Category Archives: FI

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California Umbrella Insurance

Live in California? Do you wonder “how much personal liability umbrella insurance should I have?”

In this article, I cover the basics of personal liability umbrella insurance and then discuss five principles I believe to be most relevant in deciding how much personal liability umbrella insurance California residents should have. 

Insurance for Personal Liabilities 

Living our lives generates the possibility of liabilities to others. Accidents happen. It’s part of the human experience.

Most Californians have two primary insurances to guard against personal liability to others.

The first is homeowners insurance. For those who rent, this is renter’s insurance. This insurance can cover things like slip-and-fall accidents inside one’s home or one’s stoop.

The second is auto insurance, specifically liability insurance to third parties. 

Often homeowners and auto insurance have limits on the amount of liabilities it will pay to third parties. These could be $300,000 or $500,000 per accident, for example.

In today’s environment, particularly in California, it is very possible that our liabilities to third parties through auto accidents or in-home accidents can exceed these liability caps. Thus, many can and should obtain additional insurance coverage in the form of personal liability umbrella insurance, often referred to as “umbrella insurance.”

Personal Liability Umbrella Insurance

An umbrella policy sits on top of, not “instead of” or “in addition to” primary insurance. Umbrella insurance is generally secondary coverage.

Here is an example of how that works in practice. Oscar has a car and has a $500,000 auto insurance liability policy. Further, Oscar has a $2 million personal liability umbrella policy. Dollars $1 through $500,000 of Oscar’s potential auto liability to third parties would be paid out by the auto policy. Dollars $500,001 through $2 million of liability would be paid out by the umbrella policy

It is not the case that Oscar now has $2.5 million worth of auto liability coverage. Oscar’s $2 million umbrella is not added to his primary auto insurance coverage. Rather, the umbrella fills in coverage up to its limit, in this case $2 million. 

You can see that with respect to Oscar, the most likely insurance to pay out is his auto insurance. Say Oscar rear-ends another car and causes $25,000 worth of damage. His auto insurance policy would pay out $25,000 and his umbrella policy would pay $0.

Since umbrella insurance is generally a secondary policy, it tends to be somewhat affordable. That said, in California my experience has been that even umbrella insurance premiums are rising fast as of 2026. 

Oftentimes it is logical to bundle home, auto, and umbrella. Carriers often give discounts when consumers bundle. 

Umbrella carriers generally require minimum levels for home and auto protection. They don’t want consumers using an umbrella policy as a backdoor home and/or auto policy, so it is quite common for an umbrella carrier to require certain minimum coverage amounts with respect to home and auto policies. 

Umbrella insurance is generally offered in million dollar increments. In most cases, insurance companies will issue up to $5 million of umbrella insurance as long as the insured (a) has sufficient minimum home and auto coverage and (b) can write the check. Beyond $5 million generally requires additional underwriting. 

Protected Assets and Umbrella Insurance

In theory, if all of one’s wealth was in protected assets in certain states, there’s not much need for any umbrella coverage. The person could be sued, but if every significant asset was protected, at least in theory there would be little to nothing to collect in litigation. 

Depending on the state, creditor protected assets often include 401(k) and other ERISA protected retirement accounts. States also offer varying degrees of protection for one’s primary residence. In Florida, the entirety of one’s primary residence value is a protected asset. 

Retirement account protection depends on both federal and state law.

IRAs have been subject to relatively weak California law creditor protection, though they do qualify for decent federal protection in bankruptcy. A relatively new California law, AB 2837, has placed distributions from 401(k)s and other ERISA protected accounts at some risk. It remains to be seen how courts implement new AB 2837.

Ultimately, the amount of retirement account wealth that will be protected in litigation in California is subjective and dependent on all the facts and circumstances, including whether bankruptcy has been declared. Limited retirement account protection is a risk of living in California. 

The amounts protected by California’s homestead exemption vary by county and may not fully cover the value of one’s primary residence. 

For Californians, residents of what is generally perceived as a litigious state, the question arises, how much umbrella insurance coverage should I have?

California Umbrella Insurance Principles

I don’t have the silver bullet formula for exactly how much personal liability umbrella insurance you or anyone else should have.

But I have some principles that I believe can be helpful in making that determination. Of course, these five principles are not the only potential considerations one has when determining umbrella insurance coverage level. But I do believe they can be helpful for many Californians.

The Most Important Million is the First Million

In my opinion, the most important million in umbrella coverage is the first million. 

Why?

First, a $1 million personal liability umbrella insurance policy covers a significant swath of the liability probability curve. 

Generally speaking, the liability probability curve is at its highest at lower levels of monetary liability and slopes down. The greater the amount of monetary liability, the lower the likelihood of incurring it.

Further, consider the practicalities of settlements, as discussed in the second principle. The potential to settle a liability claim at $1 million is very valuable. 

Second, it is helpful to have a deep pocket in one’s corner if one has a liability event. The umbrella insurance company is on the hook for a significant amount of money if the insured has a liability event (such as a car accident) and thus has incentive to work through their legal team to limit the ultimate settlement amount. Obviously this is beneficial to the insured.

I look at umbrella insurance coverage level like an elementary school spelling test. When I went to Catholic elementary school, in second grade we had 20 word spelling tests on Friday mornings. Each word was worth 5 points.

For many Californians, having no personal liability umbrella insurance is like getting a 0 on the spelling test, while having $1 million of personal liability umbrella insurance is like getting a 100 on the spelling test. 

For some more well-to-do Californians, the $1 million umbrella policy is like getting an 80, 85 or 90 on the spelling test. Increasing umbrella coverage to $2 million, $3 million, $4 million, or $5 million (depending on the circumstances) would get these well-to-do Californians to a 100 score on the test. 

Consider Potential Exposure

Perhaps the most important question to ask is “how much could someone sue me for?”

In this regard, Dr. Jim Dahle, known online as The White Coat Investor, makes a very helpful assertion: most people are very willing to walk away for a $1 million settlement. Thus, Dr. Dahle argues that for most people a $1 million personal liability umbrella insurance policy can be sufficient. 

For this reason I believe even the extremely wealthy rarely need more than $5 million worth of personal liability umbrella insurance, even in a litigious state like California. 

One can never precisely predict the ultimate outcome of a future dispute. But settlement practicalities, including both sides’ desire to avoid a lengthy and costly legal process, do help define, to a certain degree, potential exposure.

Consider Unprotected Assets

I believe Californians should look at things like taxable accounts, HSAs, high housing values, rental real estate, etc. and consider protecting them with umbrella insurance. As discussed above, the extent to which retirement accounts are protected will depend on various facts and circumstances, including but not limited to whether bankruptcy has been declared. 

The extent to which Californians should protect retirement accounts with umbrella insurance is highly subjective and should be considered, in today’s environment, very much in conjunction with the other principles mentioned here. 

If In Doubt, Round Up in California

California is a challenging environment when it comes to cost of living, asset protection, litigation, and the like. No one precisely knows exactly how much personal liability umbrella insurance is optimal. Why not round up, not down, on umbrella insurance coverage level if in any doubt?

Frequently Revisit Umbrella Insurance Coverage Levels

I believe Californians should frequently revisit coverage levels. People’s circumstances change. California law changes. The frequently evolving landscape both legally and personally strongly suggests Californians should frequently revisit umbrella insurance coverage levels.

Consider Driving Less

Risk mitigation is certainly not limited to personal liability umbrella insurance. 

What’s the highest risk personal activity most Californians engage in? It’s easily driving. 

Living in California usually requires time behind the wheel. But is every last mile behind the wheel necessary?

