Tranquil Protection Island, which we visited during our first year of FIRE
Part 4 of my FIRE AMA
I thought my One Year of FIRE AMA was complete. But apparently, it’s still got some steam! I decided to add this fourth installment when two of my readers (Dividend Earner and Max) left excellent, detailed comments on Part 3.
Their comments were so thoughtful that I felt they deserved their own post… so they’re featured here, in Part 4 of my (seemingly endless) AMA. 😅 I hope you find the questions, comments, and replies helpful.
In case you missed them
Here are the links to parts 1, 2, and 3 of my One Year of FIRE AMA:
Part 4 questions
These are the questions and comments I replied to in this post (scroll to the end for the questions I answered in Parts 1, 2, and 3):
- Do you include wellness care in your list of medical expenses?
- Will you revisit your health insurance decision?
- Do you find that not having coverage is making you think twice about the spending?
- As a parent, now I am curious about how I can ensure they take care of their health when it’s so expensive…
- Do you have life insurance and if no, why not?
- What do you do for travel insurance?
- Do you ever think about how your kids will afford rent when it comes to that? Or do you expect to be a multi-generational home?
- How 50% leverage can take your net worth to $0.
- Less leverage looks better.
- The Smith Manoeuvre helps.
- Another twist with the Smith Manoeuvre.
- Shrinking leverage.
- Adding more leverage (and the effect on returns).
- Tax advantages.
- Use caution with the 4% rule.
- It depends where you start.
- Averages and Monte Carlo simulations.
- Use actual long-term data.
- The future will be different.
- Variations on the 4% rule.
- It’s a complex subject.
One Year of FIRE: Ask Me (Almost) Anything—Part 4
Alright, now that we’ve got the preamble out of the way, let’s get to the main attraction—Dividend Earner and Max’s questions and comments!
Dividend Earner
I first ‘met’ Dividend Earner on Twitter, where he reached out to say hello and ask about our leveraged investing strategy. As we chatted, I also discovered that we have a few things in common:
- We both live in the Lower Mainland (aka Vancouver and its surrounding areas).
- We’re both interested in FI (me in FIRE and him in FIE—financially independent early).
- We both have an affinity for Japan.
It’s also clear from his questions that Dividend Earner and I have another thing in common—we both think about ‘what-ifs’ and plan well ahead for them. Here are his questions:
Dividend Earner: I think your list of expenses are deemed necessary expenses for health as opposed to potentially including wellness care? Is that correct?
Chrissy: By wellness care, I assume you mean things like counselling/therapy, massage, or physio. If so, yes, I do include these in our list of medical expenses.
However, we could spend thousands on therapy (or dental) in one year, then far less (or nothing) the next. This means our spending in each category and our overall total can vary by thousands per year.
Therefore, I opted to use a five-year average of all our medical expenses. This gives me a slightly more accurate number to plan around. In addition, I didn’t include one-off anomalies such as:
- Equipment for Kid 1’s broken leg.
- Dental surgery for Kid 2.
- A root canal, extraction, bone graft, and dental implant for me.
- Orthodontics for both kids.
These expenses are unlikely to recur in the future, so I didn’t include them. (Doing so would have skewed the numbers too much.) I hope this sheds more light on our medical spending and planning.
Dividend Earner: While you are still young and healthy, is that a final decision and not being reviewed every year? Or do you review every year or so?
On the healthcare insurance front, my parents never had it and still don’t to this day (both in their 80’s). However, we (family of 4) make massive use of my employer’s healthcare coverage. It covers massages and other practitioners.
Chrissy: If I only had a year or less of expenses to base our decision on, I would definitely revisit our decision annually for the first few years. However, I had 5+ years of medical expenses to look back on.
This gave me an accurate snapshot of our health insurance needs and how much it cost us. I compared these numbers to the 3–4 insurance quotes I received online, and it was clear that we’d be better off paying out of pocket.
You mention your parents never had health insurance—my in-laws are the same. They did the math and, like us, found that insurance would have cost more. And so, they opted to pay out of pocket for their medical expenses.
To be sure, their expenses are higher than ours as they’re in their 70s and have more health issues. But even then, their medical spending is neither a scary nor unaffordable amount.
In addition, we expect that our kids will (hopefully) start to pay for or get coverage of their own—long before our medical needs and expenses increase. I’m quite sure that these two factors will offset each other and keep our medical spending flat over time.
So, based on all this real-world info, my research, and the advice of our financial planning team, we plan to self-insure for the rest of our lives. However, I’m not saying we’ll never revisit this decision—I might if there’s a compelling reason to do so!
For example, if an insurance company comes up with a unique offering that doesn’t currently exist, we’re absolutely open to changing our minds. If that were to happen, I’d get all the details and do the math before making a decision.
*If anyone comes across a great extended health offering in Canada, let me know.
Dividend Earner: Do you find that not having coverage is making you think twice about the spending?
