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JWR1945
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PostPosted: Thu Mar 17, 2005 8:39 pm    Post subject: TIPS Equivalents Reply with quote

I wrote in my recent Overview post:
Quote:
Of course, there is a problem with 2% TIPS. They no longer exist. The issue is whether a person can actually construct a good equivalent portfolio. There is a requirement to be able to handle emergency cash needs. There is another requirement to match inflation. There is an additional requirement to produce sufficient income (above any return of capital that might distort the numbers).

Peteyperson has mentioned international inflation-matched bonds that still yield 2%+.

Mike has identified higher dividend stocks as part of a solution. He has also identified several problems in constructing a TIPS equivalent portfolio.

Mike has pointed out the importance of the time frame. Some solutions fail because they take too long. For example, to buy a meaningful holding of Ibonds may take so much time that stocks become attractive again.

There is the side issue of coming up with something for an actual portfolio. Generally, I have used TIPS in an idealized, theoretical manner to establish baselines. Our calculators are limited in this respect as well. We have glossed over numerous details. The real world is different. For example, peteyperson has pointed out difficulties when drawing down principal: prices may have fallen.

What has happened is that investing in the equivalent of 2% TIPS turns out to be one of the better approaches for today. We might need to hold on to such an investment for a decade or even longer. Our theoretical baseline beats many standard strategies.

Does anyone have suggestions? Are there additional points that we need to consider?

Have fun.

John R.


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peteyperson
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PostPosted: Sat Mar 19, 2005 12:40 am    Post subject: Reply with quote

JWR1945 wrote:
I wrote in my recent Overview post:
Quote:
Of course, there is a problem with 2% TIPS. They no longer exist. The issue is whether a person can actually construct a good equivalent portfolio. There is a requirement to be able to handle emergency cash needs. There is another requirement to match inflation. There is an additional requirement to produce sufficient income (above any return of capital that might distort the numbers).

Peteyperson has mentioned international inflation-matched bonds that still yield 2%+.

Mike has identified higher dividend stocks as part of a solution. He has also identified several problems in constructing a TIPS equivalent portfolio.

Mike has pointed out the importance of the time frame. Some solutions fail because they take too long. For example, to buy a meaningful holding of Ibonds may take so much time that stocks become attractive again.

There is the side issue of coming up with something for an actual portfolio. Generally, I have used TIPS in an idealized, theoretical manner to establish baselines. Our calculators are limited in this respect as well. We have glossed over numerous details. The real world is different. For example, peteyperson has pointed out difficulties when drawing down principal: prices may have fallen.

What has happened is that investing in the equivalent of 2% TIPS turns out to be one of the better approaches for today. We might need to hold on to such an investment for a decade or even longer. Our theoretical baseline beats many standard strategies.

Does anyone have suggestions? Are there additional points that we need to consider?

Have fun.

John R.

In terms of TIPS, I would think that 10-years is as far out as one could manage. One could ladder that effectively, buying one each year. Most likely in a handful of years one would be able to setup the ladder to come due yearly (1/10th of the TIPS holding). If one had a 4% w/r rate and 2% in cash dividends, then one would want a 2% TIPS to fall due each year in case it was needed. This would indicate a 20% TIPS allocation in order that 1/10th of that be 2%. It would cost a bit more initially buying TIPS that would come due in a year, or two, or three, etc. to setup the ladder. One would want to avoid the need to sell capital each year and to avoid experiencing volatility in capital sale received. Such a plan if I've done my sums right would be appropriate to that goal. The 2% TIPS coupon would help pad out the portfolio dividend but I would plan from the perspective that these are sold down first and setup for that ideal. Either than or I-Bonds if that is more preferable. In the UK I-Bonds have no price volatility and no fees to sell, and work on a 5-year ladder up to $25k invested each year but they only payout 1.05% net. 2% TIPS is gross and so net of taxes and brokerage fees, not much in it. Neither offer attractive yields and even the spend-it-down-in-30-years plan I assume would not deliver much beyond 2% on 1.05% rate per year. You able to compute that for me, John? Question Also would be interested to see the number for 35 and 40 years spenddown! I plan from the perspective currently that I don't like off TIPS or I-Bonds, but use them as a foundation to the portfolio that contains other more vulnerable, volatile but long-term higher returning investments. My job in some ways is to provide a moat around those higher returning investments to allow me to ride out the storm when it happens. It is possibly a different approach than you guys are planning in this forum.