A personal anecdote: This Fall I am speaking at and attending a three day financial planner conference in San Diego. My original plan was to drive down from Los Angeles. The problem with that plan is it required 150 miles each way fighting Southern California traffic. That’s 300 miles for me to get into an accident, only to have my car sit in a hotel garage for three days incurring parking fees.

So I chose a different path: I’m taking the Amtrak Pacific Surfliner to and from the conference. I even upgraded (for just $20 each way) to Business Class. Instead of fighting traffic and risking an accident, I’m relaxing in Business Class drinking free coffee, catching up on work and/or listening to the Hindley Street Country Club. 

Consideration should be given to taking an Uber or Lyft to the airport instead of driving and parking there. There are marginal tactics like these available that can reduce the miles we drive. 

Conclusion

Asset protection is a significant financial planning consideration in California. Personal liability umbrella insurance is one of the best available tools to provide financial protection in the event of an accident. Californians often benefit from having personal liability umbrella insurance. There’s no precise science for determining exactly how much coverage to have. But I hope the five principles I provided in this article are helpful as Californians consider the appropriate level of coverage they should have. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on LinkedIn: @SeanWMullaney

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Spreadsheets Don’t Answer Every Personal Finance Question

There’s a temptation to boil personal finance down to calculators and spreadsheets.

Can I retire?

Should I do Roth conversions?

When should I take Social Security?

Many say “find the right retirement calculator” or “put together a spreadsheet” and use that to make the decision.

I’ve thought about this issue often during my career as a financial planner and personal finance content creator. In 2024 I discussed this issue during my CampFI presentation.

In the past week, two pieces of content have put this issue back on my radar.

First is Pete Adeney’s article The Shockingly Simple Math Behind Social Security. Mr. Adeney is more commonly known online as “Mr. Money Mustache” or “MMM.” In this article, MMM argues that the question of “when to claim Social Security?” is resolved by a net present value calculation. 

Second is Rory Sutherland’s Doorman Fallacy. 

I believe we can properly assess MMM’s argument by unpacking the Doorman Fallacy.

The Doorman Fallacy

Here’s my rough version of the Doorman Fallacy: 

Picture a 5 star luxury hotel with a doorman. It actually has six doormen. Three Monday to Friday doormen, each working an eight hour shift and each collecting salary and benefits. The hotel also has three weekend doormen who occasionally also substitute for the weekday doormen. These three doormen collect an hourly wage.

Consultants can put their annual costs and the cost of installing an automatic door into a spreadsheet.

The spreadsheet tells us that in less than 8 months, the hotel breaks even from laying off the doormen and installing an automatic door. The automatic door needs to be replaced every 7 years. Thus, guided by the consultants and their spreadsheet, the hotel lays off the doormen and installs the automatic door.

In a couple of months, the hotel finds their average TripAdvisor rating fell from 4.8 stars to 4.4 stars. They notice that they have to lower room rates by 15 percent most nights to sell out the hotel when previously they had only a few nights that were not sold out. They also notice that now they occasionally get guest complaints about suspicious people hanging out in the lobby. 

My very rough retelling illustrates that the Doorman Fallacy is a classic case of seeing the data but failing to recognize the pattern. Yes, spreadsheets can help us see the pattern. 

Nevertheless, it is often the case that spreadsheets focus us on the data and obscure the pattern. The consultants’ spreadsheet focuses on one piece of data: the immediate cost saving from laying off the doormen and replacing it with an automatic door. 

But doormen in the case of a 5 star hotel are much more than what the spreadsheet can easily capture–their salary and benefits. It turns out that for a 5 star hotel, the doorman is part of a pattern that is much more dynamic than what a spreadsheet can tell you.

Social Security and Spreadsheets

It’s tempting to boil Social Security down to a spreadsheet. Do a net present value calculation and make your claiming decision.

MMM’s recent article advises us to do that. He argues:

Because when it comes to deciding on how Social Security fits into your retirement strategy, it really boils down to only one number: 

The Net Present Value of your future lifetime stream of Social Security payments.

Generally speaking, we compute net present value on a spreadsheet.

As much as I appreciate MMM (see below), I strongly disagree with the conclusion of his recent article. Why?

MMM’s take misses Social Security’s role in the pattern of investing and drawdown in retirement. Let’s dig into the pattern.

Volatility 

First and foremost is volatility. Social Security, generally speaking, is the least volatile financial asset retirees have. Social Security is adjusted for inflation. Delays in claiming Social Security increase annual collected benefits under an established formula. 

Compare and contrast Social Security with the other financial assets retirees rely on. For most, these are stocks, bonds, and cash. Stocks, bonds, and cash are good to have. But they are more volatile than Social Security, in my opinion. 

You say cash isn’t volatile. I say its value can be eroded away by potentially unpredictable inflation. Bonds are subject to volatility due to movements in interest rates, and we know stocks have all sorts of volatility.

Picture a 70 year old retiree who has achieved what some call their “FI number.” Do you want him or her to have more or less volatility in their lives?

When we’re working in our 30s and 40s and have years if not decades until retirement, volatility is our friend. Volatility tends to, over long periods, fuel portfolio growth. Further, those in their 30s and 40s have years to make up for portfolio declines. 

In our 70s and 80s we’ve experienced much of the portfolio growth we need for financial success. Further, we generally can’t go back to lucrative work at this point, so we struggle to make up for losses. In retirement, volatility is mostly our enemy.

I believe (generally speaking) most financially successful retirees should look to reduce volatility in their 70s and 80s. What does that look like when it comes to Social Security claiming strategies?

Delay, delay, delay!

From this perspective, financially successful retirees should live off volatile assets entirely in their 60s and collect Social Security starting only at age 70. This has the effect of reducing reliance on the stocks, bonds, and cash (the volatile assets) in one’s 70s and 80s and increasing the amount of nonvolatile income, Social Security, in one’s 70s and 80s. 

While it is theoretically possible to use backwards looking statistics to illustrate volatility on a spreadsheet, doing so creates complexity and potential confusion while only looking backwards. Why focus on backwards looking statistics when the relevant numbers are future unknown numbers? Thus, I don’t believe that spreadsheets are all that helpful in recognizing this part of the retirement drawdown pattern. 

Those focused on Social Security net present value calculations while ignoring how Social Security claiming strategies interact with the rest of a retiree’s financial portfolio focus on a subset of data instead of recognizing the relevant pattern. 

Claiming at age 62 to invest: Some in the FI community claim Social Security benefits at age 62 to invest them. The idea is to “do better” in the stock market. I disfavor this approach. Why? It increases volatility by increasing volatile portfolio assets while decreasing the monthly amount of Social Security collected in one’s 70s and 80s. 

Tax Planning

Another important consideration in Social Security claiming decisions is tax planning. Claiming Social Security early tends to limit or foreclose some outstanding mid-to-late 60s tax planning opportunities, including Tailored Taxable Roth Conversions and the Hidden Roth IRA. I discussed both of these opportunities in detail during my 2025 Bogleheads Conference presentation.

Delaying claiming Social Security can also reduce the amount of Social Security income subject to income tax. The rules subject 0 to 85 percent of one’s Social Security to income tax based largely on one’s other income. If you have less other income in your 70s and 80s (since you spent down more of your portfolio assets in your 60s) you are at least somewhat more likely to have less of your Social Security income subject to income tax. Note that this potential benefit is usually nonexistent for very affluent retirees.

Tax planning rarely boils down to just spreadsheets. It’s about recognizing the pattern of where taxes on retirees are likely heading in the future and how tax rules on retirees relate to comprehensive drawdown strategies. Cody Garrett, CFP(R) and I discuss this in great detail in our recent book Tax Planning To and Through Early Retirement. 

