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A reader asks:
I have $1.6 million in my taxable brokerage account, $250k in my traditional 401k, and $150k in cash. No debt. There is no house. I have no dependents, I am single. I need an annual income of $170 thousand to retire. With a 4% withdrawal rate, I would need $4.25 million to reach this income goal. In recent years, covered call funds have become popular. For example, SPYI provides a 12% “yield.” This means that $1.4 million invested will have a return of $170 thousand per year. Is this too good to be true? Why is this a bad idea? I am 42 years old and unhappy. I own a small business and have been working almost every day for over ten years. I don’t know if I can do it anymore. I’m completely exhausted and I just want this to be over.
The investment question here is an interesting thought exercise in terms of numbers, but the small business angle is much more important from a human perspective.
Let’s start with the numbers since it’s the simpler part of the equation.
I’ve written about covered call strategies before. At work explanation A few years ago I gave:
A call option is a contract that gives the buyer the right to purchase a security at a predetermined price at some point on or before a predetermined date. The seller of this call option has the obligation to sell the security at the predetermined price if the security reaches the predetermined date.
If the stock never reaches the strike price within this time frame, the buyer only loses the premium paid, while the seller keeps the option premium.
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 cost 50 cents per piece, so you earn $25 in income on your $1,000 position. That’s good enough for a 2.5% return.
But now your advantage is limited to a 25% gain (going from $20 to $25) plus a 2.5% option premium.
If the stock rises to $30 or $35, you miss out on the extra gain over $25, and the option buyer misses out on the $25 premium.
In a covered call strategy, you are the seller of individual assets or call options on an index.
So this is the type of strategy that should underperform in a noisy bull market. Income from selling options can help but in a tough bull market, but you will likely miss out on some gains and fall behind the overall market.
However, in a bear market this strategy should outperform the market because the option income acts as a buffer. Also, in a bear market, there are volatility spikes that should actually increase your income since volatility plays a large role in option pricing.
There were comprehensive call funds All the rage following the 2022 bear market because they performed better in the down market and came with high returns.
Covered call strategies are perfectly reasonable as a way to reduce equity volatility and increase your income. However, when it comes to the income component, you need to understand how these funds work.
The return on a covered call strategy is not the Holy Grail that many assume. You are not necessarily defeated 4% rule because the efficiency is very high. You need to consider the total return, not just the revenue component.
For example, take a look at the difference between price return and total return for a few of the largest call strategies covered:
Total returns have been pretty good over the last few years. But look at the price returns. They are essentially unchanging.
This basically tells you that all of the return comes from the return. If you don’t plan on living off the income, there’s nothing wrong with that. If you are spending the return component of these funds and not reinvesting them, inflation becomes a big risk.
This is especially true if you’re trying to retire in your 40s. A 3% inflation rate would make a dollar today be worth 40 cents in 30 years.
Your income also becomes much more variable in these funds. Covered call strategies should decline less than the overall market during a downturn because of the income component, but they still own the stock. During last year’s Independence Day sales, these funds dropped from 16% to 22%.
In a prolonged bear market, your income also declines.
Covered calls can certainly play a role in the income portion of your portfolio, but there’s more to it than just the return listed here.
I would be remiss if I did not mention the single stock call strategies that have become very popular in recent years. YieldMax has ETFs that sell calls on individual stocks. Currently, covered call ETFs for Amazon, Google, and Apple return 43%, 39%, and 37%, respectively.
Sounds great, right?
Look at the difference between the price and total return of these funds:
There is no free lunch. Higher returns mean higher risk. Risk also never completely disappears.
The good news is that you’re 42, worth $2 million, and debt-free. This is a huge success.
The bad news is that you’re working too much and it’s making you unhappy.
This is a reminder that running your own business can be extremely lucrative, but it also requires a lot of work.
If you want to spend $170k a year on a $2 million portfolio, that’s an 8.5% withdrawal rate. At your age there is no margin of safety because the money has to last you a very long time.
You can dial down your expenses.
You can try to sell the business.
You can hire a manager for the business and take yourself out of daily life.
When you don’t have dependents, you have enough money to take a year or two off to decide what you want to do next.
Maybe you don’t have enough money to live off dividends at your current spending rate, 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 comfortable and reduce your stress.
This should be your goal.
Bill Sweet helped me solve this question in the all-new Compound Ask:
We also answered questions about box spread loans, small business retirement plans, Seaside FIRE, and tax-efficient asset placement strategies.
Further Reading:
Can Covered Call Options Serve as a Note Exchange?
