the 'principal' would be invested in something that pays a coupon/dividend but the absolute value of the principal would increase with inflation; equities and real estate are the best examples, as well as TIPS (before the Fed's ZIRP made yields negative)

I think the effect of inflation on muni principal is underestimated - so in essence even if you get the principal back in x years time the purchasing power is dramatically less - not really any different than having a fixed x% SWR on a portfolio that might be drawn down over time

Of course the expectation is the principal would increase over time by more than the SWR otherwise the FIRE plan would fail, on any given year you might incur a lose, but that is expected, but overall the expectation is growth. The Muni's would not get the same type of growth but should stay consistent as it is an ETF which continually reinvests.

I would not anticipate using Muni's in the accumulation phase (at least not exclusively), but converting an already established portfolio (tax efficiently) over time.

If we were discussing discreet Muni Bonds I would agree with you regarding the inflation effect on Muni principal, however a Muni fund will reinvest bonds at maturity at keep pace far better.

nuprinmmm

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Re: Never touch the principal?
« Reply #7 on: July 30, 2014, 11:11:45 AM »
i am not there yet.

in my discussions with my advisor i tell them to use up all my savings and assume i live to 110, i.e. spend my principal to zero assuming i die at 110.

that way if i live past 110 and i'm broke, well that's life

Mister Fancypants

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Re: Never touch the principal?
« Reply #8 on: July 30, 2014, 11:12:38 AM »
A portfolio size of $1m is needed for a 4% SWR to get $40k in annual spending and assume you have set up your portfolio to be tax free either Roth or you are below in the 0% capital gains/dividends tax. In NY where I live if you were to have a taxable portfolio of the Triple Tax Free iShares Muni ETF NYF currently yielding 2.92% you would need a portfolio size of $1,369,863. Both portfolios give you $40k to spend, you pay no taxes but to never touch the principal you need over 30% more in principal.

What you're really asking here is if you should work longer for 2.92% WR instead of a 4% WR.  Obviously, a 2.92%WR is safer by definition, but only you can decide if it's worth it or if you're comfortable with a less conservative draw.

I gave 2 portfolio examples to elaborate the point, but in essence yes, by lowering the WR the 2nd portfolio is able produce the same spending via income alone where the first is via income and asset sales.

My question is what are people opinions regarding that... I am an advocate of a lower WR personally. It seems to me most people who discuss FIRE are very comfortable with the 4% SWR. And from my initial post I'm trying see how people use the principal if they plan on tapping into...

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Re: Never touch the principal?
« Reply #9 on: July 30, 2014, 11:16:19 AM »
in an ideal world, the 'principal' would be invested in something that pays a coupon/dividend but the absolute value of the principal would increase with inflation; equities and real estate are the best examples, as well as TIPS (before the Fed's ZIRP made yields negative)

I think the effect of inflation on muni principal is underestimated - so in essence even if you get the principal back in x years time the purchasing power is dramatically less - not really any different than having a fixed x% SWR on a portfolio that might be drawn down over time

Of course the expectation is the principal would increase over time by more than the SWR otherwise the FIRE plan would fail, on any given year you might incur a lose, but that is expected, but overall the expectation is growth. The Muni's would not get the same type of growth but should stay consistent as it is an ETF which continually reinvests.

I would not anticipate using Muni's in the accumulation phase (at least not exclusively), but converting an already established portfolio (tax efficiently) over time.

If we were discussing discreet Muni Bonds I would agree with you regarding the inflation effect on Muni principal, however a Muni fund will reinvest bonds at maturity at keep pace far better.

is the ETF required to pay out coupons as a dividend to shareholders?

if so, wouldn't their reinvestment of principal upon individual bond maturity be the same as you buying a bond ladder and reinvesting them (i.e. the principal loses purchasing power over time)

the bond fund (incl ETFs) is worse imo because you carry massive duration and reinvestment risk - at least with a discrete bond you know exactly what you will get in x years

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Re: Never touch the principal?
« Reply #10 on: July 30, 2014, 11:31:43 AM »
A portfolio size of $1m is needed for a 4% SWR to get $40k in annual spending and assume you have set up your portfolio to be tax free either Roth or you are below in the 0% capital gains/dividends tax. In NY where I live if you were to have a taxable portfolio of the Triple Tax Free iShares Muni ETF NYF currently yielding 2.92% you would need a portfolio size of $1,369,863. Both portfolios give you $40k to spend, you pay no taxes but to never touch the principal you need over 30% more in principal.

