Can You Live With Your Benefits?

A student asks:

I have $1.6M in a taxable brokerage account, $250k in a regular 401k and another $150k in cash. There is no debt. There is no house. I am single and have no dependents. I need $170k in annual income to retire. At a 4% withdrawal rate I would need $4.25M to meet that income goal. In recent years, pooled call funds have become popular. For example, SPYI “yields” 12%. That means $1.4M invested will generate $170k per year. Is this too good to be true? Why is this a bad idea? I am 42 years old and miserable. I own a small business and have worked almost every day for over ten years. I don’t know if I can do it. I am completely exhausted and want to be done with it.

The investment question here is an interesting thought exercise from a numerical point of view but the small business angle is more important from a human point of view.

Let’s start with the numbers as that is the easy part of the equation.

I’ve written about calling strategies before. Here is an explanation I gave a few years ago:

A call option is a contract that gives the buyer the right to buy a security at a predetermined price at a specified time on or before a predetermined date. The seller of that call option is obligated to sell the security at that predetermined price in case it becomes available on the predetermined date.

If the stock never reaches the strike price in that time frame, the buyer takes out only the paid premium while the seller keeps the option premium regardless.

For example, let’s say you own 50 shares of a stock that is currently trading at $20. Call options with a strike price of $25 are worth 50 cents a piece for a $25 profit on your $1,000 position. That’s good enough for a 2.5% yield.

But now your upside is limited to 25% profit (from $20 to $25) plus that 2.5% option premium.

If the stock reaches $30 or $35 you take out those gains over and above the $25 and the option buyer takes out their $25 in premiums.

In a covered call strategy, you are a seller of call options on each of your holdings or indicators.

Therefore, this is the type of strategy that should not work well in a roaring bull market. The income from the sale of options can help but in a hard charging bull market but you will likely lose other gains and slow down the market as a whole.

However, in a bear market, this strategy should outperform the market because the option income acts as a buffer. Also, in a bear market, volatility spikes should actually increase your earnings as volatility plays a major role in option prices.

Covered call funds became all the rage following the 2022 bear market because they outperformed the bear market and came with high yields to boot.

Covered call strategies make perfect sense as a way to reduce equity volatility and increase your income. But you need to understand how these funds work when it comes to the revenue part.

The yield of an integrated call strategy is not the Holy Grail that many think it is. You don’t break the 4% rule just because the yield is too high. You need to consider the total return, not just a portion of the income.

For example, look at the difference between price return and total return on a few large covered call plans:

Total returns have been very good over the past few years. But look at the prices. In fact, they have not changed.

This tells you that basically all of the return came from the yield. There’s nothing wrong with that, unless you plan to live off the income. If you use part of the yield of these funds and do not reinvest them then inflation becomes a big risk.

This is especially true if you are trying to retire in your 40s. A 3% inflation rate would make one dollar today worth 40 cents in 30 years.

Your income also fluctuates significantly in these funds. Covered call strategies should underperform the overall market during a downturn due to a portion of the income but still owning the stock. During last year’s Independence Day these fees dropped from 16% to 22%.

In a long bear market, your income also goes down.

Covering calls can absolutely play a role in the income portion of your portfolio but there is more to it than just the product listed.

I’d be remiss if I didn’t say single stock compound call strategies have become all the rage in recent years. YieldMax has ETFs that sell calls on individual stocks. Currently hedged phone ETFs for Amazon, Google and Apple yield 43%, 39% and 37%, respectively.

Sounds good, right?

Look at the difference between the price and the total return of these funds:

There is no free lunch. High yield means high risk. And the danger is never completely gone.

The good news is that you are 42 years old, worth $2 million and have no debt. That is a huge achievement.

The bad news is that you are working too hard and it is treating you badly.

This is a good reminder that running your own business can be very rewarding but also requires a ton of work.

If you want to spend $170k a year on a $2 million portfolio, that’s an 8.5% withdrawal rate. There is no safety limit to your age because the money should last you for a very long time.

You can refuse to dial in your spending.

You can try to sell the business.

You can hire a business manager and outsource yourself from day to day.

Since you have no dependents, you have enough money to take a year or two to figure out what you want to do next.

Maybe you don’t have enough money to live on dividends at the rate you’re spending now but you have plenty of money to take a break and reevaluate what you want to do with your life.

Money may not make you happier but it can make you more relaxed and relieve some stress.

That should be your goal.

Bill Sweet helped me answer this question in the new Ask the Compound:

We also answered questions about distribution box loans, small business retirement plans, COAST FIRE and tax-exempt property strategies.

Further reading:
Can Covered Call Options Work as Bond Substitutes?