Since you shared your story about mental health, it doesn’t take long that the cost can add up and when you pay out of pocket and trying to get better, the cost of getting better can come to mind and be an additional barrier (paying for 3 in the family to help with mental health right now).
Chrissy: I absolutely agree that mental health therapy is VERY costly—especially if multiple family members need it. 😨 You’re also right that the high cost of therapy can be a barrier to the healing process. This is a valid concern and it’s wise of you to bring it up.
Here’s my personal experience with this issue and my thoughts on how to deal with it:
Our past experience
When M was working, we were fortunate to have had top-notch coverage through his work plan. The annual maximums were so generous that we rarely had to pay out of pocket for therapy.
Given how accustomed we were to 100% coverage, I wondered if we’d hesitate to pay out of pocket for therapy in retirement. We’ve been paying out of pocket for more than a year now, and the answer is… it’s complicated.
To start with, I see therapy as a necessity and have always willingly paid for it as needed. Even so, it pains me very much to add up how much we spent on therapy in 2022. When I see this number, I can understand how cost could be a barrier in the healing process.
But as high as our therapy costs were in 2022 (and will be in 2023), we’re still within a safe spending limit. However, if our therapy costs were a lot higher, we’d have to revisit our numbers and make alternate plans. Below are some ideas.
Ideas to manage the high cost of therapy
Obviously, it’ll be easy to manage the cost of therapy when our investments are doing well. Strong stock market returns would give us a big buffer, so we’d be able to afford plenty of therapy without issue.
But if markets are like they were in 2022 (or worse), and our therapy costs are even higher, we’d have to be more thoughtful. In that situation, here are some of the ways we’d provide for our mental health on a lower budget:
- Prioritize spending on the family member(s) with the most critical needs.
- Stretch out the time between sessions.
- Do more homework, reading, and learning on our own.
- Sign up for group therapy.
- Find free or low-cost programs through youth centres, schools, and other community-based resources.
- Look for free or low-cost self-help programs (such as support groups).
- Borrow self-help books from the library.
- Make use of free apps (such as my favourite, Insight Timer) to work on our mental wellness.
Obviously, there’s no replacing one-on-one sessions with a good therapist. But these alternatives would be enough to get us by until our investments recovered.
Looking ahead
Fortunately, my family’s mental health is very good. I’m also quite knowledgeable about how to maintain our mental health and prevent issues (thanks to my decades-long journey out of postpartum depression).
Additionally, I kept a meticulous log of the therapy we’ve had in the past. When I examine our usage, it never added up to an unmanageable amount—even when we had full coverage and could spend freely on therapy for the whole family.
These factors give me confidence that we’re all pretty resilient and that our therapy spending will continue to be reasonable. 🤞
Dividend Earner: As a parent, now I am curious about how I can ensure they take care of their health when it’s so expensive…
Chrissy: This is a worry for me too—like you, we want to ensure that our kids take care of their health when they’re on their own. I’m hopeful that they’ll receive coverage through their post-secondary institutions and then later, through their workplaces.
Their health is a priority for us, so if there’s ever a lapse in their coverage, we’re fully prepared to help out. (Our retirement plan includes all expenses for all four of us—including medical. Therefore, if required, we can afford to pay for our kids’ healthcare indefinitely.)
Dividend Earner: Another question is if you have life insurance and if no, why not?
Chrissy: We no longer have life insurance. I gleefully cancelled it once we reached our FI number! (Our financial planner also advised us to cancel it as soon as we reached FI, but not a day sooner than that!) Below are more details behind our life insurance decision:
Why we had life insurance
We only purchase insurance to cover catastrophic losses (which are losses we’d have a hard time affording). This is why we don’t purchase insurance for things like our appliances. Having to replace items like these would not be catastrophic. So in those cases, insurance isn’t necessary.
However, we do purchase car and home insurance due to the potential for catastrophic losses. We also purchased life insurance for the same reason—if one of us was to pass away before we reached FI, it would have been financially catastrophic.
Without life insurance, the survivor would have no choice but to go back to work. Neither M nor I wanted this for each other or ourselves. That’s why we decided to purchase enough life insurance so that the surviving spouse would never have to work again.
(In other words, the insurance payout would instantly get the survivor to financial independence. This would free them from having to work and give them the time and space to grieve, care for the kids, and deal with the estate.)
Cancelling our policy
Once we reached our FI number, we were, by definition, financially independent. In other words, our investments had grown enough to cover all our living expenses for the rest of our lives.
Since our life insurance was purchased to ensure the survivor would reach FI, there was no longer a need for it once we became financially independent.
Note: Reader Bob Wen left an interesting comment on my PolicyMe review post. He and his wife are retired but purchased a small life insurance policy to cover the survivor in case they were faced with a bad market at the time of the other’s death.
I hadn’t considered this creative and interesting use for life insurance. It could be helpful for some of you, so I thought I’d share it. (To read Bob’s full comment, scroll to the end of my PolicyMe review.)
How much coverage?
If you’re not sure how much life insurance you need, I recently wrote a post that you may find helpful: How Much Life Insurance Do I Need (as a FIRE Seeker)?
