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Karsten Jeske: Cracking the Code on Retirement Spending Rates

The founder of the EarlyRetirementNow website and member of the FIRE community speaks about his experiences and thoughts on retiring early.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

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Our guest on the podcast today is Karsten Jeske, the founder of the website EarlyRetirementNow and a thoughtful and technically proficient member of the Financial Independence, Retire Early (FIRE) community. In 2018, Karsten retired in his early 40s, after a career in the financial world. He served as Director of Asset Allocation Research for Mellon Capital Management from 2008 through 2018, and before that, was a research economist at the Federal Reserve Bank of Atlanta for a decade. Karsten has his PhD in economics from the University of Minnesota and has taught undergraduate and PhD-level economics at Emory University. He's also a chartered financial analyst.

Background

Karsten Jeske Bio

Early Retirement Now

FIRE Definition

The Pandemic’s Impact on the FIRE Movement

The Shortest Recession Ever? My Thoughts on the State of the Economy,” by Karsten Jenke, EarlyRetirementNow.com, Aug. 25, 2020.

Tanja Hester: The Pandemic Will Stoke Interest in Early Retirement,” by Christine Benz and Jeffrey Ptak, The Long View, June 3, 2020.

The Coronavirus Pandemic and Retirement Security,” by Mark Miller, Morningstar.com, Aug. 24, 2020.

Retiring During a Pandemic,” by Christine Benz and Maria Bruno, Morningstar.com, Aug. 14, 2020.

Can You Retire Early? Should You?” by Christine Benz and Susan Dziubinski, Aug. 7, 2020.

Early Withdrawal Rates for Early Retirees

The Trinity Study

The Safe Withdrawal Rate Series--A Guide for First-Time Readers

Do We Really Have to Lower our Safe Withdrawal Rate to 0.5% Now?” by Karsten Jeske, EarlyRetirementNow.com, Aug. 31, 2020.

Shiller P/E Ratio Definition

Who’s Afraid of a Bear Market?” by Karsten Jeske, EarlyRetirementNow.com, Oct. 30, 2019.

Low Bond Yields and Withdrawal Rates

Jamie Hopkins: How Low Bond Yields, Recession Impact Retirement Planning,” by Christine Benz and Jeffrey Ptak, The Long View, July 14, 2020.

Wade Pfau: The 4% Rule is No Longer Safe,” by Christine Benz and Jeffrey Ptak, The Long View, April 29, 2020.

What Ultralow Yields Mean for Your Financial and Retirement Plan,” by Christine Benz, Morningstar.com, May 4, 2020.

Low Rates Aren’t Going Anywhere. Here’s What That Means for Retirement Planning,” by David Blanchett, ThinkAdvisor.com, Aug. 14, 2020.

IRA Required Minimum Distribution Worksheet

Bogleheads’ Variable Percentage Withdrawal

Sequence of Return Risk/Asset Allocation

Sequence Risk Definition

The Extraordinary Upside Potential of Sequence of Return Risk in Retirement,” by Michael Kitces, kitces.com, Feb. 20, 2019.

The Pros and Cons of Rising Equity Glide Paths in Retirement,” by Wade Pfau, forbes.com, May 4, 2017.

The Portfolio Size Effect and Using a Bond Tent to Navigate the Retirement Danger Zone,” by Michael Kitces, Kitces.com, Oct. 5, 2016.

Cut Stocks or Add to Them? A Key Dilemma to Your Retirement Plan,” by Christine Benz, morningstar.com, July 25, 2019.

How to Determine Asset Allocation in a Retirement Portfolio,” interview with Christine Benz and David Blanchett, Morningstar.com, April 29, 2015.

The Yield Illusion: How Can a High-Dividend Portfolio Exacerbate Sequence Risk?” by Karsten Jeske, EarlyRetirementNow.com, Feb. 13, 2019.

Healthcare and the FIRE Movement

Top 3 Health Insurance Options If You Retire Early,” by Thom Tracy, Investopedia.com, April 14, 2020.

How Does the F.I.R.E Movement Affect Insurance?” by Brianna Slattery, clearsurance.com, Jan. 23, 2020.

The Ten Commandments of Whole Life Insurance,” by Karsten Jeske, EarlyRetirementNow.com, Sept. 26, 2018.

Health Care Sharing Ministry

Affordable Care Act

Social Security

Taxation of Social Security: The Tax Torpedo & Roth Conversion Tightrope,” by Karsten Jeske, EarlyRetirementNow.com, Nov. 13, 2019.

Social Security Benefits: Early or Late Retirement?” ssa.gov.

Networking & Socializing in Retirement

Work, Retirement, and Social Networks at Older Ages,” by Eleonora Patacchini and Gary V. Engelhardt, Center for Retirement Research at Boston College, November 2016.

