He is married to a veterinarian who hung up her white coat a couple of years ago, and he recently recapped the process of giving his early retirement notice, sharing people’s reactions.
In this guest post, he writes about his realization of needing a formal investment policy statement after the market took a turn a couple of months before he was planning on giving notice.
Enjoy the post, and if you haven’t already, start working on an IPS of your own! Take it away, Robert.
An Early Retiree Creates and Shares His Investment Policy Statement
I was Guilty of Not Having an Investment Policy Statement
2018 finished the year with one of the more interesting investment performances we’ve seen. The market saw two all-time highs, a greater than 10% drop (correction) in February, and then celebrated Christmas Eve with a 21% total drop from the highs and an official bear market.
It can be easy to be an investor when the market is going up, but having a written document becomes important when the market gets volatile. Quick drops in the market can create an emotional reaction, which is exactly why you need an Investment Policy Statement.
I had outlined my general investment guidance through the various quarterly updates. These included discussion about asset allocation, goals, some opportunistic purchases, and some movement into cash.
My general goal was to have a lower beta portfolio, the fancy investment terms for “not as good when times are good, but not as bad when times are bad”. The most basic way to accomplish this is to have a portfolio with around 70% stocks and 30% bonds.
I have declared early retirement in 2019 and preservation of capital in the early years is critical. This is a sharp contrast from my investing strategy as I’ve accumulated money.
My wife and I were good savers in our twenties and worked hard, then through a series of promotions at work in my 30s, I’ve found myself making a specialist physician style income (and she hung up her white coat, specifically the four legged, non speaking patients). We’ve been able to invest large sums of money every month and in hindsight, I realized some excessive risks.
I’m an eternal optimist and it led to me being an aggressive investor. I believe in owning equity long term. When the market went down, I would buy. If it went down more, I’d move my cash allocation all into equities. If it kept going down, I’d buy more on margin. If the market stayed down, it wasn’t that big of a deal because monthly deposits and an annual bonus quickly paid back the margin loan.
I continued this pattern in December, buying equities as the market fell. I was sitting there after the plunge on Christmas Eve and for the first time in ten years, I actually felt nervous as an investor. Should I have done that? What do I do next?
A sharp drop followed by a prolonged downturn is the biggest risk to my early retirement plan! I should know better, I had the benefit of advice provided by Early Retirement Now in this case study.
It was time for me to formalize an Investment Policy Statement.
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Why should you develop an Investment Policy Statement?
The IPS is about having a formal document to review when you make investment choices. This is a document that should be reviewed in great times and in the toughest of investment times. It should be written and reviewed over a number of years and should not be revised for a single investment opportunity.
Experience is a great teacher, it separates intelligence from wisdom. I sat down and carefully put together this IPS, with some encouragement from reading on Physician on Fire and the White Coat Investor. How do I start writing this though? I decided to start by thinking about the changes I *wish* I had made in 2018 to better align with my pending retirement.
1) Holding Cash/Bonds
I proudly announced that I moved 7.8% of my assets into cash/bond investments in Q3. This number was way too low based on how soon my firehose of cash from employment will disappear.
I should consider being even higher in bonds for the first couple years of retirement (equity glide path). The #1 risk to the portfolio holding up to the 4% rule is a deep and prolonged downturn which can be protected with a high bond allocation that declines over time.
2) Don’t let taxes entirely guide your decisions
We’ve used a regular brokerage account in addition to various retirement accounts. There *were* some nice gains in our regular brokerage account, but I chose to let the grumpiness of capital gains plus some recency bias prevent me from selling.
I had thought about selling to rebalance, but I just couldn’t stomach paying the tax man. The result? I was sitting there on Christmas eve with less value than I would have had selling and paying the taxes.
3) Allocating more into equities without strict guidelines
Unfortunately, I failed to pay attention to the volatility index, a market indicator (VIX) that quantifies the level of panic in the market. If I am going to change my allocation during steep declines, I need to clearly define the what specifies a steep decline and how much/when I am willing to deploy the funds.
4) Specifically outline my option/margin exposure
I’ve not been concerned about being 100% invested or slightly over 100% via a margin line until now. I’ve always had a fire hose of cash coming in through work, interest rates were historically low, and the market hasn’t dropped by more than 20% in the last 10 years.