Social Security Probability Analysis

Another factor to consider is “what claiming strategy is most likely to produce the highest total present value benefits collected from Social Security?”

The best free resource in this regard I’m aware of is Mike Piper’s opensocialsecurity.com. 

Note that this resource simply answers one relevant question. As we’ve already seen, there are other relevant factors. The Open Social Security calculator in no way measures tax planning benefits of delaying. It also does not measure the volatility benefits to the investor of having more of one’s overall portfolio in increased future Social Security payments in their 70s or 80s. 

Other Factors

Volatility, tax planning, and probability analysis. All three factors are relevant and are part of the pattern that informs our Social Security claiming decision. But there are other factors that are important. How long do you expect to live? Are you married? Are you the higher earning spouse or the lower earning spouse?

None of this is to say that Social Security claiming decisions are to be agonized over. I believe the pattern often emerges with informed consideration of the relevant factors. Spreadsheets and calculators can be helpful but are certainly not the be-all-and-end-all in this regard.

Social Security claiming decisions do not boil down to a single spreadsheet calculation.  

Social Security’s Future: But Sean, won’t Social Security benefits be reduced in the future? Allow me to respond with a question: Will future politicians cease to act in their own best interests? A pay cut for retirees is hardly in the politicians’ own best interests, considering that in 2024, 58 percent of the electorate was aged 50 or older. The most likely explanation of Social Security benefits over the next few decades is that retirees will collect 100 cents on the dollar or very close to it. 

Spreadsheets Do Have an Important Role in Personal Finance

Spreadsheets play a role in personal finance. I ought to know. I’ve now spent hours of YouTube videos going through spreadsheets demonstrating how retirees using traditional retirement accounts are taxed when taking feared required minimum distributions (“RMDs”).

It turns out that there’s nothing to fear when it comes to RMDs. The spreadsheets uncover the truth that too much personal finance commentary omits. 

Long before my YouTube videos, the one and only Mr. Money Mustache used a spreadsheet to recognize a pattern. The Shockingly Simple Math Behind Early Retirement is a classic article. He used a spreadsheet to roughly translate a savings rate into “Working Years Until Retirement.” 

MMM’s spreadsheet wasn’t used for precision. Rather, it was used to illustrate a pattern. Retirement is very possible if one reduces expenses to increase investments. The spreadsheet put data together–in this case, combining annual expenses and savings rate–to produce the pattern. MMM’s spreadsheet illustrates retirement is sooner than most think if you can reduce annual expenses and invest the savings. 

The above said, let’s not get carried away when it comes to spreadsheets and online calculators. Gary Gulman helpfully observes that $20 to most people is not the same as $20 is to Bill Gates. A spreadsheet says $20 equals $20. 

Trying to boil down personal finance decisions to what a calculator or spreadsheet says reflects a problem in decision making: what is most appropriately done based on multiple factors and inputs is boiled down to a “high school maths” problem. 

Conclusion

Social Security claiming decisions cannot be made in a vacuum. There is no single silver bullet. 

Social Security claiming decisions have implications for investment allocation and tax planning. Patterns can be understood only after considering all the important relevant factors. 

Thus, a one-off net present value calculation is not sufficient to make a Social Security claiming decision. Using a spreadsheet to determine a Social Security claiming decision is equivalent to a spreadsheet claiming it is “optimal” to lay off doormen and install a cheaper automatic door at a 5 star hotel. 

Yes, spreadsheets can play a role in retirement drawdown and financial planning. Far more important, however, is recognizing patterns that account for all relevant factors including investment volatility, tax planning, and the unique characteristics of each retiree. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on LinkedIn at @SeanWMullaney

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Why I Don’t Worry Much About Sequence of Returns Risk

If there is a single article of faith in the personal finance world, it’s you’ve gotta worry! IRMAA! RMDs! Widow’s Tax Trap! 

You’re rich? Great, start worrying! There’s plenty to worry about. 

Hopefully most long time readers and YouTube viewers know I’m kidding since I’m a glass half-full type. Today I tackle one worry that sometimes dwarfs the previously mentioned three. Sequence of returns risk. People wonder if they should hold years of cash at retirement because of sequence of returns risk. 

What is Sequence of Returns Risk?

Broadly defined, sequence of returns risk is that during the early part of a lengthy retirement, one or more bad years will hit the stock market. The early retiree is no longer accumulating, drawing down, and losing equity value. If the market takes years to recover, this could significantly hamper the early retiree’s chance of financial success in retirement.

Karsten Jeske, known as Big Ern online, discusses sequence of returns risk here.  

Below I discuss five reasons I don’t worry about sequence of returns risk much as applied to well diversified retirees. 

Diversification

We tend to think our portfolio exists in a vacuum. It doesn’t. 

As Rick Ferri has observed, a well diversified equity portfolio rapidly declining will be accompanied by several offsetting things in the world. Policy makers and central banks are likely to take action, perhaps significant action. As the economy is down, layoffs are up and fellow retirees are feeling the pinch.

What’s happening to prices in that environment? Fewer businesses are paying for work travel and fewer retirees are staying at hotels. Fewer workers are getting bonuses and bidding up the price of grass-fed ribeyes at the supermarket. In environments where the entire economy is hurting, prices for goods and services are likely to be stable or themselves falling. 

Will it be good for the early retiree to have their well diversified equity portfolio tank in early retirement? No. But Rick Ferri’s observation that related factors reduce the adverse impact of significantly falling equity prices is very instructive as to the importance, or lack thereof, of sequence of returns risk.

Where sequence of returns risk worries me greatly is a situation where an early retiree has a very undiversified portfolio. Imagine Sean retires today and 80 percent of his equity portfolio is in Apple stock. Apple stock can drop for a host of reasons while the rest of the economy is booming. The price of steak, travel, accommodations, etc. could care less about the stock price of Apple. 

For the undiversified early retiree, sequence of returns risk is one of many very significant risks in early retirement and one worthy of spurring on major changes to a portfolio. 

Social Security

Many early retirees will receive significant Social Security benefits. Those benefits are not too far out in the future for the early retiree. Social Security benefits are not subject to sequence of returns risk. Further, Social Security benefits reduce the retiree’s reliance on their equities and bonds. 

You Won’t March Off the Cliff

People worry about financial failure caused by things like sequence of returns risk. Here’s the thing: you will not blindly march off the cliff when it comes to your spending, as Michael Kitces observed on the BiggerPockets Money podcast.  

Both subconsciously and consciously, retirees will adjust their spending in down markets. A 14 day vacation becomes a 10 day vacation. You eat out one less meal a week. A new Camry becomes a new Corolla or becomes a used Corolla. 

Spending adjustments during down markets can mitigate sequence of returns risk with little impact on lived experience quality. 

Market Bounce Backs

When discussing the sequence of returns risk issue, we need to consider two issues. First, how much of the portfolio does an early retiree need at any one moment in time? Yes, this year’s withdrawal at reduced equity prices hurts the early retiree. But the rest of the portfolio declining this year is not at detrimental this year. Further, the rest of the portfolio might bounce back spectacularly, as I’ll discuss below. 

Second, what is the investment horizon for an early retiree? For the 55 year old retiree, it could easily be 35 years.

Let’s picture Amelia. Amelia is retiring today (congratulations!) and is currently 60 years old. According to the most recent Social Security Trustees’ Report actuarial data, Amelia is expected to die, on average, a bit before her 84th birthday. Obviously most Americans do not do financial planning to account for living only to their average life expectancy. Amelia easily has a 30 year or more investment time horizon today.