Why It’s Important to Stay Social in Retirement and How to Do It,” by Rob Pascale, forbes.com, Oct. 31, 2019.

Transcript

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.

Ptak: Our guest on the podcast today is Karsten Jeske, the founder of the website EarlyRetirementNow and a thoughtful and technically proficient member of the Financial Independence, Retire Early community (FIRE). In 2018, Karsten retired in his early 40s, after a career in the financial world. He served as Director of Asset Allocation Research for Mellon Capital Management from 2008 through 2018, and before that, was a research economist at the Federal Reserve Bank of Atlanta for a decade. Karsten has his PhD in economics from the University of Minnesota and has taught undergraduate and PhD-level economics at Emory University. He's also a chartered financial analyst.

Karsten, welcome to The Long View.

Karsten Jeske: Thank you for having me.

Ptak: Let's start with a really basic question. What attracted you to the Financial Independence, Retire Early movement in the first place? It sounds like the financial crisis when you just moved over to Mellon from the Federal Reserve Bank of Atlanta was a pivotal event. Can you talk about that?

Jeske: I had worked for the Federal Reserve Bank of Atlanta from 2000 to 2008. So, relatively safe job, maybe not quite as safe, say, as a tenured professor position at a university, but still a relatively safe job. And I moved over to the financial sector in 2008 right at the time when the global financial crisis hit. And then, you see the stock market tank, you see layoffs, mass layoffs. And so, that definitely left an impression on me. Even though I was financially savvy before--but that definitely instilled this idea in me that your job isn't really secure. Think of this stint in the finance sector as almost like an athlete who doesn't have a 45-year shelf life in the job market, who has maybe only a 10-year shelf life in the job market. So, I never lived according to my paycheck. I always thought that I wanted to live below my means and have a very high savings rate just because of that.

Benz: Do you think the notion that the bond between employers and employees has frayed has been the catalyst for the FIRE movement to take off in recent years? Or do you think there are other factors contributing to the popularity of FIRE?

Jeske: I think it's both. For example, my parents' generation--you work for one company and you work for that same company for 30, 35, 40 years and it gives you this stability and security. And that would definitely contribute to this uncertainty about your career. You can't really diversify your career as much as you can diversify your portfolio. So, you want to build up this nest egg, your retirement savings as quickly as possible to have the capital stock so that if your career takes a stumble, or if your job becomes obsolete, or if your company gets into trouble, that you have, well, potentially at least a little bit of money that you can use to find a new career, which isn't so easy anymore, or potentially then do a complete exit from the corporate world, just like I did.

Ptak: Do you think that the pandemic has stoked interest in FIRE? Or do you think it's been the opposite?

Jeske: I think it's both. There might be some people in the FIRE community who are not yet retired, who saw their portfolio drop. So, it might have poured a little bit of water on that fire, so to say. But on the other hand, I think from outside of the FIRE community, there is a lot of renewed interest. There's a lot of people who, back when we talked in 2018 when I left the workforce, they said, “Oh, it's good for you, but you know, I like my career and I don't think I would want to do what you are doing.” Well, guess what? They have now reached out to me and asked me, “So, tell me more about this. How can I do this myself?”

So, I think it's a give-and-take a little bit. There might be some people in the FIRE community who might have lost track now because they might have a job loss, or one spouse has lost a job where their path to FIRE has stumbled a little bit. I've heard from people in the FIRE communities: “OK, well, I used to be interested in FIRE, but this is no longer for me.” But I've also heard a lot of interest from people that were not in the FIRE community before that want to become members now.

Benz: So, you mentioned that you have always tried to live below your means. But within the FIRE community, there is this group that focuses on an extremely frugal lifestyle where the person is a super saver while they're still working. Was that the tact that you took? Were you part of that extremely frugal preretirement group?

Jeske: No, I was not really. And again--so, I used to work in finance. I had a very high-paying job--middle management--and I didn't have to really. So, in order to reach a 50% savings rate or even more than 50% savings rate, I didn't really have to tighten my belt too much. So, when I retired, nobody had any idea that this is what I had been doing in the background for the last 10 years. So, it's not like [they said] “Oh, yeah, I mean, I totally knew that you were doing this; you were just a cheapskate and so tight with your finances all the time. That's exactly--I knew what you were doing.”

We were pretty normal, middle class, maybe upper- middle-class Americans. We were going on vacation; we had friends over for dinner; we would go out with friends, just in moderation. And so, we were definitely not on the extreme frugal side, because we didn't need to. If we had been even more frugal than that, yeah, we could have retired maybe one year earlier, but it's not really worth it to be that miserable potentially during so many years while accumulating assets.