Buying something in advance of selling something else or in advance of a bonus didn’t bother me. I will occasionally play with options, even if I haven’t done any better / any worse than the market with them. These items need firm limits on them when the employment income stops.
What does my Investment Policy Statement look like?
I sat down and drafted out the investment policy statement. Below are some highlights I decided to share:
Withdrawal Rate: To have a portfolio that will support a lifelong sustainable withdraw rate of no more than 3.83%.
Investment Volatility: Obtain at least 65% of the Total Market Return while not experiencing more than 65% of a Total Market Decline. In investment lingo, the portfolio should obtain a beta of 0.65%.
Active Investment: Keep a majority of our investments (more than 50%) in broad market index funds. These should include the Total Stock Market Index, Small/Mid Cap Indexes, and International Index Funds.
I’ve chosen to keep the goals of the IPS straightforward. The first two goals aren’t necessarily for everyone, they are specific to us as early retirees in our 30s. I’ve chosen a rate slightly lower than 4% for the initial target and am attempting to avoid absorbing a large market crash. The third bullet point about active investing is to specifically put limits on *my* activity.
1) Individual stocks should be well researched and purchased with an intended holding period of more than five years.
2) The company should be profitable, have an identifiable “moat” for their business, and exhibit friendly activities towards shareholders without obtaining excessive debt levels.
3) Consider the “line up” philosophy when buying. What companies have their customer’s line up to spend money with them? Some of my best investments have come from watching customers line up at a business before it opens. (Disney, Costco)
3) We will be willing to sell companies that no longer meet these guidelines, even if it means incurring capital gains taxes.
Individual stock investing isn’t for most people. This is as much a mentally stimulating hobby for me as anything else. In 10+ years, my returns haven’t been significantly better or worse than the S&P 500, but I have found it to provide a lower volatility since I tend to avoid growth stocks. The peaks are not as high, the lows haven’t been as low.
Real Estate Investment Trusts (REITs)
1) REITs can serve as a mix between a stock and a bond.
2) The target REIT will pay a rate equal to at least 4% plus the consumer price index at the time of purchase. It must not have more than 50% funded debt to total assets.
Real Estate Investment Trusts are a nice addition to most portfolios. I know crowdsourced direct investment is all the rage, but I’m a bigger fan of picking specific real estate investment trusts to own. I also think this is the one sector I would NOT buy the index in (VNQ is the most popular). A REIT is already a fund of property, so buying VNQ is purchasing a fund of funds and layering an additional management fee. Not every REIT is the same either, some perform like a glorified bond while others take on debt to buy mortgages and carry significant risk.
I invest in REITs that keep their size relatively small, carry half or less of their assets in debt, and have a diversified tenant mix.
1) The cash target will be between 10% of the Total Portfolio and at no time less than eighteen months of living expenses
2) Only dip below this target in times of total market uncertainty, as defined by a VIX ratio greater than 25.
It was time to fully define when to reallocate cash into market uncertainty.
1) Bonds will be considered for part of our portfolio and the combination of cash plus bonds should be 20-30% of our portfolio.
2) We will either buy bond funds through Vanguard/Fidelity’s index or utilize the Wellington/Wellesley fund through Vanguard.
Cash and Bonds have not been part of our plan until recently. #2 in the cash section is still up for debate, but sets specific limitations on my desire to time the market. The IPS is also about self control.
On the specific bond funds, I have the option to pay Vanguard 0.15% in the Wellesley Admiral shares to actively manage my bond exposure. I’ve been in the business of issuing debt and there’s some dumb debt that gets issues and the rating companies aren’t always accurate. The 0.10% difference between owning the index vs. owning the actively managed fund may pay for itself over time.
1) We will consider alternate investments such as syndicated real estate, direct investment in private companies, private loans, and options exposure.
2) This allocation will not exceed 3% of our net worth in any one investment and not exceed 10% of our net worth.
3) This allocation will be revisited if overall net worth increases and/or various hobbies in early retirement begin producing income.
These are specific restrictions set on myself to prevent chasing returns. I was guilty of putting five figures into Lending Club early in its existence and had a whopping 1.7% cumulative return since 2011 on an illquid junk bond portfolio.
1a) Deferred compensation paid out over fifteen years.
1b) Use all but $100,000 of taxable investment accounts first. The combination of these two should provide five to ten years of living expenses depending on choices made around housing. Taking a mortgage into retirement leaves us with significantly more cash, but also increases the monthly minimum expenses.