So I am curious who thinks its worth it?  How many of you think touching the principal is ok? If so when and how to access will your principal? If so how much principal is ok?

-Mister FancyPants

Taxes are an expense and should be included in the $40k number that you withdrawal.  The way you have framed the problem, you move to tax free investments with a lower rate of return to avoid the expense of taxes.

However, the 4% rule does not mean the your portfolio earns 4% on average.  It actually has to earn 6-7% on average to account for 2-3% inflation AND 4% withdrawals.

Going to a tax free investment that earns less than 3% means that you can safely withdrawal less than 1% to preserve the real value of your nest egg from inflation.  So in that case you would need over $4 million, not $1.4 million.

Mister Fancypants

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Re: Never touch the principal?
« Reply #11 on: July 30, 2014, 11:34:50 AM »
is the ETF required to pay out coupons as a dividend to shareholders?

if so, wouldn't their reinvestment of principal upon individual bond maturity be the same as you buying a bond ladder and reinvesting them (i.e. the principal loses purchasing power over time)

the bond fund (incl ETFs) is worse imo because you carry massive duration and reinvestment risk - at least with a discrete bond you know exactly what you will get in x years

The ETF does pay the coupons as dividends to shareholders.

The ETF is actually quite like a bond ladder, except it matches the index and is managed for you by BlackRock (iShares) instead of having to do it yourself, now for me it is academic I might be able to beat the index, but in general the ETF is the cheapest approach.

The exceptionally wealthy pay advisors to buy discreet Muni's to beat the indices and get better returns, but that goes into the active vs passive investment debate and with a $1m portfolio Goldman Sachs isn't taking you on as a client. I actually have a friend who does Muni Bond fund selection at GS for the Ultra High Net Worth investors I think the minimum is $10mm for individuals or families.

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Re: Never touch the principal?
« Reply #12 on: July 30, 2014, 11:42:55 AM »
If we were discussing discreet Muni Bonds I would agree with you regarding the inflation effect on Muni principal, however a Muni fund will reinvest bonds at maturity at keep pace far better.

So from this you are counting on the yield to keep up with inflation so your initial assumption of 2.92% will fluctuate, but you still intend to maintain a 2.92% withdrawal?  Have you considered the scenario where we get really low or negative inflation and the yield drops below your initial 2.92% target?

I would run your portfolio tough the FIRE simulator and see what your success rate is?

Mister Fancypants

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Re: Never touch the principal?
« Reply #13 on: July 30, 2014, 11:49:07 AM »
Taxes are an expense and should be included in the $40k number that you withdrawal.  The way you have framed the problem, you move to tax free investments with a lower rate of return to avoid the expense of taxes.

However, the 4% rule does not mean the your portfolio earns 4% on average.  It actually has to earn 6-7% on average to account for 2-3% inflation AND 4% withdrawals.

Going to a tax free investment that earns less than 3% means that you can safely withdrawal less than 1% to preserve the real value of your nest egg from inflation.  So in that case you would need over $4 million, not $1.4 million.

From my understanding the 4% SWF takes into account inflation, it is a parameter in all the simulators. So assuming you have your expenses inline to make the $40k according to however you estimate your expenses the SWF accounts for inflation.

If your only income is $40k from capital gains and dividends on a $1m portfolio Married filling Jointly there would be no taxes.

The Muni ETF is Triple tax free so the $1.4m at 2.92% gets you $40k free and clear.

Mister Fancypants

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Re: Never touch the principal?
« Reply #14 on: July 30, 2014, 11:55:18 AM »
So from this you are counting on the yield to keep up with inflation so your initial assumption of 2.92% will fluctuate, but you still intend to maintain a 2.92% withdrawal?  Have you considered the scenario where we get really low or negative inflation and the yield drops below your initial 2.92% target?

I would run your portfolio tough the FIRE simulator and see what your success rate is?

The portfolios were given as an example for comparison sake, to illustrate the point you could replace portfolio 2 with any portfolio of your choosing... I went with a common approach of Ultra high Net Worth portfolios. Munis are very tax efficient and safe.