I was motivated to write the post because I don’t agree with mainstream life insurance advice. I find it focuses on income-based calculations. As we all know, that’s not an accurate way to calculate a FI number, and it’s the same for life insurance.
In the post, I share the step-by-step, FIRE-focused method M and I used to calculate our life insurance needs. Even if you already have life insurance, it’s still worth reading the post—you may find you’re under (or over) insured.
Either way, it’s best to know so you can ensure you and your beneficiaries are appropriately covered. 👍
Dividend Earner: Further to that, what do you do for travel insurance?
Chrissy: Previously, we were covered by M’s work plan, so we never needed to buy travel insurance. We also haven’t travelled outside BC since FIREing, so we still haven’t had to purchase travel insurance.
However, once we do travel again, I’ll first look into the free coverage we receive through our credit cards. Then, to supplement the free coverage, we’ll purchase comprehensive policies through an insurance broker. (I’ll also ask other Canadian FIRE folks for their recommendations.)
Dividend Earner: Do you ever think about how your kids will afford rent when it comes to that? Or do you expect to be a multi-generational home?
Chrissy: I definitely do think about this, and am seeing this play out in real-time with younger relatives and friends. It’s certainly not easy, but these young people have shown us that it’s still possible to rent or even buy in the Vancouver area—even in or close to downtown.
This topic came up in a comment on a FIRE life interview I featured in 2021. Here’s what I replied with:
“I myself worry about how my own children will be able to afford to stay in Vancouver. Wages have not kept up with the crazy increases in housing prices. It’s not right, and I wish our governments could do more to help with this.
Even so, I want to share two success stories from young people I know. I do this not to counter your comment, but to show that it’s still possible to buy in the Lower Mainland and, perhaps, give you and others hope and ideas. Here are the stories:
Story 1
We’re good friends with a single millennial who purchased a brand-new 2-bedroom condo in 2021. This individual has no parental help. (In fact, they regularly send money home to their family.) However, their condo isn’t in Vancouver. It’s in a suburb that’s about 10 minutes away.
To save money before the condo purchase, this individual rented a room in a house in East Vancouver for several years. Every room of the house was filled with roommates!
As a result, the rent was very low but the living conditions were very good. This person also cooked most of their own meals, didn’t own a car, and entertainment was mostly hanging out at home with roommates/friends.
Story 2
Another millennial couple I know purchased an older house in 2020 or 2021. The house is in a slightly farther-away suburb (maybe 15 minutes from Vancouver). I would estimate that their household income is around $150–$200k. They have no kids, but I believe they support one of their parents financially.
This couple previously lived in lower-cost areas of Canada before moving into a small condo in Vancouver, then, more recently, buying their current house. Like the individual in story 1, they’re frugal and practical with their spending.
All this isn’t to say that it’s easy or possible for anyone to purchase property in the Vancouver area. No one would disagree with the fact that it’s much, much harder to get into the housing market in Vancouver these days.
I also know that the stories I’ve shared are only two data points. However, they’re real stories from everyday people that show that there are still ways to own near (but maybe not in) Vancouver. It may be that the only solutions going forward would be to get creative, buy in one of the suburbs, buy smaller, and/or house hack.”
My friend Liquid from Freedom 35 also created this excellent video: How to Buy Vancouver Real Estate Without a High Income. Surprisingly Simple.
In the video, he outlines a hypothetical scenario (using real numbers) which makes home ownership in the Vancouver area very much achievable.
Based on the above, I feel reasonably optimistic that our kids will be able to stay in Vancouver. But if they can’t, we’d be open to a multi-generational household (though I’m not sure how they’d feel about that)! 😅
Max
Max originally joined my AMA in Part 3, where he asked how we factored our leverage investing into our numbers. In my reply, I asked him for more details and insight, and he was kind enough to send them along.
Below, I’ve shared Max’s additional comments and my replies. (But before you scroll down, it may be helpful to jump back to Part 3 to review his questions and my replies.)
Max: Clarifying the numbers
That was an excellent and exhausting reply to my questions. Thank you for that great effort, you have shed light on many issues that arise from projections into the future and using leverage.
I’d like to first clarify my comment on using 50% leverage and how you could end up with nothing. I based that on your reply to Richnesswithinn in Part 2 where you said:
“We also hold minimal cash and $0 in GICs and bonds. That’s because these financial instruments are a major drag on returns. So… that leaves only stocks, which we’re 100% allocated to. (Or really, closer to 200% if you consider the fact that about half of our portfolio is leveraged!)”
From that I assumed that 50% (half) of your portfolio value consists of leveraged positions, which really is 100% leverage and not 50% as I stated. I should have said “With 50% of your portfolio being leveraged” rather than just “with 50% leverage”. Sorry for that confusion, hopefully I do better this time.