Opportunities in investing are such that it helps to stay nimble. I'm not sure one fixed approach really works. For instance, in 1982 the S&P 500 index made sense with an initial yield of 6.2%. Today it does not. In 1998/9 selling the S&P 500 made sense and buying into Oil & Gas, US REITs and Int'l REITs made sense. Oil was cheap, and the REITs were sitting at 20-30% below NAV. All were the unloved asset classes and tech was everywhere.

So being something of a deft asset allocator could have provided larger real returns and selling above average PEs to buy other assets below NAVS or long-run inflation-adjust Oil prices was a capital preservation strategy as well as one that boosted future expected returns. That these could all provide high income streams was just a side benefit unless one restricted oneself to finding only those prospects.

Every few years one is likely to see these kinds of strange pricing, investors running like a herd from one thing into another. Typically the thing they run from when left a while will fall sufficiently to make it attractive again. Presently private equity is experiencing declining returns because too much money is being invested there and some of the more astute institutional investors have been reducing allocations.

Being a contrarian is smart investing.

In terms of capital risk within drawdowns, this is an area one can play around with. One can buy stocks that have better payouts than average - Heinz is one example in the US today paying 3% yield - but often these companies are very mature and are barely growing. Heinz sales and earnings are flat over the past five years. One wants a company during distribution phase that is at least increasing sales & earnings by inflation and can increase dividends as much. What you are buying then is almost like an inflation-protected company with the inflation-protection tax-deferred but the income taxable each year. As such, this kind of company will not deliver a high real return. This is the tradeoff one makes when wanting the assurance of higher income streams unless one owns bonds which have an even lower real return history than slow growing stocks.

To use one example. One can own the UK total market index - the FTSE All-Share Index - and receive a 2.5% gross yield (net of index fees). If using a 4% withdrawal rate, this leaves 1.5% in capital sales to find. Alternatively one can own a higher returning active fund that received 2.5% in dividends but costs 2% in fees which come out of the fund. This leaves just 0.50% in dividends. Whilst such a fund during accumulation might compound money faster and suit the accumulating investor, it will leave them needing to sell 3.5% of capital gains each year to live. Should the market fall by 50% and stay flat for the following decade - a 1970s type scenario - this 3.5% sale will morph into 7% of remaining assets for 10 years. In an all stock portfolio this could turn a higher returning strategy into a disaster. So the investment case in distribution may well be desirably different. Higher net returns should not be the only goal. One can invest less aggressively and get as good returns if the portfolio is balanced differently.

My sample distribution portfolio under consideration is 40% in global equities, 20% in global REITs, 15% in Natural Resources (inc. 10% in Timber), 10% in Absolute Return, 5% in TIPS and 10% in I-Bonds. The portfolio yield is 1.75% gross, 2.5% capital sales per year, portfolio return estimate is 4.25%. The plan is to be able to redeem the I-Bonds which cover 4 years of expenditure (2.5% x 4). TIPS and Abs. Rtn. come next. Both TIPS & Abs. Rtn may experience unfavorable market price movements in a changing rate environment or one where stocks have fallen but I expect either asset class will rebound within a handful of years in most scenarios. So then they could be sold down next. I hope to be able to sell all of these three asset classes to fund a full decade of capital sales in a 1970s type scenario, but avoid selling off what would be 7% of my active small cap funds (those that payout 0.5% gross div. after fees are deducted and typically I would sell 3.5% a year before the stocks declined). One has the option to rebalance as you go but I would maintain the I-Bonds $ allocation because this provides immediate cash flow security. I would rebalance most of the rest where appropriate. The idea being to sell the lowest returning, most liquid, least volatile asset classes first all the way up to REITs and lasting common stocks. Common Stocks being the prime movers, most volatile but highest returning, most tax efficient investments of all. There is no point investing in such an asset class unless one can reasonably hold thru a major market decline to be able to reap the benefits of ownership. It wouldn't therefore make sense to invest 90% in them, one could not ensure an ability to avoid selling out when the shares were underwater. You overreach and suffer the consequences in the distribution phase. In the long-run you'll be broke if stocks don't recover in time and one needs to plan for that.