If Amelia is invested in a well diversified portfolio (including both an equity allocation and a bond allocation), she has plenty of time to ride out a very significant dip in the stock market. Imagine the S&P 500 is down 38.49 percent during the first year of her retirement. That’s what happened to the S&P 500 in 2008. According to the Social Security Trustees’ Report actuarial data, she has about 22.65 years over which to make up for that loss. 

How many 22.65 year periods over the past 100 years has the American stock market not made up that sort of loss? 

Let’s consider a retired couple that has already battled through sequence of returns risk. On December 31, 2007, Mark and Mary retired at age 50 with a well diversified equity and bond portfolio. The S&P 500 was at 1,468.36. A year later it was at 903.25. Since then, Mark and Mary have been through March 2020, the year 2022 when the S&P 500 was down 18.1%, and the March/April 2025 stock market decline.

How are Mark and Mary doing today? Well, the S&P 500 is at 6,000.36 (June 6, 2025 close) and now Mark and Mary upgrade their airfare to first class.  

Is the market always guaranteed to bounce back? Surely not. But you might want to refer to the 110 year Dow Jones Industrial Average graph that JL Collins shares several times in the new version of The Simple Path to Wealth, including on page 52. 

Cash is Not a Free Lunch

Let’s discuss the most commonly applied technique to mitigate sequence of returns risk: holding significant amounts of cash and spending it down first in retirement. 

This tactic has drawbacks. Cash is subject to inflation risk. It’s a store of value, and storing value is increasingly difficult, in my opinion. Further, by investing in cash the retiree foregoes the chance to invest in equities or bonds, potentially reducing future expected return (sometimes referred to as “cash drag“). Lastly, in a taxable account significant cash balances generate inefficient ordinary income in the form of interest payments. 

Conclusion

When it comes to retiree portfolio construction, I view sequence of returns risk as being similar to the prospect that the New York Jets will finish in last place in the AFC East.

Are both risks real? Yes

Are both unpleasant? Yes

Do both present significant risks of financial failure in retirement for well diversified retirees: No!

Yes, I exaggerate by equating sequence of returns risk with the performance of the New York Jets. But for the five reasons I stated above, I do not believe that sequence of returns risk should be a significant factor in portfolio construction for most well diversified retirees.

Further Reading

If you’ve gotten this far, I suspect you might be thinking to yourself, “Sean, you’ve convinced me on sequence of returns risk. But I’m still losing sleep over RMDs, IRMAA, and the Widow’s Tax Trap!”

Don’t worry. Cody Garrett and I have you covered in Tax Planning To and Through Early Retirement, our forthcoming book likely to be published later this year. Sign up to find out when the book will be published here. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on YouTube: SeanMullaneyVideos

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Medicare Resources

You know what doesn’t get enough coverage in the personal finance space: Medicare! It’s complicated, and frankly, I have neither the time nor the mental bandwidth to become a Medicare expert.

However, recently I have seen some excellent YouTube Videos on the topic. I believe all the links provided below are worthy of consideration. That consideration should, of course, include critical analysis: these videos are great, but they didn’t come down the mountain with Moses (neither did any of my blog posts or YouTube videos).

Further, none of the videos should be relied upon as advice for any particular person. They are all educational resources.

Sarasota Tim on Medicare Basics and Enrolling: https://www.youtube.com/watch?v=FNCk7x26i_M

Clark Howard Shares His Concerns with Medicare Advantage (Medicare Part C): https://youtu.be/QUSdn7nGXvQ?t=192

Danielle Kunkle Roberts on Medigap Part G: https://www.youtube.com/watch?v=XtqfO22-Tss

Danielle Kunkle Roberts on Medigap High Deductible Part G: https://www.youtube.com/watch?v=s2aRGN7pR1Q

MedicareSchool on Medigap Part G Versus Medigap Part N: https://www.youtube.com/watch?v=tYXvKvMPbpI

MedicareSchool on Medicare Part D (Prescription Drugs): https://www.youtube.com/watch?v=rSLx-lFr-DM

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Four Ways to Fight Inflation

Decisions you make today can subject you to more inflation tomorrow! Read below about ways to increase or decrease your exposure to inflation tomorrow.

Watch me discuss fighting back against inflation.

Tax Planning

As a practical matter, most Americans have the majority of their retirement savings in traditional, pre-tax vehicles such as the 401(k). Having money in a traditional 401(k) is not a bad thing. However, the traditional 401(k) involves trade offs: an upfront tax deduction is the primary benefit in exchange for future taxation when there is a withdrawal or Roth conversion.

Having money inside traditional retirement accounts subjects future inflation to taxation. Some of the future growth in a traditional retirement account is likely to be attributable to inflation, and thus there will be a tax on inflation. Further, there are no inflation adjustments when it comes to the taxation of traditional IRA and traditional 401(k) withdrawals. 

An antidote to this problem is the tax free growth offered by Roth accounts and health savings accounts. Getting money into Roths and HSAs excuses future growth from taxation, including growth attributable to inflation. 

Roth 401(k) versus Roth IRA

Of course, inflation is only one consideration. Many will do some traditional retirement account contributions and some Roth retirement account contributions. The question then arises: which Roth account to use? 

My view is that for many a Roth IRA contribution (whether a direct annual contribution or a Backdoor Roth IRA) is better than a Roth 401(k) contribution. Many do not qualify to deduct a traditional IRA contribution but can deduct a traditional 401(k) contribution. Considering that reality, why not combine a deductible traditional 401(k) contribution and a Roth IRA contribution? 

Long Term Fixed Rate Debt

Often we discuss how inflation hurts Americans, and we should be concerned about the bad effects of inflation. However, there is a way to become a beneficiary of inflation: using long-term, low interest fixed rate debt to your advantage.

That’s right: hold onto that low rate 30 year mortgage like it’s a life raft! Okay, that’s a bit hyperbolic, but the overall point holds. Inflationary environments are great for debtors, particularly those debtors who have locked in a low interest rate for a long term.

Here is an example: Sarah and Mike have a 30 year, $400,000 mortgage on their primary residence at a 2.9% fixed interest rate. By paying the required monthly payment, and no more, they benefit from any future inflation. By paying off the mortgage later rather than sooner, they are using devalued future money to pay the mortgage rather than more valuable current day dollars. 

Sarah and Mike benefit from inflation! Are there reasons to pay off a mortgage early? Sure. But in an inflationary environment, paying off the mortgage early gives the bank more valuable dollars to satisfy the debt.

To my mind, a fixed rate, long term mortgage is a great hedge against inflation.

That said, there are few perfect financial planning tactics. Most involve risk trade offs. One risk Sarah and Mike assume by not paying down the mortgage early is the risk of deflation. To obtain this inflation hedge, they expose themselves to the risk of deflation. If the U.S. dollar starts to deflate (i.e., it appreciates in value), Sarah and Mike will find themselves paying more valuable dollars to the bank in the future. 

Travel Rewards

Travel rewards can help fight inflation. One way is using sign-up bonuses and other accrued points to pay for hotel room nights or flights. Using points gets out of cash paying and thus inflation of the dollar hurts a bit less.

However, keep in mind that travel reward points are subject to their own inflation! The hotel chain or airline can devalue the redemption value of points at any time. Thus, if everything else is equal, those with significant travel rewards point balances might want to spend those points sooner rather than later for travel. 

A second consideration are the features of credit cards. Some travel branded credit cards come with certificates for free nights or a companion pass for a companion to receive free or discounted flights. If flighting inflation is a key goal, favoring cards that offer free-night certificates or companion passes can be a way to fight inflation. 