The outcome of a portfolio with my assumption would look like this:
$500,000 unleveraged + $500,000 leveraged = $1,000,000 portfolio – $500,000 loan = $500,000 net worth
50% drop = $500,000 portfolio – $500,000 loan = $0 net worth
Chrissy: Thanks for the clarifications. The math makes sense now. Yes, you are correct—if we experienced a 50% drop, our portfolio would be worth $0 on paper.
This is the double-edged sword of leveraged investing—gains AND losses are magnified, and it can get scary! However, I emphasize “on paper” as that’s a crucial investing concept.
As an investor, you must be able to withstand temporary paper losses. This is true whether you use leverage or not. If you can’t stay the course when your investments drop, and then you crystallize those losses by selling, it could be financially devastating.
Leverage would only increase the losses—potentially to a catastrophic level. This is why I always say that leveraged investing is not appropriate for most people.
Additionally, of those who use it, I highly recommend that they work with an experienced professional for guidance. As you’ve shown in your math, there’s a lot on the line. Leverage is a powerful tool, but it must be used with careful planning and an abundance of caution.
Max: Less leverage looks better
From all your comments it sounds like you are using something like 40% leverage which is not nearly as bad as my example. In your example that would look like this:
$1,000,000 unleveraged + $400,000 leveraged = $1,400,000 portfolio -$400,000 loan = $1,000,000 net worth
50% drop = $700,000 portfolio – $400,000 loan = $300,000 net worth
Chrissy: You’re right that a smaller ratio of leverage would result in numbers that are a little less scary. (However, the example I shared was hypothetical—our actual portfolio is about 50% leveraged.)
Max: The Smith Manoeuvre helps
Of course, in your case it’s different again because you’re using the Smith Manoeuvre, which means you have the market value of your home to back you up a bit.
Chrissy: Yes, that’s true. We were also in the fortunate position of being mortgage-free when we refinanced to invest. This means the entire market value of our home is still there, no matter what our leveraged investments do.
We could sell our home anytime to pay off the loan, then walk away with all our home equity plus any gains from the leveraged investments. (Indeed, this is the most tax-efficient exit strategy for us—sell the house to pay off the loan, rather than selling the leveraged investments.)
Max: Another twist with the Smith Manoeuvre
This brings up another twist on using leverage with the Smith Manoeuvre. You have $400,000 available (in your example) for investing right now and it will grow to some maximum amount when the house is paid off. That means you are periodically adding more leveraged positions to your portfolio.
Chrissy: Yes, you’re correct. When using the Plain Jane Smith Manoeuvre (where you start with a mortgaged home) each mortgage payment increases your leveraged investments.
This isn’t the case in our situation because we were mortgage-free when we started using leverage to invest. That meant we were able to take the entire lump sum we borrowed and invest it all at once. So, we went all in with our leverage from day one.
Max: Shrinking leverage
You are also counting on an 8% portfolio return per year. This means that your portfolio leverage will get lower (in %) as time goes on because your portfolio will grow more than what you put down on the mortgage and becomes available for leveraged investing (I’m assuming).
Chrissy: Yes, correct—this is indeed what happens when using leverage to invest over a long timeframe. (This is the safest, most effective way to use leverage—long term and ideally, for at least two decades.)
Max: Adding more leverage (and the effect on returns)
So, are you planning on keeping your portfolio leverage at 40% by adding some other form of leverage or will you let the portfolio leverage (in %) diminish over time? This will have an impact on your long term portfolio growth.
Chrissy: *Just so there’s no confusion, I’ll clarify again that our portfolio is at about 50% leverage (not 40%).
Yes, you’re right—as our portfolio grows, our percentage of leverage will diminish. This is an astute observation that deserves an in-depth discussion. I’ll start by answering your question:
No, we don’t plan to add another form of leverage, even if it means our percentage of leverage will diminish over time. There are several reasons why this is totally okay with us:
- We’re happy with the amount of leverage we have and don’t want or need more.
- Even if we wanted to, we can’t refinance our mortgage to borrow more because we’re retired and no longer earning employment income.
- We’re not interested in other forms of borrowing which could be riskier or a hassle to access and use.
As for the impact of diminishing leverage on our long-term portfolio growth, I suppose it depends on how you do the math:
Method 1: Leveraged returns versus regular returns
If you differentiate leveraged returns from regular returns, then your long-term leveraged return (as a percentage of your portfolio) would shrink as your leverage percentage diminishes.
Method 2: Total return
If you only look at the total return (no differentiation between leveraged and non-leveraged investments), then your long-term returns won’t be affected. They just are what they are.
Method 3: Pre and post-mortgage paydown
If you’re using the Smith Manoeuvre and differentiating between leveraged and regular returns, then your leveraged returns will increase over time as you pay down your mortgage. But once you pay down your mortgage, your leverage percentage and leveraged return will both diminish over time.
For the record, we calculate our returns using method 2—total return. The nerd in me is curious what our returns would be using method #1, but I’m too lazy to figure it out! I hope I interpreted your comments correctly, Max. Feel free to clarify if I got anything wrong.