My retirement portfolio will actually be much larger than $1m.

sirdoug007

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Re: Never touch the principal?
« Reply #15 on: July 30, 2014, 11:58:37 AM »
Taxes are an expense and should be included in the $40k number that you withdrawal.  The way you have framed the problem, you move to tax free investments with a lower rate of return to avoid the expense of taxes.

However, the 4% rule does not mean the your portfolio earns 4% on average.  It actually has to earn 6-7% on average to account for 2-3% inflation AND 4% withdrawals.

Going to a tax free investment that earns less than 3% means that you can safely withdrawal less than 1% to preserve the real value of your nest egg from inflation.  So in that case you would need over $4 million, not $1.4 million.

From my understanding the 4% SWF takes into account inflation, it is a parameter in all the simulators. So assuming you have your expenses inline to make the $40k according to however you estimate your expenses the SWF accounts for inflation.

If your only income is $40k from capital gains and dividends on a $1m portfolio Married filling Jointly there would be no taxes.

The Muni ETF is Triple tax free so the $1.4m at 2.92% gets you $40k free and clear.

I think you are missing my point.  If inflation is 3%, the 2.92% muni fund has a real yeild of -0.08%.

So, even if you do not withdrawal a dime, the real value of your portfolio will decline over time.  If you are taking out 2.9%, it will decline pretty seriously over 30 years.

To have dependable cash flow over time you need your portfolio to keep up with inflation + withdrawals which is in the 6-7% range.

Mister Fancypants

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Re: Never touch the principal?
« Reply #16 on: July 30, 2014, 12:21:02 PM »
I think you are missing my point.  If inflation is 3%, the 2.92% muni fund has a real yeild of -0.08%.

So, even if you do not withdrawal a dime, the real value of your portfolio will decline over time.  If you are taking out 2.9%, it will decline pretty seriously over 30 years.

To have dependable cash flow over time you need your portfolio to keep up with inflation + withdrawals which is in the 6-7% range.

Fair enough, my example distracting from my initial question....

I used the $1m vs $1.4m with $40k example to make it easy to illustrate my point... the numbers have obfuscated everything.

I would actually have a portfolio of about $3.4m in Muni's which would get about $100k income I would only need about $60k for spending, I would reinvest the other $40k and not worry about inflation.

My question was less about the math and more about what people do with the principal if they choose to spend it...

I think I need to start a new thread and ask my question in a different manner and not include numbers.

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Re: Never touch the principal?
« Reply #17 on: July 30, 2014, 12:56:41 PM »
To achieve the 4% SWR, I expect to have to withdraw principal.  The bulk of my investments for the foreseeable future will be invested in stock indexes (with 20-25% in other assets such as bonds), generally generating higher levels of returns than those found in munis.  My own modelling uses a 6% annual rate of return (as I'd rather be conservative in my estimates).

However, please note that I am several years away from FIRE.  Those few families that I know that are retired are only spending from their earnings (dividends & interest income) and not touching their principal.  They, however, have other forms of income such as SS.  Ideally, I think I'd prefer to only spend earnings (dividends & interest income) and leave principal.

Separately, I anticipate purchasing Munis when I am closer to the capital preservation phase of my financial life --> right now it is accumulation and growth.  Just to note, its fairly easy to buy Munis, you can purchase in individual bonds in $10K increments, so spend $100K on ten different Munis (I've watched how the retires I know do this).  This however will largely be an income tax play rather than a step to FIRE.

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Re: Never touch the principal?
« Reply #18 on: July 30, 2014, 08:13:51 PM »
I'm completely liquidating the principal of some of my taxable assets right now, while letting the deferred taxation accounts grow. I plan to spend the taxable assets down to maybe $100-200k before I'll start withdrawing from 401k's, Soc. Sec., and a pension. Overall I'm near a 4% withdrawal, but for just the taxable accounts, I have more like a 12% WR. Actually, even with very modest market returns this year, our overall net worth has gone up so far in ER.

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Re: Never touch the principal?
« Reply #19 on: August 21, 2014, 08:22:23 PM »
Keep in mind that in most historical cases of the 4% SWR, "touching the principal" still leaves you with way more money than you started.

The question becomes how safe is safe enough?  That's a personal decision.  But I don't think "touching principal" (which is a vaguely defined term, at best) is something to be scared of, or something to strive for.  I think it's a term that mostly drops away once you understand where your money is coming from.
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