There is something to be said for how one balances the returns and allocations. One could opt to avoid small cap asset classes in favor of an all-large cap position in equities. Dividends would be higher, asset sales needed lower but long-run returns would suffer too. One has to weigh-up the desire for higher returns with the desire for no interruption in returns that could threaten the portfolio. Either too safe or too aggressive an allocation pose great risks. One small example of this is whether to use TIPS at all instead of an all I-Bond allocation for liquidity foundation. Doing so is shooting for a slightly higher 0.3% return (net of taxes) and hoping for an upward revision in pricing in a flight-to-quality from other investors following a sharp market decline. This could add a little more punch and one could then sell them instead of I-Bonds. Equally this could not happen and interest rate movements could cause TIPS to decline. In this situation one may have wished to own the allocation in I-Bonds alone because they suffer no market price volatility and so provide the ultimate easy cash flow when wishing to not suffer capital loss in poor market environments. One can try too hard, overreach for return in the wrong part of the portfolio and mess up a good thing.

Petey


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JWR1945
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PostPosted: Sat Mar 19, 2005 8:21 am    Post subject: Reply with quote

JWR1945 wrote:
1.05% net. 2% TIPS is gross and so net of taxes and brokerage fees, not much in it. Neither offer attractive yields and even the spend-it-down-in-30-years plan I assume would not deliver much beyond 2% on 1.05% rate per year. You able to compute that for me, John? Also would be interested to see the number for 35 and 40 years spenddown!

Principal payments provide a floor on payments of 1/N, where N equals the number of years. The 1.05% of interest adds about 0.5% to 0.6% to the withdrawal rate.

For an interest rate of 1.05%, your payments would equal:
1) 3.90% over 30 years or
2) 3.43% over 35 years or
3) 3.07% over 40 years.

Thanks for some outstanding posts. I cannot respond adequately at this time. I hope that these numbers are helpful.

Have fun.

John R.


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peteyperson
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PostPosted: Sat Mar 19, 2005 2:06 pm    Post subject: Reply with quote

JWR1945 wrote:
peteyperson wrote:
1.05% net. 2% TIPS is gross and so net of taxes and brokerage fees, not much in it. Neither offer attractive yields and even the spend-it-down-in-30-years plan I assume would not deliver much beyond 2% on 1.05% rate per year. You able to compute that for me, John? Also would be interested to see the number for 35 and 40 years spenddown!

Principal payments provide a floor on payments of 1/N, where N equals the number of years. The 1.05% of interest adds about 0.5% to 0.6% to the withdrawal rate.

For an interest rate of 1.05%, your payments would equal:
1) 3.90% over 30 years or
2) 3.43% over 35 years or
3) 3.07% over 40 years.

Thanks for some outstanding posts. I cannot respond adequately at this time. I hope that these numbers are helpful.

Have fun.

John R.

I guess just thinking about it, the rate would not be that much lower judging by your other figures. 3.66% over 40 years suiting the 60 y.o. FIREee. The difference on rate would be the difference from the payout of 2% taxable to 1.05% not-taxable. Ultimately these numbers might be more useable from the tax perspective. Surprisingly high on a tax-free basis.

Were these run the same way as TIPS or rushed because you were short on time when you posted? When you can, I would appreciate an extension like with TIPS out to 45 and 50 years to cover 50 years olds too.

I look forward to hearing your thoughts on my long post when you have more time.

Thanks.

Petey


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JWR1945
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PostPosted: Sun Mar 20, 2005 12:30 pm    Post subject: Reply with quote

peteyperson wrote:
Were these run the same way as TIPS or rushed because you were short on time when you posted? When you can, I would appreciate an extension like with TIPS out to 45 and 50 years to cover 50 years olds too.

I look forward to hearing your thoughts on my long post when you have more time.

I have put these on another post, but I repeat them here. The payments from 1.05% I-Bonds produce a withdrawal rate of:
1) 10.59% for 10 years or
2) 7.24% for 15 years or
3) 5.36% for 20 years or
4) 4.40% for 25 years or
5) 3.90% for 30 years or
6) 3.43% for 35 years or
7) 3.07% for 40 years or
8 )2.80% for 45 years or
9) 2.58% for 50 years.

You have some great ideas on several threads.

I notice that you would limit TIPS to 20% or so of your portfolio. Is this enough? We want to be able to take advantage of low stock prices when they appear (eventually). Although this would not be an emergency, we want to take advantage of opportunities.

Still, something around 20% corresponds well with unclemick's mutual fund portfolio with its 16% drop after 2000.

I want to do this right. I am trying to identify essential elements such as the TIPS allocation with its ability to be converted rapidly to cash. There is also the use of higher dividend investments to bring the withdrawal rate up to 4%.

As an aside, 2% TIPS by themselves (and subject to a few idealizations) deliver 4.0% for 35 years, which is better than stocks plus commercial paper did around 1965-1970. Maybe the traditional numbers are too low even now.