Max shares additional info on leveraged returns
Max left a comment to further elaborate on his comment from the previous section:
I was not specific on how leverage impacts the return when using leverage, so I’m going to elaborate a bit more on how I like to look at returns. In my view, we don’t really have much of a choice, in the end it all boils down to how your net worth of your overall investing strategy performs.
Since this is a bit messy to explain, I’m going to use an example to hopefully make it clear. For the purpose of this, let’s assume your portfolio makes a 10% return after tax and your loan interest rate is 5% (after adjusting for the tax deduction you can claim) and also assuming you’re adding the loan interest to the loan at the end of each year rather than paying out of pocket.
Start
$1,000,000 savings = $1,000,000 portfolio – $0 loan = $1,000,000 net worth
Year 1
No leverage: $1,000,000 portfolio + $100,000 gain – $0 loan = $1,100,000 net worth = 10% return for the year
Year 2
Adding $500,000 leverage at the beginning of the year: $1,100,000 unleveraged + $500,000 leveraged = $1,600,000 portfolio + $160,000 gain – $500,000 loan – $25,000 interest = $1,235,000 net worth = 12.3% return for the year (on your net worth)
Year 3
No change: $1,260,000 unleveraged + 500,000 leveraged = $1,760,000 portfolio + $176,000 gain – $525,000 loan – $26,250 interest = $1,384,750 net worth = 12.1% return for the year
Year 4
Adding $500,000 leverage at the beginning of the year: $1,436,000 unleveraged + $1,00,000 leveraged = $2,436,000 portfolio + $243,600 gain – $1,051,250 loan – $52,563 interest = $1,575,787 net worth = 13.8% return for the year
Year 5
Markets crash, and your investments lose 30% instead of gaining 10%: $1,679,600 unleveraged + $1,000,000 leveraged = $2,679,600 portfolio – $803,880 loss – $1,103,813 loan – $55,191 interest = $716,716 net worth = 54.5% loss for the year
Year 6
You’re back to making 10% on your investments: $875,720 unleveraged + $1,000,000 leveraged = $1,875,720 portfolio + $187,572 gain – $1,159,004 loan – $57,950 interest = $846,338 net worth = 18.1% gain for the year
Year 7
$1,063,292 unleveraged + $1,000,000 leveraged = $2,063,292 portfolio + $206,329 gain – $1,216,954 loan – $60,848 interest = $991,819 net worth = 17.2% gain for the year
Year 8
$1,269,621 unleveraged + $1,000,000 leveraged = $2,269,621 portfolio + $226,962 gain – $1,277,802 loan – $63,890 interest = $1,154,891 net worth = 16.4% gain for the year
If you’re looking at the compounding rate in this example, the CARR for the first 4 years would be 12.0%, after 5 years it would be -6.4% and after 8 years the CARR is still only 1.8%.
You can also see how leverage increases your gains and makes your losses worse and how it can wipe out many years of gains. Ideally one would reduce leverage early in a down cycle and rising interest rates rates but that is not always possible, depending on the type of leverage used.
Chrissy: This is a fantastic example of how careful one must be when using leverage. Yes, your gains can be greatly magnified, but so can your losses. Therefore, it could be financially devastating if you had to sell assets at a loss in a leveraged portfolio.
This is why I’ll always share the following when discussing leveraged investing:
- Leveraged investing is not suitable for most people.
- If you’d like to use leverage to invest, I highly recommend that you consult with an experienced, knowledgeable expert.
- Plan to maintain your leveraged investing strategy for at least 20 years (if not more). In doing so, you’ll minimize the risk of losing money and maximize the upside of leveraged investing.
- Shorter investment time frames are far more risky and not recommended when using leverage.
Max: Tax advantages
You also touched on the fact that leverage provides some tax advantage because interest on investment loans is tax deductible. This is correct and I have taken advantage of this from time to time myself.
Tax actually plays a big part in investing and your return varies quite a bit depending on whether you invest tax sheltered (RRSP, RRIF) or in regular leveraged and unleveraged accounts and also on how frequently you are trading outside of sheltered accounts.
Chrissy: You’re absolutely right. Taxes played a big role in our accumulation phase and plays an even bigger role in retirement. There are so many moving parts to consider, and I’m so thankful that we have experienced tax experts to help us with this planning.
It’s great that you were able to take advantage of this deduction. There aren’t many ways for Canadians to reduce taxable income, but we can and should utilize all legal methods to pay less tax!
Max: Use caution with the 4% rule
The 4% rule is a rather controversial concept. The calculation depends on so many assumptions that the resulting projection is questionable and could be misleading if you’re not careful.
Any future world events, which we can’t predict, could also have a huge impact. Just using long term averages for market returns and inflation will most likely give you a high probability for a false projection because it neglects the “sequence of events”.
Chrissy: I completely agree! This is why I didn’t feel confident in DIYing our retirement planning (or doing it for our parents). There are too many things I don’t know and am not even aware of. While I’m more interested in retirement planning than the average person, I’m no expert.
