Unplanned Early Retirement, Part 2 - Asset Allocations

Includes: MAIN, PSEC
by: Kevin Arledge


In Part 1, I explained the background of my problem and introduced some of my investment philosophy..

One major message from Part 1 was that you need to educate yourself and take charge of your life and your investments. Nobody cares as much as you do..

Also from Part 1, you must make a financial plan and execute it faithfully..

There are a few additional factors, such as health care, to consider in retirement..

Starting today with part 2, you will begin to see exactly what I did with my own investments including asset classes, specific securities, and the logic behind each choice..

This is the second of several articles I am writing to show you exactly what I am doing to cope with an unexpected job loss after middle age, but before retirement age. The first installment, titled Part 1, was somewhat introductory. With today's installment, Part 2, I will begin to explore my strategy in asset allocation and specific securities. Some may disagree with my logic, some may complain that I have the advantage of age and a head start, but everyone can rest assured that I will honestly tell you exactly what I am doing with my own money.


Part 1 of this series attracted a lot of attention. Apparently, this subject struck a chord with many people who have had similar experiences. I am grateful and humbled to see the response and to read all the comments. It appears that I will learn as much from writing these articles as anyone will learn from reading them. Let's keep the dialogue going.

In the first installment, I explained the circumstances of my current position as an early, reluctant "retiree." I also discussed a little of my general philosophy for investing and for life, and gave a preview of my asset allocations. Today, I promise to begin digging into the specifics of my portfolio and why I chose to allocate things the way I have, but first I need to clarify a few things that were brought up in the discussion of Part 1. Please go back and read Part 1 if you missed it. I think you will find both the article and the comments interesting.

First, as several readers pointed out in the discussion of the previous article, when you retire early health care is a big concern. A single catastrophic illness or injury could easily wipe out a six-figure portfolio. I am fortunate in that my former employer, as part of my severance package, is subsidizing my health care until I reach the age when I will be eligible for retiree health benefits. If your spouse is still working you may get coverage under their benefits. Otherwise, you will need to purchase at least a catastrophic health care plan to protect your future. These can actually be affordable, all arguments and politics aside.

Second, I was asked about debt. We are debt free. We committed several years ago to be debt free when we reached this stage of life. We paid off our mortgage. We always pay cash for cars. I understand that some of you may disagree with this philosophy, but I sleep better at night knowing the roof over my head is not directly dependent on cash flow. I know that the penalty I pay is the opportunity cost of that capital equity, but that is okay with me. I still like being debt free. I pay myself a monthly car payment that goes into my savings account. We collect the interest and then we buy a car debt free when we want. We use credit cards for most purchases, but we have a very strict rule to pay them off every month. It has been many years since we paid a dime in credit card interest. Also, we only use cash reward credit cards with zero annual fees. One corollary to this principle is that I do not ever intend to have a debit card. As long as the credit card company is willing to pay me a cash rebate to accept a monthly interest free loan, I will take it every time.

Third, I am under no delusion that I can build my investment income to the point that it completely replaces my working income in such a short time. My hope is to do the best I can with my investments and supplement that income with some flexible work options and life simplifications to avoid tapping my pensions or retirement funds as long as possible.

Fourth, we do own some assets besides our brokerage accounts. As mentioned previously, we own our home and live debt free. We also own some real estate, but this is more a family legacy and inheritance than an income producing property. We derive some revenue from this property, but after expenses there is very little net income. Personally, I do not plan to invest in actively managed real estate because I do not think I have the disposition to be a successful landlord.

If you exclude all real estate holdings, and ignore the future value of my pension, our total net worth is about 13% cash in a money market fund, 52% invested in our Rollover IRA, 33% invested in our taxable brokerage account, and 2% in an old Roth IRA held by a mutual fund company.

As stated in Part 1 of this series, my investment philosophy has been moving toward a dividend growth, retirement income mode for several years in preparation for this time. You can see this in the asset allocation of the taxable account that I have been actively managing for the past 5 or 6 years.

Our taxable account looks like this:

Table 1 - Taxable Account Asset Allocation

You can see that I have been pretty successful as far as yield on cost. The important philosophical basis for this is my commitment to low expense dollar cost averaging through DRIPs, my preference for dividend growth stocks, and my commitment to keeping some cash to invest into market corrections. What is not obvious is the fact that I harvested some large capital gains shortly after retirement. These were stocks that had appreciated to the point that current income was in the 1% to 3% range. I still maintain a position in most of these stocks, but that position is now smaller. I used the proceeds from these transactions to start buying tax free municipal bond funds which are a new thing for me, so my early retirement has affected how I invest my taxable account as well as my rollover account.

With those points out of the way, we can get to the meat of this series of articles. The main subject is how I am investing the Rollover IRA we created when I moved my 401k from my employer to my self-directed brokerage account. I will present this in as much detail and as accurately as I can, but please realize that these purchases were made at a fixed point in time and the markets are always moving. Do not take my presentation as a recommendation to buy a particular security until you have done your own due diligence. I study each position carefully, and I never depend on just one source of information. For example, I never depend on just one source such as Yahoo Finance. So I use other tools such as Google Finance, Nasdaq.com, and the investor relations tab on each company's web site to check facts. I find the dividend history function on Nasdaq.com to be particularly useful.

I instigated the rollover in January, cashing out my 401k at what turned out to be a market peak. I had several days during the time the money floated between accounts to study and put together a detailed action list to guide my investments. By the time I was able to make the funds available for trading in my rollover account, the February 2014 market dip was in full swing. Since I already had my action list ready to go, I quickly took advantage of the pullback. You might say it is sometimes better to be lucky than smart, but I think God was looking out for me.