Spending that Leads to More or Less Future Spending

We’re used to assessing the price tag. $28,000 for that brand new car: “that’s a great deal!” or “that’s a terrible deal!” But the price tag is only one part of the financial picture.

If you buy a black cup of coffee at Starbucks, it might cost you $2.65. Fortunately, that’s it. The cup of coffee isn’t likely to cause you to incur later costs.

What about a $45,000 SUV? That purchase will cause later costs, many significant. For example, the cost to insure a $45,000 SUV might be significantly more than insuring a $22,000 sedan. What about gas? By purchasing a larger, less fuel-efficient car, you lock in more future spending, and thus more exposure to future inflation. 

Think about buying a large home with a pool in the backyard. That square footage attracts property tax, heating and cooling costs, and inflation in both costs. The pool in the backyard requires constant upkeep, subjecting the homeowner to another source of inflation. 

To my mind, food is a big one in the fight against inflation. What you eat today could very well translate into medical costs tomorrow, exposing you to significant inflation. Spending on foods with vegetable oils and sugars today is likely to increase your future exposure to medical expense inflation. 

The lesson is this: you can use today’s spending to reduce your exposure to future inflation. 

Conclusion

Is there a perfect answer to inflation? No. But with some intentional planning and spending today, Americans can reduce their exposure to the harmful effects of future inflation. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Sean Discusses the Four Percent Rule on the ChooseFI Podcast

Why was your grandparents’ furniture horribly out of date? There’s a reason that has to do with financial independence!

I had a great conversation about grandparents’ furniture, inflation, and the four percent rule with Brad and Jonathan on the ChooseFI podcast. You can access the episode on all major podcast players or on the ChooseFI website: https://www.choosefi.com/the-four-backstops-to-the-four-percent-rule-sean-mullaney-ep-376/

During the episode, we reference my recent blog post, The Four Backstops to the Four Percent Rule.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The Four Backstops to the Four Percent Rule

Introduction

Worried about an early retirement based on the Four Percent Rule? Might the 4% Rule work because of natural backstops most early retirees enjoy? 

The 4% Rule

The 4% Rule is a rule of thumb developed by the FI community. For example, JL Collins writes extensively about the 4% Rule in Chapter 29 of his classic book The Simple Path to Wealth.

Boiled down, the rule of thumb states that an investor can retire when he or she (or a couple) has 25 times their annual expenses invested in financial assets (equities and bonds). They would then spend down 4% of their wealth annually in retirement. The first year’s withdrawal forms a baseline and is increased annually for inflation.

The idea behind the 4% Rule is that the retiree would have a very strong chance of funding retirement expenses and never running out of money in retirement. As a result, some refer to 4% as a safe withdrawal rate. 

Here’s how it could look:

Maury is 50. He has $1M saved in financial assets. He can spend $40,000 in the first year of retirement. If inflation is 3% at the end of his first year of retirement, he increases his withdrawal by 3% ($1,200) to $41,200 for the second year of retirement.

The 4% Rule has a nice elegance to it. Most investors aim for a greater than 4% return. In theory, with a 5% return every year, the 4% Rule would never fail a retiree. If you spend approximately 4% annually, and earn approximately 5% annually, you have, in theory, created a perpetual money making machine and guaranteed success in retirement.

Watch me discuss the Four Backstops to the 4% Rule

The theory is great. But in practice we know that investors are subject to ups and downs, gains and losses. What happens if there is a large dip in equity and/or bond prices during the first year or two of retirement? What if there are several down years in a row during retirement? 

As a result of these risks, and stock market highs in late 2021, some are worried that the 4% Rule is too generous for many retirees. Christine Benz discussed her concerns on a recent episode of the Earn and Invest podcast. 

This post adds a wrinkle to the discussion: the four backstops to the 4% Rule for early retirees. What if worries about the adequacy of the 4% Rule for early retirees can be addressed by factors outside of the 4% Rule safe withdrawal rate? And what if those factors quite naturally occur for early retirees?  

Resources for the Four Percent Rule

These are links to articles addressing the 4% Rule and safe withdrawal rates

Cooley, Hubbard, and Waltz (Trinity University) 2011

Bengen 1994

Below I discuss what I believe to be the four natural backstops to the 4% Rule. 

Spending

A 4 percent spending rate in retirement is not preordained from on-high. Spending in retirement can be adjusted. Those adjustments can take on two flavors.

The first flavor are defensive spending reductions.  As Michael Kitces observed on an episode of The Bigger Pockets Money podcast, retirees will not blindly spend 4 percent annually without making adjustments in down stock markets.

See that the stock market is down 10 percent this month? Okay, take a domestic vacation for 6 days instead of an international vacation for 9 days. Buy a used car instead of a new car. Scale down and/or delay the kitchen remodel.

There are levers early retirees can pull that can help compensate for declines in financial assets while not too radically altering quality of life. 

The second flavor is, from a financial perspective, even better. As early retirees age, there will be natural reductions in spending. How many 80 year-olds decide to take a 12 hour flight to the tropics for the first time? There is a natural reduction in energy and interest in certain kinds of spending as one ages. It is likely that many retirees will experience very natural declines in expenses as they age. 

Social Security

For the early retiree under 62 years old, the 4% Rule must disregard Social Security. Why? Because Social Security does not pay until age 62, and many in the financial independence community delay Social Security payments beyond age 62, perhaps all the way to age 70 (to increase the annual payment).

Here is an example of how that works.

Melinda is 55. She has accumulated $1.5M in financial assets and can live on $60,000 per year. If she retires at age 55 and lives off $60,000 a year increased annually for inflation, the only financial resources she has are her financial assets (what I refer to as her 4% assets). She cannot live off Social Security payments until age 62, and may choose to defer receiving Social Security up to age 70. 

If Melinda defers Social Security until age 70, and receives $2,500 per month at age 70 from Social Security, her 4% assets now do not need to generate the full 4% once she turns 70, since Social Security will pay her $30,000 a year at age 70.

In theory, under the 4% Rule, Melinda’s Social Security is play money. Melinda funds her lifestyle with withdrawals from her financial assets, and now she’s getting additional Social Security payments. But, if her portfolio is struggling to produce the amount Melinda needs to live off of, Social Security payments provide a backstop and can help make up the difference. 

You might think “but wait a minute, didn’t Melinda significantly lower her Social Security benefits by retiring early by conventional standards? The answer is likely no, as I described in more detail in my post on early retirement and Social Security. First, only the 35 highest years of earnings count for Social Security benefits. At age 55 is it possible Melinda has 35 years of work in. 

Second, and more importantly, Social Security benefits are progressive based on “bend points.” The first approximately $12,000 of average annual earnings are replaced by Social Security at a 90 percent rate. The next approximately $62,000 of average annual earnings are replaced by Social Security at a 32 percent rate, and remaining annual earnings are replaced at a 15 percent rate. This is a fancy way of saying that reducing later earnings, for many workers, will sacrifice Social Security benefits at a 15 percent, or maybe a 32 percent, replacement rate. Even early retirees are likely to have secured all of their 90 percent replacement bend point and a significant amount of their 32 percent replacement bend point. 

I previously wrote the following example:

Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted for inflation by Social Security, total $2,800,000. Divided by 35, they average $80,000. This means Chuck has filled the 90 percent replacement bend point (up to $12,288) and filled the 32 percent replacement bend point (from $12,288 to $74,064) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security. 

An additional year of work for Chuck at a $130,000 salary netted Chuck only $557 more in annual Social Security benefits at full retirement age! 