I wasn’t willing to put our financial security at risk by forging ahead on my own. This is why I always urge others to seek out a second opinion from a professional before retiring. Even if it’s just a one-time engagement, it’s worth doing.
Max: It depends where you start
The standard 4% rule will most likely make you outlive your portfolio if you start FIRE at a bull market peak or just before a prolonged sideways market, especially if you also enter an inflationary period at the same time (which would increase the 4% amount if you follow the rule).
Chrissy: You’re right again, Max. Most FIRE seekers I know are well aware of this (especially thanks to the series by Big ERN). Sequence of returns risk must be considered and planned for.
M and I retired into a perfect storm of terrible scenarios, and are living through the reality of that right now! Thankfully, we planned for this possibility and have been able to keep our withdrawals under 4%—even with all the headwinds coming at us.
Max: Averages and Monte Carlo simulations
Rather than just assuming long term averages for the input parameters for the calculations, some people use Monte Carlo simulations which introduces random variations for the parameters, but even that may produce misleading results because real life does not follow averages with some random noise on top of it, real life introduces big market swings and sideways markets that can last ten years or more and inflation and interest rates have big swings as well.
Chrissy: I’ve also read about the pitfalls of Monte Carlo simulations. They’re a good starting point, but you certainly wouldn’t want to base all of your planning on this tool. Again, this is why I advocate for getting advice from an experienced, competent professional (preferably a CFP).
They should be well aware of the issues you’ve brought up and will ensure that you retire with realistic numbers and a sufficient buffer. Again, DIY retirement planning is a good start, but everyone should seriously consider getting a professional second opinion.
Max: Use actual long-term data
The most realistic result you would get if you used actual long-term data (100+ years) for all parameters in your simulation. You would have to include market data that represents your portfolio, inflation, and interest rates if you use margin or have a mortgage or other debt.
You could then see what would have really happened had you retired at any day in the past 100 years. There are folks who have done this (Cemil Otar being one of them), but I’m sure it’s not something for the everyday Joe to attempt.
Chrissy: I couldn’t agree more! I’m quite sure this is the same method our CFP uses when advising his clients, including us. (I’ve never heard of Cemil Otar—I’ll have to look into his work. Thanks for sharing his name.)
Max: The future will be different
And, in my view, even this approach may fail miserably in the future because our future will almost certainly look very different from the past. I base this mainly on the fact that the world population is projected to top out at around 100 billion by the end of the century and that we need to spend many trillions of $ to keep our environment suitable for homo sapiens to live in.
If that is what will happen, then we will inevitably have to transition from a business model and economy that’s based on growth to one with little or even negative growth, hence, “past performance is not indicative of future performance”. And if those population and environment projections turn out to be completely wrong, then it’s even more certain that the future performance will not look anything close to the past.
Chrissy: You’re right—our world is facing a lot of change in the coming century. It’s impossible to predict with certainty what might happen to humankind, our planet, and our world economies.
I do worry about a future with no growth. But I also wonder if that would be so bad? After all, the pursuit of endless, extreme growth isn’t sustainable. I have faith in humankind’s ability to find new, more equitable ways to live and prosper.
And if we do, it won’t happen overnight. That means those of us who pay attention and plan ahead will have time to change course (and, hopefully, still be able to sustain our retirement nest eggs).
Max: Variations on the 4% rule
Sorry, I was getting off the topic for a bit, but with your retirement horizon of 50+ years, it’s worth thinking about it. To come back to the 4% rule, I’d like to offer some food for thought on a couple of variations that I like:
1. Start with 3 or 4%
Rather than blindly starting with 4%, make your starting amount the lower of 4% of your current net worth or 3% of your peak net worth. This is equivalent to applying the 4% rule on a net worth that has pulled back at least 25% but allows you to apply it at any time.
You may have to wait a bit longer to claim FIRE status, but it will reduce the chance of outliving your savings. Net worth for the purpose of this calculation should only include assets available for spending (not your home equity or any fixed assets you don’t want to part with) but should include all debt (incl. mortgage and car loans, etc).
Chrissy: I’ve always liked this strategy—it’s essentially a guardrail strategy, which is something Michael Kitces talks about. You establish a floor and a ceiling for your spending, and as long as you stay within those boundaries, you know you’ll be okay.
2. Reset every year
Reset the 4% amount every year based on your net worth at that time, basically you are assuming you retire every year. You will never run out of funds with this approach but your cashflow will fluctuate on a yearly basis, sometimes quite a bit.
You can smooth out these fluctuations by planning the big-ticket spending like a fancy vacation or a new kitchen for the “good” years, which is a prudent strategy at any time in life anyway. Or you could establish a rainy-day fund to tide you over during lean years.
What I really like about this strategy is that it will give you an early warning if you don’t have enough savings for the long run by squeezing your spending money (rather than blindly increasing it by inflation like you do with the standard 4% rule).
Getting an early warning of a funding shortfall is important, it gives you a chance to find a source of income while you are still young and capable. This version makes you live within your means, you will never completely run out of money, and it will also guarantee you that you will have at least a small estate to pass on to your kids.
