When depleting an account makes sense:

This is a theory I've talked about before in relation to the Strategy Shares Nasdaq 7 Handle Index ETF (HNDL). The term 7 handle in the name is a reference to the fund's intended yield, 7%. I wrote about the fund twice in 2018 (here and here). In the first post I was skeptical that it could avoid the tendency of levered funds (HNDL uses leverage) that focus on very high payouts of moving from the upper left of the chart to the lower right as happens very frequently with closed-end funds, I think HNDL has some of the same characteristics inherent in closed-end funds. In the second article, I wrote about a theory of buying it with the expectation that at some point it goes to zero. I was not concerned that it would literally go to zero but end up looking like these two long-standing income-oriented closed-end funds as shown on this 30-year chart.

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I don't know the specific history of how much if any of their respective payouts have been returns of capital but anyone who bought these funds on day one of retirement 30 years ago, happily spending the payout along the way now has much less money. As a note, closed-end funds often include a return of capital (ROC) to maintain a certain dividend level and HNDL is very clear that ROCs are part of its strategy.

Here is a chart of HNDL for one year compared to the iShares Aggregate Bond ETF (AGG);

(Click on image to enlarge)

It has generally tracked the AGG while maintaining a much higher payout, ETF.com has the yield at 6.87% versus 2.52 for AGG, yes that includes leverage and ROCs for HNDL. Despite paying out more than it earns, HNDL has managed to go up which is impressive. The panic from last December is noteworthy. It would make sense to expect that a fund like HNDL or the typical closed-end fund to get crushed in slow or fast crashes. Great if they don't, but my expectation would be that they'd go down a lot. HNDL panicked down with the broader market but nowhere near what the stock market did and then snapped back. HNDL has some equity exposure and is levered so both of those factors contributed to the drop.

One important thing for retirees to get right is the order in which they draw from accounts for their spending needs. The building block of understanding is that you try to allow tax-deferred money (IRAs and Roths) to keep growing, tax-deferred, for as long as possible such that you'd first pull from a taxable account, possibly depleting your taxable account before pulling from IRAs. There are invariably going to be some unique situations where this withdrawal pattern is not optimal but make sure you understand the basic building block before doing something different.

Obviously not everyone has taxable investment accounts but I can see using HNDL or closed-end funds for that matter for a smaller taxable account that might be expected to be depleted. Someone who retires at 62 with $230,000 in a taxable account and $710,000 in IRAs might think they can safely withdraw $36,000 per year (just under 4%) and for the entire nest egg they would be right but that amount taken only from the taxable account to allow the IRA to continue to grow tax-deferred would be unsustainable in the context of the $230,000 taxable account.

I am going to assume that this 62-year-old wants to defer Social Security until age 70 if possible, has a monetized hobby that pays him $2000/mo, no mortgage and is going to take $36,000 from this $230,000 account until it depletes. I crunched some numbers assuming the full $230,000 goes into HNDL and pays 7%, I assumed that shares are sold annually to cover the rest of the $36,000 and the fund only earns back half of its payout in the form or price appreciation which is far less than what it has done in its short history.

After all that, the account depletes when he is 69 years, fourth months old, so he doesn't quite get to 70 years old but does get about another year out of the portfolio versus just leaving it in cash and taking out $36,000 per year and taking 4% of just $230,000 would have resulted in much less income. That has allowed the IRA to grow for seven+ years which depending on the sequence of returns could mean the account grew by 50% (assuming a 50/50 split and that the stock market doubles in that time). If you think doubling in seven years is too optimistic, plug in whatever number you would like. If the total growth was 25%, then the $710,000 would have grown to $887,500 which is pretty close to the original $930,000 and by going this route his Social Security at 69 yrs 4 months is almost maxed out.

One other point is that the portion of a fund's payout that is actually a return of capital is not taxable. Only a small portion of this investor's $36,000 annual payout will be taxable. Money taken from a traditional IRA is subject to income tax.

There are a lot of linear assumptions here so don't get too carried away but the point is that depletion and returns of capital are not necessarily bad things. I should also add in that HNDL could do a much better job of staying ahead of its payout through price appreciation than I am giving it credit for but I definitely want to be conservative with these sorts of assumptions.