Ptak: You're quite circumspect about heading off the risk of early retirement, and we want to talk about that. But one criticism that is sometimes lodged against the FIRE movement is that it's a bull market phenomenon. Do you think that some early retirees are making overly rosy assumptions about their plans? And, if so, what are they being unrealistic about?

Jeske: So, when you hear criticism like that, there's definitely a grain of truth to that. So, I think that if you are an early retiree, and let's take an extreme early retiree, so somebody's like late 20s, early 30s and they have saved, say under $1 million, and they say, “Yeah, you know what, I can easily live on $25,000 a year and multiply that by 25. So, I need only a little bit over $600,000 and I'll never have to work again.” That might seem like a little bit of an overly optimistic assumption. Because obviously, you can't really use the, say the Trinity study results at face value, where you say, “Well, you have a very small probability of running out of money.” If you go over all the different retirement cohorts that, say, the Trinity study looks at, well, you have to really look at not unconditional probabilities, but at conditional probabilities--conditional on today's market, and today's market valuation on today's interest rates. What are the probabilities of running out of money under different assumptions. And just because equities have had such a long rally, just very short bear market, obviously, this year interest rates are very low.

So, I have always proposed that you want to take a little bit more cautious and conservative approach to your withdrawal strategy. But there are definitely some people in the FIRE community who have a little bit rosy outlook on the future where they say, “Well, you know, I just assume that the market will keep rolling on like it is right now.” And then, yeah, then you don't have to worry about it. But I think that's a very bad assumption. But at the same time, you can also look at some of the worst retirement start dates in history, say, the Great Depression or the 1960s and 70s. Yeah, you have to reduce your withdrawal rate a little bit, but you don't have to reduce it that dramatically. So, instead of 4%, you do something like a 3.25% or 3.5% withdrawal rate. That would have been OK in some of the even worst retirement start dates in history. So, I'm a little bit in between. I'm between the super optimists, some of the super optimists in the FIRE community. But I'm also not a naysayer like some other people in the finance community who say that this is never going to work, and all of these people are going to fail and run out of money.

Benz: You have made a big contribution in the realm of withdrawal rates for early retirees, and you referenced the Trinity study, which is a withdrawal-rate study. So, let's delve into the topic of withdrawal rates a little more deeply. And specifically, I'd like to ask about whether having a really long retirement period, whether it's 40 or 50 or 60 years, does that necessarily lead to a lower starting withdrawal than if someone is embarking on a standard retirement time frame where they're thinking about maybe a 30-year time frame?

Jeske: Yes, that's a mathematical certainty, right? So, if you take one withdrawal rate and you run out of money after 30 years, in order to make your money last for 50 years, you have to start with a slightly lower withdrawal amount. It's a little bit like amortization calculation. So, you look at what are payments on your mortgage, and if you look at the payments between a 15-year mortgage and a 30-year mortgage, there's a difference in how much you have to pay every month. And this is the same with the withdrawal mathematics. So you have a longer horizon, you should withdraw a little bit less. But I was actually surprised how little the difference is. In terms of the percentage points, it's--again, instead of 4% withdrawal rate for a 30-year horizon, you're at, say, a 3.2% or a 3.25% for a 60-year horizon. You don't have to have your withdrawal amount if you have twice the retirement horizon. And, of course, you shouldn't because you can think of this as a 60-year horizon is two 30-year horizons back to back, and you withdraw a certain amount for the first 30 years, and you don't touch the other pile of money. You don't really need that much pile of money set aside because that's going to grow--because you don't touch it for the first 30 years--that's going to grow enough that after 30 years it's big enough that you can then start another 30-year withdrawal period on that money. So, there's some amortization math behind it. And it turns out that you have to lower your withdrawal amount if you have a longer horizon, but it's actually not that much. And it's the same logic as if you take a longer mortgage, you have slightly lower payments.

Ptak: You've done extensive work on withdrawal rates for early retirees and a key principle is staying attuned to market valuations or metrics like Shiller P/E, when deciding how much to take out. Can you describe how that would work in practice?

Jeske: So, the idea here is that the stock market is obviously not 100% a random walk. It's a random walk--I can't predict how the stock market is going to perform over the next day or two days or a week or a year. But there's some connection between how the stock market is going to do over the next 10 years and that correlates actually quite nicely with the CAPE ratio today. So, the CAPE ratio is--or any other valuation tool--is a way to tie your withdrawal amount and then factoring in how expensive equities are and how equity-expected returns vary over time. They vary over time. They vary over the business cycle and over the market cycle. So, using the CAPE ratio would be a nice way to tailor your initial withdrawal rate.

