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• Introduction to Hedgematic
• Is There a Best Strategy For Roth Conversions?

Introduction to Hedgematic

Larry Fink recalls the assurance of a monthly pension check, saying, “Defined contribution plans ended that, forcing retirees to trade a steady stream of income for an impossible math problem.”

I’m an old software developer. For some time, I’ve been working on this problem on my own account. I have found it greatly simplified if I start with current-dollar, after-tax, yearly check amounts, and then, working backwards from my death to the present, hedge and fund each year’s payment. If I make it all the way back to today with money left over, I know I can retire, and I know the size of my estate. If I come up short, I know how much more money I need, or, when I can commence my retirement with assets on hand.

Each year of retirement is separately funded; allocations are set per Merton maximized risk-adjusted utility with tunable aversity. One year’s required expenses plus estimated taxes are covered by a combination of:

• Safe assets (current dollars all)
  • Cash
  • Specified TIPS coupons and redemptions.
  • Social security receipts.
• Risky assets
  • A dedicated tranche of S&P (held “long”), denominated in units of S&P indexes. Real S&P yield and variance are separately estimated for each maturity, using Shiller’s TRCAPE (total return CAPE) data.

I build a linear programming model that includes all accounts, transactions, transfers and taxes. Inputs are current asset balances, yearly expense requirements, social security and demographic settings, today’s TRCAPE and S&P, and all off-the-run TIPS bonds. I optimize for maximum estate or minimum shortfall. Results include transactions to create, for each account, initial TIPS ladders and S&P positions. Draws, S&P sales, and IRA rollovers are specified for every subsequent year.

My ambition is to give investors an open, liquid, no-load, economically sound, Social Security inclusive, current-dollar after-tax retirement portfolio.

To this end, I have created an iPhone app. It is called Hedgematic and is available for free in the App Store. Check it out.

Illustrations

Meet our retirees

Let’s see how it works for a working/stay-at-home couple in the 80th percentile (65/63). They make $150K per year. They have accumulated ten times their income in retirement assets. That $150K yielded $125K in take-home pay. They plan to retire at the default age. Here’s the profile:

Turn the crank

Compute the profile. Results show expenses are covered and they leave a $854K estate. Current valuations and real yields are high enough that we don’t get out of cash until 2053. These allocations will swing in response to long moves in markets. In 2024, the same portfolio was all stock 7 years earlier.

This machine will run for thirty years

Results include transactions to create, for each account, initial TIPS ladders and S&P positions. Draws, S&P sales, and IRA rollovers are specified for every subsequent year. Shown here are TIPS bonds bought into one of the IRAs.

What goes into each draw?

Yearly draws and their safe/risky portions. In the last couple years, social security anchors the safe portion of the hedge. Note the bumps. Those are the only years with any tax liability.

Taxes are smeared across the duration of retirement

The black line shows the tax. Hedgematic is optimally rolling IRA to Roth, maxing out either the 10 or 12% bracket. The sloping taxable income figures come from non-indexed taxable social security brackets.

Lessons guide you through portfolio creation

Hedgematic comes with a suite of tools and calculators showing how the portfolio is created. Here we derive the safe portion of assets targeted at year 25. As maturity increases the annualized S&P real yield clusters more tightly around the historical 5 or 6 percent.

Is There a Best Strategy For Roth Conversions?

There are multiple strategies for Roth conversions.

• Don’t roll. Take RMDs and hold with after tax.
• Roll now. Shift the balance today.
• Apply a dollar-cost averaging strategy.
• Countless other approaches.

We can model particular strategies and gain understanding of how they might work in situations that resemble our own. But we still can’t be confident that they would work in our particular case.

Let’s step back for a minute. What is the appeal of a Roth conversion? To reduce or eliminate taxes. Maybe the best strategy is the one that focuses on taxes.

Rollovers are taxed as ordinary income. But the rate they are taxed at depends also on IRA draws, other income, capital gains, and Social Security.

What drives all these tax inputs? It’s the spending. Given all your accounts and assets, if you want to spend $100K this year, you can pick those transactions that pull your $100K with a minimum tax bite. We start with spending.

