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Earned Income and WR
Old 04-08-2014, 08:19 AM   #1
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Earned Income and WR

Hi,

2014 will be our second full year of ER. I'm trying to figure out a meaningful way to compute WR when we have earned income. We operate 2 small very part-time businesses and then we have a small ownership stake in another full-fledged business, but we are not involved in operating it, that pays out a significant amount each month in dividends.

Here are some stats:

Income biz #1: 30,000
Income biz #2 0
Dividends from biz #3: 90,000
Total 120,000

Annual spending: 156,000
Taxes (guess): 40,000

Investable Portfolio: 6,200,000

So, would I be best to calculate WR as net of cash flows divided by investable portfolio? Or, spending minus earned income divided by investable portfolio. Or, as spending divided by investable portfolio?

Scenario 1: (196,000 - 120,000) / 6,200,000 = 1.2%
Scenario 2: (196,000 - 30,000) / 6,200,000 = 2.6%
Scenario 3: 196,000 / 6,200,000 = 3.1%

Also, in investable assets, I include about 350k in equity we have in a rental beachhouse. I include it because it is a real estate investment and could easily sell it and invest the equity. Not sure if this is correct thinking.

Thanks for any input.
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Old 04-08-2014, 08:48 AM   #2
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I pick door number 2.

The only value in calculating a WR is to help you guess/estimate/limit how long your assets will last.

Based on this your calculated WR should be the amount you withdraw from your invest-able assets to meet your desired/required spending.
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Old 04-08-2014, 08:57 AM   #3
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I would agree with Door#2 assuming that the $6.2 million includes the value of Biz#3.

If not, then Door #1.
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Old 04-08-2014, 09:05 AM   #4
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I would agree with Door#2 assuming that the $6.2 million includes the value of Biz#3.

If not, then Door #1.
+1
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Old 04-08-2014, 09:31 AM   #5
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None of the above.

Biz #3 is essentially an investment providing $90,000 annually right (does it ever increase?)? It's not a job, are there expenses? I'm assuming you bought into this years ago, so think of it like a stock you purchased that paid divs. Add the marketable value of this business to your portfolio amount. For those of us with no earned income, we don't subtract divs/interest from our WR, it is part of what our portfolio throws off to provide cash flow. So:


Scenario 4: (196,000 - 30,000) / (6,200,000 + Value of Biz #3) => 2.677%


As long as you have earned income, your net withdrawals and therefore WR% are reduced. That is simple arithmetic.

Once that income goes away, then the WR% will increase. So for planning purposes, either enter these into FIRECalc with the years you expect to keep earning them, or just look forward to the values of everything when the income stops and look forward.

SS, pensions?

(I see I cross-posted with some of this)


-ERD50
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Old 04-08-2014, 09:44 AM   #6
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I would agree with Door#2 assuming that the $6.2 million includes the value of Biz#3.

If not, then Door #1.
Yes, the $6.2MM includes the estimated value of my share of all three businesses:

Biz 1 value: 338k
Biz 2 value: 100k
Biz 3 value: 468k
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Old 04-08-2014, 10:47 AM   #7
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Can I sell you an annuity?
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Old 04-08-2014, 11:32 AM   #8
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WR is the net of what comes out of the portfolio only.

Businesses are kind of tough to include in the portfolio. They won't behave like the historical stock or bond behavior modeled in FIRECalc. Certainly FIRECalc wouldn't say Biz #3, worth $468k, would generate $90k (19%!) of dividends/interest. Depending on how stable and predictable the income is you might just subtract that income from your expenses for an appropriate number of years and then add the selling price to your portfolio.
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Old 04-08-2014, 11:42 AM   #9
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I think it is definitely NOT scenario #3. Could be either 1 or 2, but to be conservative, I'd pick #2.
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Old 04-08-2014, 01:00 PM   #10
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None of the above.