2) Utilize Roth IRA contributions. Currently there are 2.5x living expenses inside the Roth IRAs. This amount can be increased through strategically using a Roth IRA ladder. Specifically focus on converting Mr. Shirt’s IRA, as Mrs Shirt’s IRA is the right size to utilize a 72t (SEPP) if needed.
3) Consider a 72t for Mrs Shirt’s IRA. This is an ideal size IRA for a 72t with a low six figure balance, especially if the distributions start in our mid-40s.
4) Consistently evaluate pension decision. Pension can be drawn at 55 but is worth twice that amount if drawn at 65. There is no COLA adjustment inside the pension, so the early bias is to take the pension early.
What does this all add up to?
Having an Investment Policy Statement in place is already paying dividends. I’ve been able to work towards a target allocation with the market’s sharp in 2019 and paid off any positions I had in margin.
I am already seeing the benefit of not getting too excited/confident with the recent run up or being disappointing that I “sold too early”. We have clear goals and every transaction will match those goals.
This will still require personal discipline to pull up this statement when I am tempted to “make a trade”, but now that I’ve invested the time into writing this I expect to put this to good use.
Have you thought about your investment plan to this level of detail? How does your Investment Policy Statement differ?
5 thoughts on “An Early Retiree Creates and Shares His Investment Policy Statement”
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Thanks for sharing your IPS Stop Ironing Shirts.
Had a couple of questions.
I like your point about not buying an index for REITS (extra layer of fees as a fund of funds setup). What REITS have you chosen if you don’t mind sharing?
You said in your drawdown period you would like to consume your brokerage money first all except $100k. What is the rationale for the $100k balance?
Personally I have divided my entire portfolio into 3 components. Two major caterogires (Retirement and Non-Retirement funds) and in the Non-Retirement funds divide that into Market and Real Estate (which is mainly syndication type deals).
Thank you for reading.
– My two long-term REIT holdings are Entertainment Properties Trust (EPR) and STAG Industrial (STAG). Entertainment Properties specializes in owning and leasing back properties that are a bit harder to re-purpose but are diversified across different types of entertainment and education. Movie theaters, Top Golf Sites, Ski Resorts, Charter Schools. They don’t take on a lot of debt and have been doing it for 40 years. STAG Industrial is more of a glorified bond fund, they own industrial buildings along interstates leased to major tenants and carry minimal debt. Neither are cheap today, but you can usually watch EPR and wait for some pundit to declare movie theaters dead (people have been declaring them dead since the Betamax came out and its still the only way for a giant movie studio to recover their up front investment) and get it at a discount. The last time I added a bunch was February of ’18 and now I’m up 35-40% on the purchase price and have a yield to cost of around 8% for EPR.
– The $100,000 is flexibility and may end up being too low. The most tax optimal thing to do is to run it to almost zero, but I want to the liquid assets available if I want/need to make a large investment or have an opportunity. I went overboard early in putting all of our money away and missed a generational sale on rental real estate in 2009-2011 when we lived in Atlanta. We were maxing retirement accounts and paying down student loan debt and a mortgage early and to buy these properties at auction it generally required cash the day of the auction.
Thanks for the questions!
I am wondering why a brokerage account is more tax-efficient to draw down sooner than retirement accounts? Specifically a non-Roth, pre-tax 401K or IRA type of account, whose entire money is taxed at regular income tax rates. Qualified capital gains on a brokerage account would be lightly taxed by comparison.
I’d think it’s better to spend down at least some of the pretax accounts early in retirement, and allow the brokerage accounts to grow over time.
Plus with pre-tax accounts, you have the pesky detail of RMDs (one day in the far distant future for you). A large sum in pre-tax accounts at RMD age could be a real bummer.
What am I missing?
OK, I went and read your drawdown strategy and reconsidered my question in light of your age. You see, I am aged 60 and therefore can pull money out of my pretax accounts without penalty.
I also see you are making use of Roth conversions, which is super-wise in light of the Roth’s tax benefits. So that answers my question about your plan for reducing the size of your pretax accounts before the dreaded RMD age rolls around. I plan on doing the same conversions although I only have, barring legislative changes, 9 years to do that in, whereas you’ll be able to easily and less painfully convert a large amount to your Roth by the time you’re of RMD age (which may well be going up soon).