Chrissy: I couldn’t agree more—especially with the “assuming you retire every year” concept. (This is also what Kristy and Bryce from Millennial Revolution suggest in their book, Quit Like a Millionaire.) As you’ve stated, getting an early warning is so important to ensure you don’t go off the rails with your spending.
If you go too far off-course (especially in the early years), it could seriously affect the longevity of your portfolio. By regularly reviewing your numbers and plans, you’ll catch problems and have time to change course before it’s too late.
Max: Use variant 2 (with #1 as an option)
Variant 2 is my favorite strategy, it’s simple and safe and has very little maintenance. If you don’t like the cashflow volatility, I suggest you combine it with variant 1, this will smooth out your cashflows quite a bit and your worries will diminish.
Chrissy: I also like variant 2! It’s how I’d always planned to manage our withdrawals in retirement. (Our financial planning team also works with retired clients this way—with regular check-ins and course changes as needed.)
I agree that combining with variant 1 can provide a little more stability and predictability. I suspect that most retirees eventually fall into a rhythm and develop a natural feel for which variant they prefer.
Max: It’s a complex subject
I hope I didn’t make your head spin with all of this; it turned out much longer than what I had in mind, but I hope it will clarify some of my earlier comments and also shed some more light on a very complex subject.
Chrissy: You didn’t make my head spin at all. I love this stuff and could discuss it all day, ha ha. I appreciate that you took the time to share so much of your knowledge. We can all learn from each other, and our knowledge deepens when learning from different teachers.
You did an excellent job of breaking down some tricky concepts, and I’m sure many of my readers will appreciate your in-depth explanations. Thank you so much for your engagement, Max!
More about our FIRE journey
To learn more about our FIRE journey and how we planned for early retirement, check out the posts below:
Share your thoughts
Well, I wasn’t expecting to add yet another post to my AMA series… but I think you’ll agree that Dividend Earner and Max’s questions and comments were worthy of their own post. 😉
I hope you enjoyed this fourth installment in my series. As always, I love hearing from you, so share your feedback in the comments!
- How is retired life different than you thought it would be?
- How many hours are you putting into your side hustles on a weekly basis?
- Do you ever get bored?
- Do you ever feel guilt about not being productive enough?
- What advice do you have that would allow me to speed up my path to FI/RE?
- What is your decumulation strategy?
- Have you altered your strategy since starting?
- Are there any surprises during your year?
- Are either of you planning to return to the workforce in the future?
- What have you discovered you liked doing that didn’t cost a lot?
- Any thoughts on getting already FIREd up people together?
- What surprised you most about your new life after achieving FIRE a year ago?
- If it was something you didn’t anticipate, how did you adjust to it?
- How do your real expenses after FIREing compare to what you had projected?
- Any unexpected expenses, and how did you deal with them?
- Still in terms of expenses, are you spending more now after FIREing compared to before FIREing?
- What do you know now after one year of retirement that you wish you knew a year ago?
- What would you do differently if you had to do it over again?
- How do you pay yourself?
- Do you live off of dividends or cash in stocks or GICs?
- Do you pay yourself monthly?
- Why do you believe some popular bloggers hate the 4% rule so much?
- What’s your withdrawal strategy? Will it shift over time?
- What would be the biggest pro to having both of you at home all the time?
- What’s the biggest con?
- Do you find that your to-do list takes even longer to complete now that you have all the time to “procrastinate”?
- What are your “big goals” to try and accomplish during these first ~5–10 years while you’re retired years before your peers?
- How is your income working for your family now that you have more free time?
- When you mention withdrawing 4% of your account, plus cost of living, does this mean that the 4% is based on the current account balance, like at the beginning of the year, or is it based on the initial account balance?
- How is your nest egg invested?
- What have you found to be the most challenging, but unexpected, adjustment that you’ve had to make in your transition to a FIRE’d life?
- From a mental health perspective, how has your first year been?
- Have you found it to be recharging or does it create extra anxiety at times?
- When you say, you are going to withdraw from your investment, is there a strategy that you put in place?
- Another question is on your RESP, how are you using it?
- How do you organize your day to be so productive?
- How much time do you dedicate to blogging?
- You said, you are active on social media like Twitter. Do you have any tips so we won’t be on all time checking our phones? Do you dedicate specific time?
- What have you decided for extended medical insurance since you FIRE’d?
- How do you factor in the interest rate on the leverage when you apply the 4% rule?
- How would you handle a 50% market drop (in your leveraged portfolio)?
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4 Comments
Steveark
February 8, 2023 at 9:53 amVery interesting series. Maybe it is a cultural difference in Canada versus the US but I find it kind of odd to assume your children even want to stay in the Vancouver area. None of our three grown kids will ever reside in our area of the US. That would greatly restrict the number of jobs they could consider in their fields of study. Here the prime consideration of where to locate after college is where the best job offer happens to be. But maybe it is the same here if a family resides in a very large city, we don’t. To me, part of getting out of college and getting my degree was to fly away to a place where I was independent and totally off my parents payroll. Going back to visit, sure, but living with or near parents? Nope.