Real Estate

Most early retirees own their own primary residence, usually with either significant equity or no mortgage. That primary residence can be a backstop to the 4% Rule.

For example, a retiree might live in a 2,000 square foot, $500,000 home with no mortgage. During their retirement, they might decide they don’t want to maintain such a large home, so they sell the 2,000 square foot home and move into a 1,000 square foot condominium at a cost of $350,000. The $150,000 difference in sale prices can become a financial asset to backstop 4% Rule assets and help the retiree succeed financially.

Alternatively, the early retiree could sell the $500,000 home and move into a smaller apartment with a $2,000 per month rent. While the retiree has increased their expenses, they also have created $500,000 worth of financial wealth to help pay that rent and fund their other expenses.

A third option is a reverse mortgage where the retiree stays in their primary residence but gets equity out of the home from a bank. 

Real estate can serve as a natural backstop to help ensure retirees have financial security and success.

Death

It’s wet blanket time. You may be considering a 30, 40, or 50 year retirement. Unfortunately, there is a good chance that you will not live that long. Sadly, not all early retirees have a long retirement. 

As demonstrated in these tables, there is a real chance that an early retiree will not live for 25 or 30 years. That factors into whether or not the 4% Rule will work for an early retiree. 

Let’s consider a 55 year old considering early retirement using the 4% Rule. He believes that he will live 30 more years and there is a 95% chance that his assets will last 30 years. He believes that the 4% Rule has a 5% chance of failing him. Further, assume that he believes there is a 30% chance that he will die prior to age 85.

His own potential death reduces the chance that the 4% Rule will fail. Remember, failure requires that he has to both run out of assets and live long enough to run out of assets. By his estimation, the odds that both events will occur are just 3.5 percent. To figure this estimated probability, multiply the probability that he will run out of assets (5%) by the probability that he will live long enough to run out assets (70%). 

A not insignificant number of early retirees will have an early retirement that lasts (sadly) only 10 years, 15 years, or 20 years. That (again, sadly) backstops the 4% Rule. 

Early Retirees vs. Conventional Retirees

I’ve contended that early retirees have four natural backstops to the 4% Rule. What about more conventional retirees? I’ll define a “conventional retiree” as one who collects Social Security soon after retiring. 

I believe conventional retirees enjoy three of the four backstops. Sadly, they “enjoy” the mortality backstop to a greater degree than early retirees. 

Conventional retirees retiring on Social Security do not enjoy Social Security as a backstop to the 4% Rule in most cases. Here’s an example:

Robert is age 65 and is planning to retire on financial assets and Social Security. He will collect $36,000 a year in Social Security and will spend a total of $76,000 a year. To facilitate this, he will initially withdraw $40,000 from his $1M portfolio.

In Robert’s case, Social Security is not a backstop to the 4% Rule. Rather, the 4% Rule is simply one of two necessary but not sufficient sources of funds for his retirement. A failure of the 4% Rule in Robert’s case would not be backstopped by Social Security. 

Conclusion

While there are no guarantees when it comes to safe withdrawal rates in retirement and the 4% Rule, it is possible that many early retirees will succeed with the 4% Rule, for two reasons. First, the 4% Rule may, by itself, be successful for many early retirees. The second reason is that even if the 4% Rule fails, there are four natural backstops in place for many early retirees that can step in and help retirees obtain financial success even if the 4% Rule fails on its own.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Early Retirement and Social Security

UPDATE October 20, 2023: This post has been updated for the 2024 Social Security numbers.

I can’t retire early! I’ll destroy my Social Security!

Is that true? What happens to Social Security benefits when retirees retire early? Are significantly reduced Social Security benefits a drawback of the financial independence retire early (FIRE) movement? 

Below I explore how Social Security benefits are computed and the effects of retiring early on Social Security.

Social Security Earnings

Form W-2 reports to the government one’s earnings during the year. For the self-employed, the Schedule SE performs this function. The Social Security Administration tracks those earnings. 

Only a limited amount of earnings every year count as Social Security earnings. There is an annual maximum on the amount of earnings that can go on one’s Social Security record, regardless of the number of jobs one has. For 2024, the Social Security cap is $168,600. The cap is increased most years for inflation. Payroll taxes for Social Security (FICA for W-2 workers, self-employment taxes for the self-employed) are not due on earnings above the cap.

Social Security Benefits

A few very general rules need to be established as we consider the amount Social Security pays.

  1. Only the highest 35 years of earnings during one’s working years count in determining Social Security benefits.
  1. For most Americans reading this, full retirement age is 67. This means a person can collect his or her “full” Social Security benefits at age 67.
  1. Social Security benefits can be collected as early as age 62 and can be deferred as late as age 70. Collecting early reduces annual benefits (by roughly 5 to 7 percent per year) and collecting late increases benefits (by 8 percent per year).
  1. Annual earnings used in determining benefits are inflation adjusted through age 59. Earnings earned at age 60 and later are not inflation adjusted for purposes of computing Social Security benefits. 
  1. Very roughly speaking, the annual benefit is computed as follows: accumulated earnings (computed based on the rules described above) in the high 35 years are summed and then divided by 35. The resulting average annual earnings are applied against the Social Security “brackets” or “bend points.” Up to $14,088 (using 2024 numbers) of computed average annual earnings is replaced by Social Security at a 90% rate. The next $70,848 of average annual earnings are replaced at a 32% rate. Any additional amount of average annual earnings is replaced at a 15% replacement rate. The bend points are adjusted for inflation.

One need not be an expert on Social Security to see directionally how early retirement might impact Social Security benefits. Because of the progressive nature of Social Security benefits, leaving work early (by conventional standards) tends to reduce benefits less than one might initially expect. Additional earnings later in life tend to only slightly increase Social Security benefits.  

Early Retirement Social Security Example

Here’s an example to help us understand the impact of an early retirement on Social Security benefits. 

Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted (thus, nominally increased) for inflation by Social Security, total $3,100,000 as of 2024. Divided by 35, they average $88,571. This means Chuck has filled the 90 percent replacement bend point (up to $14,088) and filled the 32 percent replacement bend point (from $14,088 to $84,936) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security. 

If Chuck retires now and earns nothing more, his annual Social Security benefits, expressed in 2024 dollars, will look something like this at full retirement age:

Replacement RateReplaced Annual IncomeAnnual Social Security at Full Retirement Age
90%$14,088$12,679
32%$70,848$22,671
15%$3,635$545
Total$88,571$35,896

Note that I rounded each bend point’s calculation. With the cents Chuck gets in each bend point, his total is increased by almost a full dollar. Similar rounding applies to the examples below as well.

At age 67, Chuck’s annual Social Security will be $35,896 (expressed in 2024 dollars).

If Chuck continues to work for one more year at a $130,000 salary, and then retires his annual Social Security benefits at full retirement age, expressed in 2024 dollars, looks something like this:

Replacement RateReplaced Annual IncomeAnnual Social Security at Full Retirement Age
90%$14,088$12,679
32%$70,848$22,671
15%$7,349$1,102
Total$92,285$36,453

Interestingly, an additional year of work only increased Chuck’s annual Social Security benefit by $557. Why is that? Remember that every dollar earned is divided by 35 for purposes of computing Social Security benefits. You can see that Chuck’s replaced income increased by $3,714 (from $88,571 to $92,285). By earning $130,000 in 2024, Chuck increased his Social Security average annual income by $3,714, which is $130,000 divided by 35.

Multiplying the increase in replaced income ($3,714) by the replacement rate (15%) gets us the additional $557 in annual Social Security benefits. 