And then what you can do is: You look at what are the realized fail-safe withdrawal rates over time, and what you notice is that the worst safe-withdrawal rates that you would have realized in history coincide exactly with the times when the CAPE ratio was high. So, I don't want to write any formulas here, because you can't do that in an interview without any graphics or anything. But there are some ways how you put into a formula--you look up what's the CAPE ratio, you turn that into an equity earnings rate. So the earnings yield, you take the inverse of the CAPE ratio.

So, for example, you have a CAPE ratio of 25, that will translate into an earnings yield of 4%. So, if you have $100 worth of equity value, then you have $4 worth of average long-term inflation-adjusted earnings in that. So, that means on average, equities pay 4% earnings, and you translate that into a safe withdrawal rate. And there are different ways of tinkering with that formula. I don't want to get too deep into the details. But there are ways to translate that earnings yield into an initial withdrawal rate. And the nice thing about that approach where you tie your withdrawal rates to equity earnings is that you would automatically change your withdrawal rates over time to take into account that… For example, after the equity market dropped a lot this year in March--while also the CAPE ratio was a lot lower--so, that means earnings yield was a little bit higher. You can actually increase your withdrawal rate again. That doesn't mean that you can increase your withdrawal amount, but you can increase the withdrawal rate a little bit after the market took a big beating.

Again, you could argue that you have to lower your withdrawal rate. And the 4% rule, for example, fails very often exactly at the market peak. But if we're already so far below the market peak, well, maybe then the 4% rate becomes safe again, or maybe even the 4.5% or even the 5% rate become safe again. The nice thing about tying your withdrawal rate to equity valuations is that it gives you an automated… It takes out the emotions, and it's a relatively easy number to look up. You just go to Shiller's webpage; you look up the Shiller CAPE number there. It's an easily accessible number and it's a very neat tool to tailor your withdrawal rate; not just the initial withdrawal rate, but also the withdrawal rate over time and then react to market movements and do it in a rational way. And again, you can take out the emotions that way.

Benz: So, presumably retirees using this method today would probably want to be fairly conservative given the CAPE rates' elevated levels. But as we've seen over the past several years, the market can stay overvalued for long periods of time. So, how do you think about that, that this may leave you looking a little bit flat-footed for periods of time, because you've been maybe too preemptively cautious?

Jeske: Oh, yeah, that's the other nice thing about this rule. So, for example, if you are wrong, and if you were overly cautious, and the market keeps going up, well, you would also increase your withdrawal amount. Because your portfolio goes up and the CAPE stays the same or even goes up, your withdrawal amounts would also go up. So, again, this is actually most people who start who take, for example, the naive 4% rule, they will realize that, “Oh my God, we withdrew way too little and we would actually have to move up, ratchet up our withdrawals.” So, they would have to do that, too. But the nice thing about the CAPE-based rules is that you can do this, again, in a very technical, emotionless and rational way. Your portfolio goes up, “Oh, my CAPE rule still says I should withdraw 3.5%. Well, 3.5% of my increased portfolio value is now a higher amount, so I can withdraw more.” Or if you want, you don't withdraw more. You just leave the money in there and you just leave more to your kids. But it's a very nice guideline to also walk up your potential withdrawals, which that is the likely thing that will happen over time anyways, by the way. So, you will potentially withdraw more than you started with this way.

Ptak: We've been talking quite a bit about equity market valuations. But in talking to various retirement researchers like Wade Pfau and our colleague, David Blanchett, it seems like they're even more concerned about low bond yields than they are of high equity valuations. Are you worried about the implications of low yields for withdrawal rates, too?

Jeske: Yes, of course. The average early retiree doesn't really have that much in bond. Basically, what used to be a 60-40 has now become something like a 75-25. So, the good news is that only 25% left in that asset class. And yeah, if bond yields are now below inflation, it's definitely a drag on your withdrawals. But keep in mind, bond yields have been low before. They had been low before, say, in the 1960s. And it's not as unprecedented as some people want to make it. And again, I've done safe-withdrawal analysis that included some of these earlier periods when bond yields were really, really low, both nominal and in real terms. So, it's definitely a problem.

I don't think it's the direct problem from a very low yield of about 25% of your portfolio. I don't think that direct impact is worrying me as much. I definitely have in the back of my mind some fear of some sort of a Japanese scenario. Where you have constantly low bond yields, a lot of bond issuance, a lot of debt, and then you have this deflationary sclerotic growth environment, not just for a few years, but as in Japan now, for 30 years--that's definitely something that I'm worried about. Having low bond yields for some time, that in and of itself, I'm not that worried, because we had very low bond yields, for example, after the global financial crisis, and then, without the whole corona mess, yeah, we would have had more normalized bond yields already, and they would have gone up eventually even more. So, I definitely still have the hope that after maybe three or four years, you're going to see a normalization again in the 10-year yield. But again, in the back of my mind, I always have this worry about this repeating the Japanese experience.