Biz #3 is essentially an investment providing $90,000 annually right (does it ever increase?)? It's not a job, are there expenses? I'm assuming you bought into this years ago, so think of it like a stock you purchased that paid divs. Add the marketable value of this business to your portfolio amount. For those of us with no earned income, we don't subtract divs/interest from our WR, it is part of what our portfolio throws off to provide cash flow. So:


Scenario 4: (196,000 - 30,000) / (6,200,000 + Value of Biz #3) => 2.677%


As long as you have earned income, your net withdrawals and therefore WR% are reduced. That is simple arithmetic.

Once that income goes away, then the WR% will increase. So for planning purposes, either enter these into FIRECalc with the years you expect to keep earning them, or just look forward to the values of everything when the income stops and look forward.

SS, pensions?

(I see I cross-posted with some of this)


-ERD50
+1

Based on your answer, the calc would be $196k/$6,200k=3.16%.

However, I think this is somewhat distorted toward the high side because of the treatment of your business income. Another way to treat the businesses would be like a fixed period annuity for the period(s) of time you plan to own them, and calculate the remaining WR accordingly. That WR might be more useful if you're comparing it to SWR studies or risk models to evaluate longevity risk.

And, as ERD noted, WR would decline upon inclusion of SS and any pension.

Nice sailing pics. Where's the boat now?
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Old 04-08-2014, 04:02 PM   #11
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Yes, the $6.2MM includes the estimated value of my share of all three businesses:

Biz 1 value: 338k
Biz 2 value: 100k
Biz 3 value: 468k
In that case it is Door #3 - your expenses including taxes (what you effectively take out of the $6.2m) divided by the $6.2m.

Just like if I had a $6.2m portfolio that I was drawing $196k from each year. The fact that I take dividends from the portfolio in cash doesn't affect my WR.

I guess alternatively you could argue to calculate it as your withdrawals net of biz dividends divided by your investments net of biz value (IOW withdrawals from the conventional portfolio divided by the value of the conventional portfolio).
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Old 04-08-2014, 04:16 PM   #12
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In that case it is Door #3 - your expenses including taxes (what you effectively take out of the $6.2m) divided by the $6.2m.

Just like if I had a $6.2m portfolio that I was drawing $196k from each year. The fact that I take dividends from the portfolio in cash doesn't affect my WR.

I guess alternatively you could argue to calculate it as your withdrawals net of biz dividends divided by your investments net of biz value (IOW withdrawals from the conventional portfolio divided by the value of the conventional portfolio).
Thanks everyone for the feedback.

This approach makes sense. TheI work in businesses 1 and 2, earning about 30k per year total from them. So that is earned income, not investment income.

I do include their value in my total investment portfolio, even though I am also operating the businesses. I think that is where it gets conceptually cloudy. They provide about 30k in owner draws (salary or profits, whatever you want to call it) so they are not passive income like business #3.

Maybe this can be likened to someone who actively trades their portfolio while also living on it--I mean someone spending significant time trading, as if it were a job--that person is definitely working in the "business"--IE it is not just passive returns.
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Old 04-08-2014, 04:20 PM   #13
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I guess alternatively you could argue to calculate it as your withdrawals net of biz dividends divided by your investments net of biz value (IOW withdrawals from the conventional portfolio divided by the value of the conventional portfolio).
BTW, yes, this is how I've been looking at it up to this point. When I do that my WR is about 1.5%. It is so low that I am thinking that I must be looking at this wrong.
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Old 04-08-2014, 04:24 PM   #14
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Can I sell you an annuity?
Hell no! I love the cash flow I'm getting from this.

But, I just found out this week that the majority owner is looking to sell it after founding the company back in 2007 (yes, it's only 7 years old). So, my gravy train may be coming to an end in the next few months. Though I would likely get a nice payout, I would prefer to just keep getting those monthly checks...
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Old 04-08-2014, 04:28 PM   #15
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+1

Nice sailing pics. Where's the boat now?
Thanks! It was a great trip. The boat was sold in Beaufort, NC after we got back to the states last June.
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Old 04-08-2014, 04:39 PM   #16
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You seem to be mixing apples and oranges.