Okay, but what about three more years of earnings. Say Chuck can work for three more years at an average annual salary of $135,000. What result (in 2024 dollars) then? 

Replacement RateReplaced Annual IncomeAnnual Social Security at Full Retirement Age
90%$14,088$12,679
32%$70,848$22,671
15%$18,920$2,838
Total$103,856$38,188

Where I come from, $1,735 ($38,188 minus $36,453) in increased annual Social Security benefits at full retirement age is not nothing. But is it worth delaying retirement for three full years if one is otherwise financially independent? To my mind, probably not. 

Spousal Benefits

What if Chuck is married to Mary? How does that impact the analysis?

During Chuck and Mary’s joint lifetimes, it depends on whether Mary collects spousal benefits. If Mary has Social Security earnings of greater than 50 percent of Chuck’s Social Security earnings, she will likely collect benefits under her own earnings record, and not a spousal benefit. Thus, Chuck’s Social Security earnings will be irrelevant to the Social Security benefit Mary collects.

If, however, Mary’s lifetime Social Security earnings are less than 50 percent of Chuck’s, Mary is likely to collect a spousal benefit of roughly half of Chuck’s annual benefit. In this case, Chuck working 3 more years creates $2,603 of additional annual Social Security income ($1,735 for Chuck and $868 as Mary’s spousal benefit). Even $2,603 in additional annual income isn’t likely to justify Chuck working for three more years.

At Chuck’s death, assuming Chuck predeceases Mary, Mary will collect the greater of her own Social Security benefit or Chuck’s Social Security benefit. Thus, Chuck increasing his Social Security earnings could increase Mary’s Social Security benefit as a widow.

I’ve got a plan to save Social Security and Medicare.

Resource

Most people I know cannot tell you their Social Security earnings record off the top of their head. But, this information is accessible by creating an account at ssa.gov. From there, Americans can obtain their Social Security statement which includes their Social Security earnings (though the statement does not adjust those annual earnings for inflation). The 2024 factors to increase annual earnings for inflation can be found by entering “2024” in the search box at the bottom of this SSA.gov website.

Conclusion

There are many factors to consider before retiring early. It is helpful to understand how Social Security benefits are computed so early retirees can understand the potential impact of retiring on their Social Security benefits. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Luck, Credit, and the FIRE Movement

Recently, the FIRE movement has come in for some criticism. Here is one prominent example. While I don’t want to speak for the critics, some of the arguments boil down to a version of the following: FI or FIRE (I prefer FI, but let’s not argue over terminology) overemphasizes personal responsibility and individualism, as most financial outcomes are the result of luck and the work of others. For example, if you invest $250,000 in real estate and local property values skyrocket such that your investment is now worth $600,000, most of the value of your investment is not attributable to anything you did.

While I appreciate the perspective provided by these commentators, I respectfully disagree with the criticisms. 

My Journey with FI

Before I address the criticisms, I thought it would be helpful to share a bit of my perspective on FI. My journey with personal finance mostly starts in college, when I began to become interested in some of the tactics of personal finance. Things like the Roth IRA and passive investing. 

For me, the tactics were like the quartz countertops, cabinets, and ceiling beams on a home construction site: shiny objects drawing attention, but by themselves not all that impactful. As applied to personal finance, when you add in the FI framework, you transform shiny objects into a house. Having the FI framework and goals ultimately drives better choices and better luck. 

Getting introduced to FI in 2017 flipped a switch for me. It gave meaning to the personal finance tactics. More important, it encouraged me to make better choices. For me, it’s not about a FI number or a retirement deadline.* And it has never been about anyone who retired at a particularly early age. Rather, to me FI is all about making better choices that give me and my family more options and better financial luck. 

This is why I don’t believe “financial literacy” is an adequate substitute for FIRE. You can teach people about 401(k)s and HSAs until you’re blue in the face. Without something akin to the FI framework, financial knowledge by itself does not often materially improve choices and outcomes. Financial literacy without a framework and goals is sort of like teaching algebra in high school. There’s nothing wrong with it, but how much did algebra affect your adult life? 

Having shared a bit of my own FI journey, here are my thoughts on the recent criticisms of the FIRE movement. 

* Note: For some, FI is about hitting a FI number and/or retiring by a certain date. That’s great–to each their own. 

The Role of Luck

Michael Jordan won six NBA Championships. Wouldn’t we all say that he was a great basketball player?

But wait a minute. Wasn’t almost all of his success attributable to luck? First, Dr. James Naismith invented the sport of basketball. Then players, promoters, and team owners spread the sport throughout the United States such that professional leagues could become a way to earn an income. Then the founders, players, coaches, owners, television executives, and fans of the National Basketball Association had to build it and sustain it through some very challenging times. Without the work and support of countless people, Michael Jordan would not have been able to make a living playing basketball, much less win six championships playing basketball.

And what about Jordan’s height, good health, parents, coaches, and teammates? Talk about lucky . . .

Most of us, when confronted with all the luck Michael Jordan had in his basketball career, would simply acknowledge that luck played a role, but that in no way diminishes all the hard work he put into his craft and the fact that he was a great basketball player. 

In all situations, luck plays an important role. There is little anyone can do to avoid being subject to a significant degree of luck. All you can do is make choices based on judgment and what experience and history teach. Often, you will enjoy more good luck as you make better choices. 

Luck and choices are not entirely unrelated. The better financial choices you make, the more likely it is you will have good financial outcomes and enjoy better luck along the way. For example, you can’t get lucky with an investment if you don’t make the investment! 

Investment growth could** be thought of as luck. But without an individual financial choice (the decision to invest), you get absolutely none of that luck! The FIRE movement simply says “we have hundreds of years of economic data: we know diversified baskets of productive investments generally tend to grow over long periods of time, so start investing!”

FI provides a framework for capturing financial luck. Why shouldn’t there be a “movement” (if you want to call it that) of people who are intentional about making better choices that increase the odds that they and others will experience financial luck and success? 

** Note: I do not believe investment growth is luck. I simply acknowledge that some might think of investment growth as luck. 

Credit versus Choices

The FIRE movement is not about claiming credit for financial outcomes. It’s about encouraging good financial choices. 

To my mind, arguing that the FIRE movement is lacking because most of the credit belongs to others misses the point. The point of the Financial Independence movement is not to “deserve” financial success. Rather, the point is to make choices that increase the odds of financial success and having more financial options. 

If I wear a seatbelt, I’m making a choice that increases my odds of staying safe. 

I (hopefully) don’t demand credit for being safe. Rather, I simply make an informed choice that makes my life incrementally better. 

That is what the FIRE movement is all about: make good choices in your financial life, and, generally speaking, your financial life tends to have good outcomes. If someone wants to give you credit for the resulting outcomes, that’s fine, but that credit is not what the FIRE movement is all about.

None of this makes financial independence easy, and financial independence as an end goal will be more difficult for some than for others. 

But practically everyone has financial choices to make. Thus, the FIRE movement can speak to everyone. The FIRE movement offers a framework and encouragement to make good choices. Regardless of the luck you have had up to now, it is better to be intentional about your financial choices and seek to improve your future financial choices. 

Room for Improvement

Is everything perfect in the FIRE movement? Surely not. For example, extreme examples of FIRE tend to get overemphasized in the media and within the movement (in my opinion). 

Overemphasizing certain stories causes a distorted view of financial independence. But podcasts, YouTube, blogs, and other forums help all sorts of FI stories to get out there. The FIRE movement is constantly developing and different FIRE voices appeal to different listeners (and hopefully to a growing number of listeners). 