Benz: So, some of these flexible withdrawal strategies can get pretty complicated because they need to incorporate the portfolio balance and the retiree's age. But one simpler approach is to use a required minimum distribution sort of system. So, for a 40-year-old that would translate into a roughly 2.3% withdrawal rate. Do you like that general approach?

Jeske: No, I don't. And I think if you follow this approach with a portfolio that has enough equity exposure, you'd basically generate a withdrawal profile that would be very unappealing to me. You would have very low initial withdrawals. And then, over time as your portfolio grows and you would have extremely high withdrawals toward the end, or because you might actually have that much money, that you can't even consume all of it toward the end that you would leave a lot of money on the table in the end. So, I think it's good as a starting point, as a reference point initially. But in general, I don't like these kinds of rules. They don't take into account your asset allocation. It doesn't feel like a very scientific approach to do that RMD schedule and translate it to your withdrawal amounts.

Ptak: So, if you were to make a couple of tweaks to try to improve upon it, what would that look like? What would be the top two or three items that you would prioritize to build on that?

Jeske: There is, for example, one neat way to do this, and that would be… So the Bogleheads, the Bogleheads have this VPW, variable withdrawal percentages. They basically do an amortization exercise. Because nothing in life is really as linear as this RMD. So, you want to do something that takes into account your expected asset returns going forward. So, yeah, if I wanted to tweak it, I would do that variable percentage withdrawal rate as the Bogleheads propose. The disadvantage of that is that you could argue that over time your withdrawal percentages would go up, because your expected horizon will get shorter and shorter. So, your withdrawal percentages get higher. But you would also be exposed to variability in your portfolio. Your withdrawal amounts would have roughly the same volatility as your portfolio, give or take a little bit, because you have to keep in mind that it's not 100% a perfect constant percentage rate, but from year to year it's almost constant. So, you could almost consider that a constant.

The problem with that approach, again, is your withdrawal amounts are going to be just as volatile as your portfolio. And again, with this approach, you are potentially ignoring valuations. Now, it depends on how technical and how scientific you want to get with your expected asset returns over time. If you bring in valuation through that into your VPW formula, yeah, it might work better then, but just the base version of the VPW, again, doesn't take into account asset valuation. So, I'm still not 100% convinced, but that's definitely an improvement over that RMD approach.

Benz: One topic related to withdrawal rates is sequence-of-return risk. And in traditional retirement planning, that's usually defined as the possibility that the new retiree encounters a really bad market environment right out of the box. So, let's talk about sequence-of-return risk for retirees with a long retirement time horizon. Can you talk about how they can mitigate that? And can you talk about how sequence-of-return risk looks different for people who have long retirements?

Jeske: Well, first of all, qualitatively, it is the same. Your retirement success relies very much on your first five, 10, maybe 15 years of returns. So, for example, if you wanted to run a regression on what is your final portfolio value, and you regress it on your returns over time, what you would notice is that this front loadings, or the first few years, have the highest impact, the highest explanatory power. And then, as you get toward the end, you get less explanatory power. And that is the same whether you're an early retiree or a late retiree.

So, in that sense, both traditional and early retirees, so we all face sequence of return risk. So, you could argue that as an early retiree, you face it even worse, because you could say that, well, if the 30-year retiree--maybe that person is out of the woods if they made it through the first 10 years or first 15 years when they have only 15 to 20 years left, and they see they have a portfolio value high enough. If you have only 15 years left in your retirement and you still have your initial amount, then yeah, you're home free. Well, if you started with a 60-year horizon, now you would basically have to wait for 45 years until you reach that point where you can say, “OK, now I have only 15 years left, I don't have to worry about anything anymore.” So, in that sense, sequence-of-return risk is going to haunt you potentially longer if you're an early retiree.

But again, what are the different ways of dealing with sequence-of-return risk? Well, the first one is just be flexible. The nice thing about early retirees is that we are young. If your retirement looks like it's not going to work out as well as you thought after five years, well, you can always go back to work and do some side gigs. That would be the easy out. If you don't want to do that, then I've advised some early retirees--they say, “Well, we want to live on a boat and sail across, maybe not the world, but live on the sailboat for nine months of the year in the Gulf of Mexico.” Well, they can't do any side gig, because they live on a boat and then the remaining three months they want to live on land, and then also they don't want to have a job. So, some early retirees even don't want to do that. So, what do you do then?