Chrissy
February 9, 2023 at 7:52 pmHi Steve—thanks for sharing your perspective! There are definitely differing opinions/norms when it comes to living close to family (or not). However, I don’t think it’s so much a cultural difference between Canada and the US. In my experience, it’s bigger than that. Based on the family, friends, and acquaintances we know, all of the following factors (and others) play a role in this decision:
– Job opportunities (as you’ve pointed out).
– Housing affordability.
– Desired lifestyle.
– Livability of hometown.
– Availability of entertainment, dining, and amenities.
– Quality of familial relationships.
– Desire for kids to grow up around grandparents and other relatives.
– Need for childcare from grandparents.
For us, we love that we and our kids were able to grow up surrounded by a large extended family. (To be clear, we’re not on our parents’ or any relative’s payroll!) We just enjoy their company (and they ours). For us, these close relationships are priceless and what makes our lives full and happy.
However, I absolutely understand why others, such as your kids, might choose to move away. I think it’s wonderful if that’s what they want and it allows them to reach their life goals and desired lifestyle. While we made different choices, I don’t think it’s odd either way. What works for one family or person won’t work for others and that’s totally okay!
Again, I appreciate your perspective. It’s always interesting to hear other viewpoints. 🙂
Max
February 13, 2023 at 8:16 pmHi Chrissy, thank you for your extensive reply to my comments and questions. I enjoyed reading it and I’m sure many of your followers will benefit from everything you said.
I was not specific on how leverage impacts the return when using leverage in the above “Max: Adding more leverage (and the effect on returns)”, so I’m going to elaborate a bit more on how I like to look at returns. In my view, we don’t really have much of a choice, in the end it all boils down to how your net worth of your overall investing strategy performs.
Since this is a bit messy to explain, I’m going to use an example to hopefully make it clear. For the purpose of this, let’s assume your portfolio makes a 10% return after tax and your loan interest rate is 5% (after adjusting for the tax deduction you can claim) and also assuming you’re adding the loan interest to the loan at the end of each year rather than paying out of pocket.
Start:
$1,000,000 savings = $1,000,000 portfolio – $0 loan = $1,000,000 net worth
Year 1, no leverage:
$1,000,000 portfolio + $100,000 gain – $0 loan = $1,100,000 net worth = 10% return for the year
Year 2, adding $500,000 leverage at the beginning of the year:
$1,100,000 unleveraged + $500,000 leveraged = $1,600,000 portfolio + $160,000 gain – $500,000 loan – $25,000 interest = $1,235,000 net worth = 12.3% return for the year (on your net worth)
Year 3, no change:
$1,260,000 unleveraged + 500,000 leveraged = $1,760,000 portfolio + $176,000 gain – $525,000 loan – $26,250 interest = $1,384,750 net worth = 12.1% return for the year
Year 4, adding $500,000 leverage at the beginning of the year:
$1,436,000 unleveraged + $1,00,000 leveraged = $2,436,000 portfolio + $243,600 gain – $1,051,250 loan – $52,563 interest = $1,575,787 net worth = 13.8% return for the year
Year 5, markets crash, and your investments lose 30% instead of gaining 10%:
$1,679,600 unleveraged + $1,000,000 leveraged = $2,679,600 portfolio – $803,880 loss – $1,103,813 loan – $55,191 interest = $716,716 net worth = 54.5% loss for the year
Year 6, you’re back to making 10% on your investments:
$875,720 unleveraged + $1,000,000 leveraged = $1,875,720 portfolio + $187,572 gain – $1,159,004 loan – $57,950 interest = $846,338 net worth = 18.1% gain for the year
Year 7:
$1,063,292 unleveraged + $1,000,000 leveraged = $2,063,292 portfolio + $206,329 gain – $1,216,954 loan – $60,848 interest = $991,819 net worth = 17.2% gain for the year
Year 8:
$1,269,621 unleveraged + $1,000,000 leveraged = $2,269,621 portfolio + $226,962 gain – $1,277,802 loan – $63,890 interest = $1,154,891 net worth = 16.4% gain for the year
If you’re looking at the compounding rate in this example, the CARR for the first 4 years would be 12.0%, after 5 years it would be -6.4% and after 8 years the CARR is still only 1.8%.
You can also see how leverage increases your gains and makes your losses worse and how it can wipe out many years of gains. Ideally one would reduce leverage early in a down cycle and rising interest rates rates but that is not always possible, depending on the type of leverage used.
Chrissy
February 16, 2023 at 11:15 pmHi Max—wow, thank you for sharing yet another detailed, thoughtful comment. This is a fantastic example of how careful one must be when using leverage.
When I have time in the next few weeks, I’ll add your comment to the post so that it’s easy for future readers to find.
Thank you, as always, for sharing your knowledge with me and my readers, Max!