My hope is that the movement and the media reduce the emphasis on some of the more extreme FIRE examples (while still acknowledging their validity) and choose to promote a diverse array of FIRE perspectives. No one has all the answers, but everyone can make a contribution. 

The Future of FI

In May, I published the following: 

FI/FIRE will survive out of economic necessity. What else are people to do? Tie their entire economic future to one job that can be gone in an instant? The economic downturn occurring due to Coronavirus demonstrates that you need multiple sources of economic support. Part of FI (or FIRE) is that you ultimately build up so many sources of support (essentially, a well-diversified portfolio) that your job becomes an unnecessary source of support.

I stand by that. Some argue that FIRE is unrealistic. I’d argue that tying your financial future to a single job (or, more broadly, to your ability to always earn an income from your labor) is unrealistic. 

The FIRE movement provides a framework for improving your financial condition through better choices. That is a movement worth staying in. 

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Defending HDHPs

In the financial independence community and beyond, high deductible health plans (“HDHPs”) have received significant criticism. Few downplay the significant tax benefits of their tag-team partner, the health savings account. But some have written that the HSA sweetener is not sufficient to make high deductible health plans desirable. 

Below I offer a different perspective. I write regarding the approach of anyone seeking financial independence, but I believe much of what is discussed below applies regardless of whether you are seeking financial independence. 

One quick caveat: the below assumes that you are relatively healthy when you select your medical insurance, and that you expect that you will most likely remain so. For those with significant, chronic medical conditions, an HDHP is not likely to be a good medical insurance choice.

HDHP Critiques

High deductible health plans have been criticized by both the national media and by financial independence writers. Several studies have found that those covered by HDHPs tend to delay or forego needed medical assistance when compared with the population at large. This study found that those with HDHP insurance tend not to take advantage of free preventive services. Based on these study findings, there is a concern that the use of HDHPs can cause long term harm and worsen medical and health outcomes. 

Financial Independence Mentality

Those actively seeking financial independence (“FIers”) embrace two beliefs. First, they believe they are not constrained by others’ failures. While FIers understand that others’ failures can be indicative of difficulties they themselves might face, FIers believe that with intentional action they can overcome those difficulties.

FI exists because people see what the “average” or “typical” person does (for example, a very low savings rate) and say, “wait a minute, I’m going to do something very different.” FIers acknowledge a societal trend and then pursue a different path with intention. 

Second, FIers prioritize valuable purchases over immediate bottom-line results. Being financially independent (or seeking FI) frees you from the tyranny of any particular financial number when considering necessary expenses.

Health Insurance and Behavior

Your medical insurance should not determine whether you seek medical care. Only your current condition should determine whether you seek medical care. Assuming, only for the sake of argument, that the studies’ findings are correct, should those findings deter someone pursuing FI from using an HDHP as their medical insurance? I argue that they should not, for several reasons.

First, the studies probably did not include you. Why would you have a limiting belief about your own future behavior based on studies of other people? Even if you were in one of the studies and delayed or forwent necessary medical treatment, is it not possible that you could change your behavior?

Second, why not simply accept that cost will deter some people from obtaining needed medical assistance, but resolve that you will not act in such a shortsighted fashion. Many FIers seek to obtain financial assets of $1 million, $1.5 million, $2 million or more to fund the rest of their lives. Neither an unanticipated $300 medical expense nor an unanticipated $5,000 medical expense will derail your plans to achieve financial independence. 

If you commit to FI, you are committing to acting very differently than most people when it comes to spending and saving. Why then would you believe you will act like the average study subject when it comes to obtaining medical treatment for a medical need? 

Third, there is nothing preventing those with HDHPs from taking advantage of free preventive services. Many workers do not take advantage of the employer match to their 401(k). That outcome does not make a 401(k) a bad retirement plan. Rather, it illustrates that in many areas of life, people should be more intentional about taking advantage of what is offered to them. Suboptimal human behavior does not make 401(k)s and HDHPs bad, and others’ mistakes should not limit your insurance choices.

Finally, financial independence exists in part to make personal finances revolve around what needs to happen, and not to have what needs to happen revolve around personal finances. FIers ought to make medical care decisions based on their health, and not based on avoiding a medical bill that is ultimately minor in the grand scheme of things.

The Role of Insurance

What the studies appear to illustrate is a widespread misunderstanding of medical insurance. Insurance does not exist to determine whether you obtain medical assistance. Insurance exists to prevent financial ruin. 

Might an unexpected medical situation be expensive if you have an HDHP? Yes, absolutely. But should it be ruinous? It should not be. Your annual out-of-pocket maximum for medical expenses will be high: imagine in your mind’s eye that it is $10,000. In the event of a medical calamity, you will pay $10,000 in expenses annually. Then your finances are protected. 

Does an unexpected $10,000 expense hurt? Absolutely. But if your FI plan was to build $1.5 million in assets to fund the rest of your life, is not possible that you instead build $1.51 million in assets? Why would you put off necessary medical care to avoid a very slight increase in the assets you will need to build up to become financially independent? Are you much worse off in this situation than someone with zero-deductible medical insurance? Their “FI number” is $1.5 million; yours is $1.51 million. 

You might argue “but might my insurance company deny my claim?” That is a valid concern with insurance. But it is a concern whether you have a gold-plated, zero-deductible insurance plan, an HDHP, or any other type of medical insurance. Thus, the possibility that you might have to fight with your insurance company to get an expense covered is not a reason to avoid HDHPs. 

Risk/Reward Trade-off

When you use an HDHP, you assume additional risk. Put simply, you risk paying annual medical expenses up to the higher deductible. Two things should be noted about that risk. First, it is capped, as described above. A capped risk is the sort of risk that those building up assets should usually be willing to take on, as long as there is sufficient benefit to doing so.

Second, you are compensated for taking that risk. While your future annual medical expenses are uncertain, the benefits of using an HDHP are largely certain and immediate. Namely, they are:

  1. Lower insurance premiums
  2. Income and payroll tax savings (if the HSA is properly funded)
  3. Employer contributions to the HSA on your behalf
  4. Tax-deferred or (if withdrawn correctly) tax-free growth of the investments in the HSA

For taking on the risk of medical expenses up to the annual out-of-pocket maximum, there are two or three measurable, guaranteed benefits every pay period for using the HSA/HDHP combination. And while the fourth benefit can vary greatly (depending on the length of tax-free growth, future tax rates, etc.), it too is a significant benefit.

When evaluating an insurance plan, the risk/reward trade-offs and the costs are what should be evaluated. When comparing an HDHP with a lower deductible insurance plan, you must weigh the assumption of a speculative, capped risk in exchange for the benefits listed above. Based on the protection against very high annual medical expenses and the four benefits listed above, an HDHP appears to be, in many cases, a good risk/reward trade-off for those without expensive, chronic medical conditions. 

Conclusion 

The studies have not found that an HDHP is suboptimal from a risk trade-off perspective. Rather, they have found suboptimal consumer behavior. That’s where FI comes back in. FI is all about turning around suboptimal saving, investing, and consumer behavior and re-ordering financial priorities. Why shouldn’t obtaining necessary medical care be among the highest financial priorities? Why can’t you examine your own healthcare purchasing behavior and improve it? 

There can be good reasons not to select an HDHP based upon your particular circumstances. Perhaps you have a chronic condition, you do not like the HDHP’s particular insurance carrier, and/or you do not believe the risk trade-off benefits are sufficient. But don’t eschew an HDHP because of a limiting belief about something under your own control: your behavior as a patient and medical consumer. 

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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.