Different methods of dealing with sequence-of-return risk is, obviously, you have to have right around your retirement time, you have to have enough diversifying assets that you're not exposed to that most volatile asset in your portfolio if you have only this paper or asset portfolio, stocks and bonds. So, you can't be 100% stocks; you have to have some diversifying assets. Most people would choose bonds, some people would choose just short-term cash, money market. You would want to have potentially something like a glide path, where right around retirement you have a very high bond allocation, but then over time, you can take that down again. And the idea is that, “Well, I might be out of the woods after maybe 10 to 15 years. So, in 10 to 15 years, I want to be back at maybe a little bit higher equity allocation.” And if you do that, it almost works like, well, if you have a bear market right at the beginning of your retirement, you're not really selling your equities, you're selling only your bonds and you're preventing some of this issue that is sequence-of-return risk. A sequence-of-return risk means that you are selling your depressed assets at low prices. And to generate a certain amount for your living expenses, you have to then sell more shares. So, it's the opposite of dollar-cost averaging.

You have to sell more right at the worst possible time. And so, if you have enough other diversifying assets, or potentially you use this glide path approach where you start with a little bit higher bond allocation right around your retirement date, and then you start taking down your bond allocation and move back into stocks. That is actually a proven tool to alleviate some of the sequence of returns. So, you will never eliminate sequence of returns, but at least you can alleviate it somehow.

For example, Michael Kitces, and I think Wade Pfau, they coined this term “bond tent.” You look at your bond allocation around the time of your retirement, you take up your bond allocation the last few years before retirement, and then you're in retirement. That’s the first year in retirement--you have the highest bond allocation and then you take it down again, because you want to have enough equity allocation to make it through the long term. And that's definitely a very intuitive and intriguing tool that I've proposed, which, by the way, is the opposite of what a lot of target-date funds are doing. So, the target-date funds, they get the first leg of that bond tent. So, while you're still working, you're taking up the bond allocation, you're taking down the stock allocation. But then through retirement, they keep doing that. So, moving further out of stocks in retirement, which is actually the worst thing you want to do, dealing with sequence-of-return risk. That's actually something where some of the practices in finance and personal finance are at odds with some of the empirical evidence on sequence-of-return risk and safe-withdrawal simulations.

Benz: I thought the reverse glide path research that Kitces and Pfau did was super interesting, too. I think a counter argument, one that our colleague David Blanchett has talked about is that just behaviorally, especially for traditional retirees, where you tell a retiree who is now 75 or 80, that they need to ramp up their equity allocation again, that just behaviorally it might be a hard sell. Do you think that's less of an issue for early retirees? It seems like it may be.

Jeske: It may be. And then obviously, I think there might even be some regulatory business going on in the target-date funds, but obviously, behaviorally. And then by the way, part of the way I interpret some of this glide path research is that for most people who don't suffer a very big loss and a recession and bear market right around your retirement start, they might not even have to take their equity allocation up again. So, the idea of the glide path is that if you are unlucky and you suffer through a bear market early on, you want your equity allocation to be high right around the bottom point of that bear market so that you can participate maximum in that recovery again.

Of course, you could always argue that if there is no bear market, well, then you just shouldn't even touch the allocation, then you just leave it at that allocation. So why keep gambling if you've won already? You're already out of the woods in terms of sequence-of-return risk. Why do you want to now increase your equity allocation? You could squeeze out a little bit more of final asset value that you leave to your heirs. But, yeah, it depends on your personal preferences. So, it's probably for a lot of people, I would almost look at this glide path as an option. You see, you start with a certain stock-bond allocation, and then if you have a bad sequence event, then toward the end of that event, you want to increase your asset allocation to participate in the big recovery. But if you don't, if the market keeps going up, and up and up, maybe don't touch the stock-bond allocation.

So, in that sense, that glide path that you do, no matter what, there might probably have to be some additional asset-allocation rules so you don't just do this glide path blindly. If you start with a 60-40 stock-bond allocation and nothing happens, then you're out of the woods, right? So, you succeeded. Why do you want to now increase your stock allocation? In that sense, it's really nice to look at this research and everything on how glide paths do better. The actual retiree might not even do it that way. Because if it works out for the first five years, then why even touch anything? So just leave it as it is and don't worry about that rising equity glide path.

Ptak: You had a great blog post about how holding a basket of dividend-paying stocks doesn't necessarily mitigate sequence-of-return risk, even if it seems like it might. Can you summarize your response to those who might write you and say, “I figured it out that the answer is to just hold a dividend-paying stock portfolio that pays the bills”?

Jeske: I was hoping that this could be something that would alleviate sequence risk, because the problem is obviously that you would sell a part of your principal at depressed prices, then why not just pick a stock where you have dividends that are high enough that you could just live off the dividends, then you never have to sell the principal and there you go, off you go.