Withdrawal rate typically is meant to be a percentage of an investible portfolio of liquid assets. In my mind, the definition of liquid is a security that can be marked to market daily such as a stock, bond, money market fund or cash. Another way to think about it is defining an investable asset as anything that can be liquidated within a 3 day settlement period.

Withdrawal rate formulas are calculated based upon that because historical values in public markets are more readily accessible than private markets. Trinity study, etc. have all been based upon public market historical data.

Private market valuations are highly correlated to market conditions over a greater period of time due to their illiquid nature. They can not be marked to market with high accuracy. It's a bit like horseshoes. The valuation is only worth what the buyer will pay on the day the transaction closes. It really doesn't matter what one may think their equity is worth. This is why l.p. venture capital fund investments are truly not compensated for the risk they take.

With all that said, I would boil down the withdrawal rate to those assets that are traded within public markets or are cash equivalents. Any income you are receiving as a result of the private investments and the beach property should be counted separately and not included in the withdrawal rate. The private investments and the beach property would not be as readily available for liquidation in a severe downturn. Thus, the income generated from them falls in a different bucket.

For example, if your liquid assets (as defined above) were $100 and you were withdrawing $4, your withdrawal rate would be 4%. The other income from private investments and beach house should be looked at as a bonus. If the private investments and beach house are liquidated and converted into public assets, they can then be counted as a part of the portfolio withdrawal rate.

If you don't co-mingle the assets and their income for calculation purposes, you'll be better off.
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Old 04-08-2014, 04:42 PM   #17
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1. I would not include my businesses in the withdrawal portfolio. Those aren't sufficiently liquid.
2. The withdrawal on the remaining portfolio is amount required minus income generated by businesses. Use that to compute rate.

So ($196,000-$120,000)/~$5.3M = 1.4%

Wow - that's a pretty low withdrawal rate!

Your businesses are paying you very well!
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Old 04-08-2014, 07:42 PM   #18
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You seem to be mixing apples and oranges.

Withdrawal rate typically is meant to be a percentage of an investible portfolio of liquid assets. ....
I'm not sure liquidity is a requirement. I've certainly never seen that in any definitions of WR.

For example, let's say I have $2m of stocks and bonds and withdraw $60k a year so 3% WR.

I then sell $1m of stocks/bonds and buy $1m commercial real estate that generates returns similar to the assets sold. To me, my WR is still 3% $60k/$2m)

Under your construct, my WR would increase to 6% - $60k/$1m (I think).
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Old 04-08-2014, 08:06 PM   #19
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I don't have a strong opinion about which method is the best, and in many ways it really doesn't make a difference.

To me the thing that stands out is a business that you think is worth $468K that is generating 90K in dividends. That is a net profit margin of almost 20%.

It would seem hard to imagine that level of profit is sustainable over the long term, especially since you aren't putting in time to manage it. So I'd assume either that valuation is much too low, or some of that $90K is really a return of capital. How long do you expect to get $90K a year from business #3?
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Old 04-08-2014, 10:58 PM   #20
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I don't have a strong opinion about which method is the best, and in many ways it really doesn't make a difference.

To me the thing that stands out is a business that you think is worth $468K that is generating 90K in dividends. That is a net profit margin of almost 20%.

It would seem hard to imagine that level of profit is sustainable over the long term, especially since you aren't putting in time to manage it. So I'd assume either that valuation is much too low, or some of that $90K is really a return of capital. How long do you expect to get $90K a year from business #3?
Business #3 is managed by the founder and I only own about 2% of it. I am not involved other than receiving my dividends. It is a software business that has 40-50% net profit margins and has been growing at about 20% a year the past 2 years. Unfortunately the majority owner is in talks to sell it, I just found out this week, to a large silicone valley tech company. We'll see if it pans out as the close rate on these types of acquisitions tends to be low. If it does close, my shares should be valued in the $1.25MM to $2.5MM range, but I use very conservative valuation models for tracking my portfolio for all the private businesses I have some stake in (a total of about 6).

The other two businesses I mentioned are wholly owned and operated by me part-time.
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