My action plan consisted of asset allocations and specific dollar targets for each security within each asset class. By the way, these are not necessarily standard financial theory asset classes; I classified the assets according to my own thinking. Some of the holdings are the same as my taxable account, but some of my prior holdings did not qualify for my IRA because I worked with a slightly different set of rules. I was looking for positions that either had dividend growth with a yield at least 3% or 4%, or in the absence of dividend growth, I wanted yields in the 5% to 6% range or higher. I did allow myself some flexibility on these rules for the sake of diversification. I also avoided positions that might generate foreign taxes or otherwise would make no sense in a tax deferred account. My final asset allocation plan, as executed in February 2014, was as shown in the following table:

Table 2 - Rollover IRA Allocations

With the rest of this second installment in the series, I will discuss the first asset class, Business Development Companies, and the specific BDC securities I purchased. The first question might be, "why would you want to invest in Business Development Companies?" There are several reasons. The most important reason is that these companies typically provide high current income, and over the past few years the particular companies I chose have proven to be safe and reliable income and growth generators. I started some time ago with relatively small positions in these BDCs in my taxable account. These relatively small positions have grown to be a substantial part of my taxable account largely on their own through reinvested dividends.

In addition, I understand that the Business Development Company managers are doing something that I cannot do for myself. They are intelligently using debt to fund economic growth and collecting the difference in interest rates as their payment for providing this service. I really believe that the smaller companies these BDCs fund can help drive job growth and the future of America. I never (okay, almost never) play with penny stocks or companies that do not fit my income and growth philosophies. I am happy to let the BDCs do that research and due diligence to decide which companies are really worthy of support. The BDC managers can make those kinds of investments for me. I only hold two BDCs which I consider to be the best of the breed.

The first of these is Prospect Capital (NASDAQ:PSEC). I rarely read anything bad about PSEC, though there are a few detractors out there. My own experience with PSEC has been positive. Right now the P/E is around 9.5 and the yield is an eye popping 12.2% per year. Normally, such a yield would make me run the other way looking over my shoulder to watch the crash, but PSEC has had the cash flow to back it up consistently. I have owned PSEC since June 2009. Beta is only about 0.85 so PSEC is not prone to wild price gyrations.

Since I first bought PSEC the stock price on my earliest shares has only gone up 20% or so, but the reinvested dividends have continued to grow and pile up an ever-increasing cash flow that I can tap at some point. PSEC consistently grew the quarterly dividend through March of 2010; at that point the dividend was a hefty 13.5%. As the financial crisis deepened they cut the dividend from 0.41 per quarter to 0.10 per month. I never like it when a dividend stock cuts back, but I like very much that they changed their payout from quarterly to monthly. I love monthly compounding.

When they cut the dividend, the price dropped as you might expect. After the price drop, the yield was back up to 11.1% per year, so I bought more. Since that time, the monthly dividend has been raised 51 times if you include all the dividends that have already been announced out through September 2014. That is every month. The increases have been very small, but they are increases. This month, April 2014, the payout will be 0.1104 per share. I am happy to continue putting that payout in my DRIP program for now.

So when I looked for BDCs for my new Rollover IRA, PSEC was at the top of my list, not just because everyone else seemed to like it, but because it has been good to me for several years. I put roughly 4.36% of my IRA in PSEC in February 2014.

The second BDC in my IRA is Main Street Capital (NYSE:MAIN). I actually put even more money in MAIN because I consider it to be the number one BDC out there. As such, MAIN got 4.56% of the cash in my Rollover IRA. My experience with MAIN is similar to my experience with PSEC.

Just like PSEC, I rarely read anything bad about MAIN. As a matter of fact, I cannot recall reading anything critical of MAIN. If you have a different opinion, please make sure you comment on this article so we can all learn from your experience.

My own experience with MAIN has been positive. Right now the P/E is around 12.16 and the yield is a solid 6.3% per year. Unlike the PSEC yield, these numbers do not set off any alarm bells. I like them as they are, but this dividend number is actually not the whole story.

MAIN has been a monthly dividend payer as long as I have owned it. As previously stated, I like monthly payouts. I have owned MAIN since March 2010. In that time the monthly dividend has been increased 8 times from 0.125 per share when I started to the 0.165 payout today. That is good, but in addition MAIN has in the past couple of years gotten in the habit of making a couple of extra dividend payments per year. These special dividends have been 0.20 to 0.275 per share. I like that they hold a little back and pay me a bonus based on how good business is. If you add in these special payments, the yield is closer to 7.5% per year than the published 6.3%. I like it like that.

Beta is a very low 0.49 so MAIN is rock steady, yet my earliest shares in my taxable account have increased in value from around $15 to today's price at just over $32. What's not to love?

Again, just like PSEC, the reinvested dividends in MAIN have continued to grow and pile up an ever-increasing cash flow that I can tap at some point. I am happy to continue putting that payout in my DRIP program for now, and I was happy to drop 4.56% of my Rollover IRA on Main Street as well.

In my next installment, I will continue by explaining my thinking on the Real Estate Investment Trust asset group and why I chose twelve specific REITs. I hope you will tune in.

Disclosure: I am long PSEC, MAIN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long and intend to stay long in PSEC and MAIN for the foreseeable future. This article serves as a journal of my own experience. I am not a certified financial expert of any kind.