And I looked at how that kind of approach would have fared in 2008-09, and what I found is that basically started with a with a 60-40 portfolio, which is 60% S&P 500 and 40% U.S. intermediate government bonds. And then, asset class by asset class, I tried to mix in all the ETFs that give me higher dividend yield. So, on the on the stock side, I replaced part of the S&P 500 with high-dividend stocks, high-dividend-yield stocks and REITs, and then also some international stocks because they tend to have often very high-dividend yield. There's some countries like Australia, for example, have traditionally very high-dividend yield. So, how would that have worked out? And I found out that that approach has totally backfired.

I think it came from three different sources. So, the first source is that if you go on the fixed-income side and you pump up the yield, well, obviously, you also increase more risk. So, you lose some of that diversifying potential that U.S. government debt has--government debt in the U.S. is safe-haven asset. If we have a recession, usually yields go down, value goes up. But you lose more and more of that the higher risk and higher yield you go. So, if you go from government stocks to corporate bonds to high-yield bonds to preferred shares, you lose more and more of that diversifying feature. So, you have higher yield, but you also have much more risk.

And on the stock side, I found that if you replace the S&P 500 with just a higher dividend yield focus ETF, it wouldn't have done much damage. It actually performed slightly worse than the S&P in 2008 and 2009. That approach, by the way, would have done really, really poorly in 2020. So, it's actually the nondividend payers in the S&P that did much better in 2020, by the way. And then, also international stocks--but then you now introduce the risk that sometimes international stocks do better. Sometimes they do worse. So, it turned out that in 2008-09, international stocks were hammered just as badly during the recession. And then they had a very, very slow recovery. So, where the U.S. came out of that recession relatively quickly, Europe especially went through a lot of trouble afterward.

So, this high-dividend focus just completely backfired. And again, the reason is that you have to look at your total return. So, your dividend yield might not hold up forever. So, the dividends could be cut. Even if they're not cut, they might not increase in line with inflation. So, this "solution" that, “Oh, just pick something that has a high enough dividend yield and just live off the dividends, never have to sell the principal,” just has so many negative side effects. Of course, it might have worked during some other recessions than bear markets. But it definitely very badly backfired in 2008-09. And I haven't run long-enough simulations yet on what happened in 2020. But my early results show that that approach also would have done very poorly again in 2020. So, don't rely on dividends, look at the total return.

Benz: So, beyond plain-vanilla stocks and bonds, you like the idea of owning assets that produce passive income. What types of assets would you recommend under that heading?

Jeske: I've been a passive investor all my life. So, I've invested in index funds for most of my accumulation phase. And I have recently branched into some other passive assets. I've invested a little bit in real estate through private equity funds. So, that is, again, extremely passive on my side. It's a private equity fund. You sign an agreement, you become part of an LLC, and they manage the money and they buy, in my case, multifamily real estate for that. And so, I really like that. It's passive on my side, it's some diversification. And it's, yeah, it's passive income, it pays you quarterly dividends. And then, at the end, I hope that there's also going to be some capital gains to be shared. And I really like that because it's very hands off for me, and I don't have to deal with tenants myself. I don't have to manage anything myself and it’s also nationwide diversified. So, each fund has multiple properties in multiple states. And that's a nice diversifying asset.

And then I also have a little flavor that I do probably slightly different from most people in the FIRE community. I do an option-trading strategy where I sell put options on the S&P 500. I sell the downside risk, very short-dated put options, usually only one or two trading days ahead. That's no longer passive, because I actually have to do something multiple times a week. I have to get on the screen and sell some options. So, this is basically a little bit of my hobby. I do that just to stay sharp and have something to do in early retirement.

Ptak: It sounds like some of these investments that you just described, real estate and options, it doesn't sound like you would consider those an essential part of an investing plan of someone who has adopted a FIRE approach. Is that correct?

Jeske: That's right. So, my standard assumption is, this is somebody who wants to have only a paper portfolio, and then have something like 75% equities, 25% bonds, and totally hands off. Because not everybody wants to do the private equity side. There's also some regulatory restrictions. There's some income and net worth limits. You have to be an accredited investor. And then the same with the option trading. I write about it on my blog, and there are probably a handful of people that do the same thing. But I would never recommend that as a general recipe for people to either reach FIRE or do it while in FIRE. So, my standard assumption is, is all paper assets, stocks, bonds, or index funds.

Benz: One of the most troublesome aspects of FIRE in the U.S. is paying for healthcare and health insurance. You've actually contributed to research on the relationship between U.S. health policy and taxation, which we're not going to focus on here. But how would you counsel would-be early retirees to approach this issue? How should they go about getting healthcare coverage?