We can model accounts, assets, and 25 years of spending, then pick the transactions that successfully cover each year of your spending or barring that, minimizes any shortfall.

Once you have your expenses covered, your focus will shift to the size of your estate.

My goal

I actually have two goals.

• Spend what I want.
• Die with the most money.

The best Roth conversion strategy will be the one that best meets my goal. Impossible to know in advance, it will fall out, as a side-effect of this exploration.

Hedgematic for IPhone

I will use Hedgematic to explore my approach.

Hedgematic starts with birthday(s), retirement and after-tax account balances, Social Security status, health, and yearly current-dollar, after-tax income requirements, then constructs a stream of transactions to realize a yearly paycheck, including estimated taxes, for the duration of retirement. Each year is hedged separately with a combination of S&P and TIPS inflation protected bonds; Shiller’s CAPE10 is used to tune proportions for each maturity.

My Portfolio

I have a $1M IRA and an empty Roth account. I maxed out Social Security; my spouse stayed home. We’re both 67, and have chosen to take Social Security at full retirement age. We figure we’ll outlive 80% of our high school class. I want to know if I can I count on $100K/year of current-dollar after-tax income. I plug the numbers into Hedgematic and compute my portfolio.

The portfolio is literally just a list of transactions for each account for each year. Shown here are my day zero TIPS transactions. I purchase a ladder of bonds to provide current dollar payments into the future. Elsewhere, I am instructed to buy S&P.

IRA Balance to Zero

The recommended strategy drains the IRA, but not all at once.

TIPS are blue. Stock is red. The IRA has been drained. Contents have all either been spent, or sent to the Roth.

Roth Conversion

The IRA draws are incorporated into yearly spending. Rollovers charge the Roth account in the middle years.

Blue bars show IRA draws. Violet and green bars show S&P and cash rollovers respectively.

This is not a strategy that anyone would come up with independently. In fact, it only makes sense in the larger context of spending and taxes.

Income Taxes

Income tax is levied on two income sources:

• Ordinary income is the sum of IRA draws and rollovers, as seen in the above screenshot.
• Depending on income, between zero and 85% of Social Security is taxable. Taxable SS brackets are not adjusted for inflation, accounting for the sloping bars in chart.

Tax computation falls into four phases:

• 2025 – 20% bracket – $20K tax – Draw $120K to cover one year’s expenses and taxes.
• 2026-2031 – 10% bracket – $3K tax – IRA rollovers have not commenced.
• 2032-2043 – 12% bracket – $12K tax – IRA rollovers max out bracket.
• 2044-2051 – Standard deduction applies – $0 tax – IRA is gone; start pulling from Roth.

Assets

Do I die with the most money? Well, there are certainly countless portfolios that will outperform this one, and more that won’t, but this one is fully hedged, and is likely to end up looking like this. Some observations:

• I bought $290K of S&P on day zero and didn’t touch it for twenty years, during which I rolled it (and reinvested dividends) all into my Roth account.
• Given today’s historically high stock valuations, the red bars show modest gains for some time, followed by a return to the more typical real yield of around 6%.
• The ending balance is over $700K and climbing. I am not running out of money; my heirs will raise a glass to me in grateful thanks for my prudent investing and after-tax bequest.

The Lesson

Reflecting on my generosity, I decide to see how the heirs will make out if I take $110K/year instead of $100K. I run the new numbers.

I find that results are very sensitive to initial conditions. Instead of $700K, I end up with $70K; I am now concerned about running out of money; my heirs will curse me.

And compare rollovers below with the $100K example above. Completely different! A big tranche on day zero, and very few moves down the line!

Roth conversions are an important part of portfolio management, but they are not the goal. The 4% rule is not the goal. The 60/40 split is not the goal. The goal is to describe the retirement you want, and your wishes for your family, and put it into place, using the tools you have avalable, among them, Roth conversions.

The secret to getting that annuity-like stream of payments that retirees crave is to specify payments, then fund them. Then go out and enjoy your retirement without worrying about the market. You don’t have time for that.