[No bets or side bets allowed. Probably not.]

Have fun.

John R.


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peteyperson
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PostPosted: Mon Mar 21, 2005 11:20 am    Post subject: Reply with quote

JWR1945 wrote:
peteyperson wrote:
Were these run the same way as TIPS or rushed because you were short on time when you posted? When you can, I would appreciate an extension like with TIPS out to 45 and 50 years to cover 50 years olds too.

I look forward to hearing your thoughts on my long post when you have more time.

I have put these on another post, but I repeat them here. The payments from 1.05% I-Bonds produce a withdrawal rate of:
1) 10.59% for 10 years or
2) 7.24% for 15 years or
3) 5.36% for 20 years or
4) 4.40% for 25 years or
5) 3.90% for 30 years or
6) 3.43% for 35 years or
7) 3.07% for 40 years or
8 )2.80% for 45 years or
9) 2.58% for 50 years.

You have some great ideas on several threads.

I notice that you would limit TIPS to 20% or so of your portfolio. Is this enough? We want to be able to take advantage of low stock prices when they appear (eventually). Although this would not be an emergency, we want to take advantage of opportunities.

Still, something around 20% corresponds well with unclemick's mutual fund portfolio with its 16% drop after 2000.

I want to do this right. I am trying to identify essential elements such as the TIPS allocation with its ability to be converted rapidly to cash. There is also the use of higher dividend investments to bring the withdrawal rate up to 4%.

As an aside, 2% TIPS by themselves (and subject to a few idealizations) deliver 4.0% for 35 years, which is better than stocks plus commercial paper did around 1965-1970. Maybe the traditional numbers are too low even now.

[No bets or side bets allowed. Probably not.]

Have fun.

John R.

Hi John,

It is difficult to believe that I-Bonds paying just 1.05% can give a 40-year retiree 3.07% inflation-adjusted withdrawals. If so, it certainly gives one pause. The thing here is that it is crucial to ensure one actually gets that return and does not suffer safe withdrawal rate losses set against total returns because of poorly timed sales. As a simple example, one can perhaps afford to lose 3% of a withdrawal on a 7% real return asset class but not one using your 3.07% number over 40 years. There is no room for error there.

In terms of the allocation percentage, it was designed purely to cover the difference between the diversified income stream of 2% and the planned 4% withdrawals, 10-year TIPS, and removing the market price volatility by way of the redemption at the end of the term. The problem here is should one retire planning on the 3.07% return from age 60 thru age 100, will you be able to buy TIPS again in a decade for the same yield? This presents real problems because all we've seen from TIPS so far is a falling yield thru time. I have less of a concern on the I-Bonds here however because they have been issued for 35 years now and the rate is so low already (albeit with no tax implications). So I would feel more comfortable using that even though it is on a 5-year term and so returns are locked in for less time.

The alternative is to buy 20-year and 30-year TIPS in developed countries where they are available. I believe they offer 30-year TIPS here and in the US. I might be wrong but I think France is 10-years and 25-years. So there are a mix of options available but the difficult term would not work for the sample portfolio I've shown and the reason for holding the 20% allocation on a ten year term with 2% coming due automatically per year. With I-Bonds on a 5-year term here, I suppose one would still allocation 20% but have 4% coming due each year. Unavoidable if one is to ensure 10 years of cash flow on tap.

In terms of "is it enough?", I would answer that it is for this portfolio model. You're working on something completely different and so everything needs to be considered fresh. I may be wrong but you appear to desire a solution where you get as little volatility as possible in order to ensure an ability to redeem shares, etc., without market price impact on your expected withdrawal rate. If one can successfully ladder enough TIPS over a long timeframe like 30 years, then perhaps. It may require a combination of TIPS from different countries but for many that will cost more in foreign taxation on the income, transactions costs, full tax on total return whereas some investors are only taxed on the income coupon (my situation). So it is not a level playing field in getting int'l diversification for diversification sake or a spread of redeemable periods to work with.

I am not sure what assets one could use in order to avoid the problem of "what price capital at sale?" REITs and Timber provide a lovely yield one can live off, but you are still accepting 15-17.5% SD on the capital (if only 5-7.5% SD on the rental/harvest yields. Any plan that requires the sale of assets as you go along brings into question how to extract the full return. You then have the same problem I have. How do you cover halting capital sales when market tank? I am not sure I have heard an answer from you on that score.