Jeske: Again, it depends on your personal parameters. We have Obamacare, obviously. If you play this really smart and you keep your taxable income low enough, you get subsidies and you can get a health plan, relatively generous health plan, for relatively little money. But then there is this cliff. If you go above this Obamacare cliff and you have to pay for healthcare all yourself, be prepared to spend potentially somewhere around $10,000 to $15,000 a year just on the premium of a basic plan. And then that plan, by the way, is not going to pay all that much until you reach your deductible.

So, yes, in the U.S., we definitely have this issue of healthcare in early retirement. You have to self-insure until you reach age 65. And then, by the way, age 65 is so far in the future, I don't even know if Medicare is still there in its current form when I reach that age and when my wife reaches that age. So, yes, definitely healthcare--don't be too stingy on your retirement budget. Because that is the one line item where you could argue that early retirement is more expensive than your work life. Everything else--people can argue, “Well, I don't have to commute to work anymore. We need only one car instead of two cars. I don't need work lunches anymore. I have to no longer buy clothes for work.” All of your expenses usually go down in early retirement. But that health insurance portion, that definitely goes up, and it goes up for especially the early retirees that plan a little bit higher standard of living where their taxable income is above the ACA cliff.

And in my personal case, we use a so-called health share ministry. It qualifies as a health insurance. It's a PPO, but the premiums are probably a little bit low. But it's also an extremely high-deductible plan. So, I think our deductible is more than $10,000 a year. And we can do this as long as we are healthy. And, of course, once health problems start creeping up, we probably have to also invest "in one of the more expensive" plans. And again, this is something we budgeted for that and we budgeted very, very generously for that.

Ptak: You mentioned one entitlement program. Another one that we haven't talked about so far is Social Security. We talked to Tanja Hester several months back, and she indicated that her plan wasn't at all reliant on Social Security. How would you urge other early retirees to think about their potential benefits from the Social Security program? Does it depend on their age?

Jeske: Yes, absolutely. I'm putting on my hat a little bit as an economist, and then a little bit of a political scientist--I think that the older you are, the less likely you are that your benefits will be cut. I think there seems to be this age limit, age 55. If you make it to age 55, and the formula hasn't changed, chances are that you should be home free. Because I don't think that politically, Washington can change retirement, the Social Security benefits for people aged 61. And then say, “Hey, guess what, your benefits will go away next year.” That is not going to fly. It has to be a plan that is slowly phased in. And then, there will be age groups that will be completely protected. Definitely current retirees will not suffer as much. And then there will be a transition phase where politicians will say, “Well, you know what, you're already so close to retirement that we'll probably leave your benefits untouched. But then if you're younger than this age, then for every year that you're younger than this age, we're going to take away a little bit of your benefits.” I think this is the way it's going to be phased in.

I'm 46. I think I have to make it nine more years before they change anything. So you do your math. How many years do you have until you reach that magical age, maybe 55, maybe 60, until benefits will be cut? And then I would also assume that benefits will not be cut all the way down to zero. There will be some haircut that everybody will have to suffer. But, of course, it's not going to be 100% loss. I actually factor in my Social Security. It's not that much anyway. In dollar amounts, it's actually a pretty nice amount. But as a percentage of our budget, it's not that much. So, if it were to go away, it's not the end of the world. And if maybe it's cut by 20%, it would be a drop in the bucket for me. My approach is, I take it into account, both for me and my wife--and it's small enough that, say, a 20% haircut to my Social Security benefits is not going to make a huge difference.

Benz: It seems like one thing we get from our jobs is a built-in community and social network. How can retirees, early retirees or traditional retirees, make sure they have such a network in retirement, too?

Jeske: Oh, yeah. We have a very active network here because we have a six-year-old daughter. She goes to first grade. So, we have a lot of friends through her. We have neighbors that we hang out with. We have a community, obviously, of other early retirees. We live close to Portland, Oregon. And there are Facebook groups that deal with the topic. Before the pandemic we used to have monthly meetings and meetups with those people. But that has come a little bit to a standstill now for in-person meetings, but I'm sure it's going to pick up soon again.

I never felt that by leaving the workforce that I have less social interaction. I would almost say I have more social interaction now. I have less everyday interaction with a small group of people that I used to have at the workplace. But I would probably say that I have a bigger social circle. And I don't meet them quite as frequently as I used to meet my colleagues. I'm not really worried about issues like losing your social contacts.

Ptak: Well, Karsten, this has been a really illuminating discussion. Thanks so much for sharing your time and insights with our listeners. We enjoyed having you on The Long View. Thanks for coming on.

Jeske: Yeah, thank you for having me.

Benz: Thank you.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

Benz: You can follow us on Twitter @Christine_Benz.

Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

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