Timing Leverage in Retirement – SWR Series Part 52
March 21, 2022
A quick recap, the appeal of using leverage in retirement is that we would borrow against the portfolio instead of liquidating assets. Nice! That might help with Sequence Risk if we avoid liquidating assets at temporarily depressed prices. There could also be a tax advantage in that we keep deferring the realization of taxable capital gains, potentially until we bequeath our assets to our daughter who can then use the “step-up basis” for complete forgiveness of all of our accumulated capital gains. That’s the famous “buy, borrow, die” approach popular with high-net-worth folks.
The gist of the post last year: Not so fast! Leverage could potentially even exacerbate Sequence Risk if you are unlucky and retire right before a bad market event that’s deep enough (like the Great Depression) or long enough (like the 1965-1982 stagflation episode) to compromise the portfolio so badly that the margin loan becomes unsustainable relative to the underwater portfolio.
One solution proposed by several readers: instead of always borrowing against the portfolio, maybe we should carefully time when we use leverage. For example, borrow only when the stock market is down “far enough” and use withdrawals from the portfolio otherwise. And if the market is doing well again, potentially pay back the loan again! Sounds like a reasonable and intuitive plan. But I want to put that to the test with some real simulations. Let’s take a look at the details…
A quick recap of the 1929 and 1965 cohorts
In the post last year, I modeled the margin loan with a fixed real interest rate. I realize that a slightly different assumption might be more realistic, namely using a fixed spread over a short-term government reference rate. That’s because if you want to borrow on margin, your broker will likely not quote you a rate as “x% over CPI inflation” but, more likely “x% over the Federal Funds Rate (FFR)” or some other short-term rate like the 3-month T-Bill rate or LIBOR. What would be a reasonable assumption for the margin loan spread?
- A Home Equity Line of Credit (HELOC) often has an interest rate tied to the Prime Rate, which is itself about 3 percentage points above the (overnight) Federal Funds Rate (FFR). I remember back in the good-ol’ days you could get HELOCs for Prime minus 0.75%, even 1.00%. But I think today’s rates are closer to Prime +/-0% or maybe minus 0.25% if you have good credit and shop around a bit. So, if you get a HELOC with a rate equal to prime minus 0.25%, you’ll pay around 2.75% above the FFR.
- M1 Finance offers rates between 2% and 3.5%. That’s a wide range. It looks like the upper edge is actually inferior to the average HELOC. I couldn’t ascertain what benchmark rate they use, but I’d suspect, the range of interest rates will likely move up in line and 1-for-1 with the Federal Reserve policy rate.
- Interactive Brokers will lend to you at a rate of 1.50% above the FFR for smaller amounts, and 1.00% for medium-sized loans ($100,000-$1,000,000). Loans up to $50,000,000 go for 0.75% above the policy rate. And 0.50% for loans $50m+, if you’re loaded enough. This is all for the IBKR PRO account. The IBKR LITE account charges significantly more.
- Borrowing through a box spread trade as I discussed in my post in December 2021, you might get rates as low as 0.3-0.5% above the T-Bill rates. That’s likely the lowest rate you will encounter anywhere. (side note: most likely you’d choose a longer-term loan, maybe 1-2 years. Potentially as long as 5 years. The 0.3-0.5% spread refers to the spread above the T-Bill or Treasury bond of the same maturity, not necessarily the spread above the realized Fed Funds Rate. But over shorter horizons, the T-Bill rate is a pretty accurate prediction for the average FFR over the same time span)
It turns out that the choice of the loan rate will make quite a difference in the margin loan calculations. For example, last time I used real rates of 0%, 1.5%, and 3% with the middle value of 1.5% above CPI as my “preferred” value. I like to recalculate the scenario for the November 1965 retirement cohort with a $1,000,000 initial portfolio withdrawing $30,000 annually and supplementing the withdrawals with a margin loan worth $10,000 annually. For the CPI+x% loan rate, I use the middle value of 1.5% and contrast that with three different FFR+x% loan scenarios: a 0.50% spread (best possible case: box spread trade), 1.25% spread (margin loan with Interactive Brokers), and 2.75% (HELOC, and other not so attractive brokers). The portfolio value net of the 3% withdrawals is the same in all four scenarios but the loan balances are quite different, see the chart below. It turns out that the FFR+x% loan interest looks far worse in the 1965-1995 time span than I had previously assumed. That’s bad news because it means that the margin issues that hamper our “buy, borrow, die” efforts would have been even more constraining than I previously assumed. Inflation-adjusted short-term rates were much higher during the crazy 70s and early-80s than I previously assumed!