Purely in terms of a balanced mix of assets you are trying to put together, certainly a good case can be made for holding a higher allocation to TIPS/I-Bonds if real returns can be obtained of circa 3% over 40 years. This would look acceptable for people aiming to retire at 55 who most likely won't actually make it till 60 (I expect this to be me). This has to be on the basis of being able to ensure one can get those returns by avoiding selling in the open market. So one perhaps could hold 40% in TIPS in a 10-year ladder and just reinvest what you don't use. Have that be the most stable cash flow provider - as I plan in my setup - knowing that in this setup 4% comes due. With your spend-down-plan, you would be spending some of the capital and reinvesting some, plus using the coupon which is received separately. So the "inconvenience" of having 4% fall due a year when you don't need that much most years would be fine. I know that you're looking at this from the perspective of a mix of assets and getting as close to 4% as possible - as a simple rule of thumb target as much as anything. You see 3%+ spending down over 40 years (which for me looking at a typical 60 y.o. FIREee is plenty) and opinioning that loading up on other assets that might not give you 4% today or much more than 4% long-term is questionable. I would not go quite that far, but I would agree that if 3% on TIPS/I-Bonds is do-able as you say (as yet I have no way to verify the numbers and I check everything myself as I'm the one who would pay the price if it were wrong!) then one could afford to hold 20-40% as long as one owned 5-6% real returning assets too.

In terms of holding more TIPS to be able to take advantage of low stock prices later, that is a personal choice. One has to consider the opportunity cost on either side of that equation. That is a little like someone who wishes to overweight value and particularly small cap value. You are right on long-term data to do so, but one cannot be sure over 20 years that you'll be right. Here in the UK I feel I have lower valuations and history on my side there. We just went thru a 20 year period where small cap index did not beat large cap index (value did). So given the starting point today, odds are especially good that the next 20 years will deliver better returns for small & micro than large-cap. That would be my reasoning for going much heavier into those areas almost to the complete exclusion of UK large-cap. But I plan that knowing I am playing the odds but that the odds are in my favor (yet I might still lose). One does much the same thing when one refuses to own stock in favor of treasuries waiting for stocks to fall. You're playing a waiting game. Certainly I would not be in large cap index in the US for the next decade. There has never been three decades of P/E expansion nor avoidance of revision-to-the-mean after two decades of P/E expansion. It would be unprecidented then if we reached the end of 2009 and P/Es have not mean reverted. But that could still be the way of it. One has the choice whether to overweight over more affordable, better returning equity asset classes instead or whether one wants to sticks with country/regional weightings and when one cannot do that due to low future real return expectations then one holds TIPS instead. That would be a fairly strict interpretation. Perhaps it is different in distribution phase to accumulation phase in this instance because I anticipate new funds each year to deploy and someone already fully allocated & no longer in employment is not. So perhaps I feel I can take advantage of cheaper markets as I go along and so holding cash makes less sense? I still believe I see 4-8% real from certain equities and so holding 1.05% net I-Bonds or 1.25% net TIPS doesn't make too much sense. Whilst returns would be boosted in a market fall, large cap especially this isn't as much as it seems. Jeremy Siegel's new book discusses how some cheap sectors like railroad stocks actually outperformed the S&P 500 index because they started dirt cheap in the 1930s and if you had reinvested the large dividends (due to low P/E), you would have accumulated so many extra cheap shares that you go out ahead. This ignores taxes on those dividends tho' (perhaps this is diff. in the US). If one paid taxes on them, then the math doesn't work out like he says so it is a little bit of wishful thinking on dividends there. This is also one of the reasons why small cap can beat large cap even though the dividends are so much lower historically. Small cap gains much more than 1.8% real growth in the US (and 0.50% real growth in the UK) and this is tax deferred for as many years as you can afford. This tax deferral overcomes the lower dividends and lower reinvestment. Ignoring the effects of taxes on dividends changes the whole picture.

Apologies for length, but your post covered a range of subjects spanning two different portfolio structures! Wink

P.S. It is easy to see that the 30-year TIPS/I-Bonds return being circa 4% matches the S&P500/Treasury Bond Balanced withdrawal rate spending down that capital over 30 years (especially at today's expected returns). For my own purposes though, I reject the notion of planning to spend capital down and yet being FIREd at 60. With modern medicine and staying healthy one can live to be 100 or more. So a plan that runs out at 90 doesn't work for me and I dare say most people. For those who retire late at 70, most certainly it will be of greater interest! So I reject any plan for "30 years and bust". Particularly because the markets are so volatile that a bad early return series would blow apart a 75/25 S&P 500/Bond Index portfolio, leaving you broke not much past 20 years into retirement. For people retiring at 60, this would leave them age 80, pretty unemployable and screwed. So as a general rule, I would not want a spend-down-plan on stocks. One needs to be able to know exactly how long an asset class will last when spending it down - to lock that down exactly - which is why I favor a plan that has TIPS/I-Bonds held to maturity. The problem comes into paradise on your plan there on the matter of what reinvestment rate one achieved for TIPS. This will change the withdrawal rate and so potentially cause the same problem as the 30-year S&P 500 spend-down-plan. Possible less impactful though due to lower volatilty instruments. On my plan I work as close to perpetual funds as I can - the endowment fund model - and use TIPS as a source of cash flow insurance in the first decade rather than as a way to lock-in close to 3% w/r rates on a good chunk of the portfolio in an ultra-safe manner. Of course I could adopt two TIPS allocations. The first as the insurance policy and the second as one of several investment asset classes (I don't plan to rebalance the 20% TIPS-for-cash-flow, just the 80%). I could then plan to have perpetutual funds on everything else that is far more volatile but plan to spend down the TIPS and realise a higher return on this lower-risk asset class. That then speaks more to your plan in combination with mine.

Petey


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JWR1945
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PostPosted: Mon Mar 21, 2005 1:23 pm    Post subject: Reply with quote

peteyperson wrote:
It is difficult to believe that I-Bonds paying just 1.05% can give a 40-year retiree 3.07% inflation-adjusted withdrawals. If so, it certainly gives one pause. The thing here is that it is crucial to ensure one actually gets that return and does not suffer safe withdrawal rate losses set against total returns because of poorly timed sales. As a simple example, one can perhaps afford to lose 3% of a withdrawal on a 7% real return asset class but not one using your 3.07% number over 40 years. There is no room for error there.

Keep in mind that we are drawing the principal down to zero. The 40-year retiree would get a return-of-capital of 2.50% even if the interest rate were zero. Inflation-matching is a powerful benefit all by itself.

The 1.05% interest ends up adding 0.67% to the withdrawals. This is less than 1.05% because the principal declines during the 40 years.

As for taxes: since the 2.50% is a return of capital, it will not be taxed directly. Instead, all adjustments to the principal amount to match inflation get taxed. If inflation were zero, everything would be great. But watch out if inflation gets out of hand.

Here is a good idea for someone who wishes to draw down principal such as your 40-year retiree who is getting 1.05% and who wants to withdraw the full 3.07% each year. If he is able to purchase the right issue on the secondary market, he won't have to sell anything to draw down principal.

The key is for him to purchase TIPS at a premium. If he holds to maturity, he will receive par at maturity, which is a fraction of his purchase price. His coupons have been higher than for a bond at par with the same yield-to-maturity. The extra amount in the coupons is a return of capital as far as he is concerned.

This is a clever trick. It is a good idea for someone with a long time frame.

Have fun.

John R.


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PostPosted: Mon Mar 21, 2005 9:53 pm    Post subject: Reply with quote

JWR1945 wrote:
peteyperson wrote:
It is difficult to believe that I-Bonds paying just 1.05% can give a 40-year retiree 3.07% inflation-adjusted withdrawals. If so, it certainly gives one pause. The thing here is that it is crucial to ensure one actually gets that return and does not suffer safe withdrawal rate losses set against total returns because of poorly timed sales. As a simple example, one can perhaps afford to lose 3% of a withdrawal on a 7% real return asset class but not one using your 3.07% number over 40 years. There is no room for error there.

Keep in mind that we are drawing the principal down to zero. The 40-year retiree would get a return-of-capital of 2.50% even if the interest rate were zero. Inflation-matching is a powerful benefit all by itself.

The 1.05% interest ends up adding 0.67% to the withdrawals. This is less than 1.05% because the principal declines during the 40 years.

As for taxes: since the 2.50% is a return of capital, it will not be taxed directly. Instead, all adjustments to the principal amount to match inflation get taxed. If inflation were zero, everything would be great. But watch out if inflation gets out of hand.

Here is a good idea for someone who wishes to draw down principal such as your 40-year retiree who is getting 1.05% and who wants to withdraw the full 3.07% each year. If he is able to purchase the right issue on the secondary market, he won't have to sell anything to draw down principal.

The key is for him to purchase TIPS at a premium. If he holds to maturity, he will receive par at maturity, which is a fraction of his purchase price. His coupons have been higher than for a bond at par with the same yield-to-maturity. The extra amount in the coupons is a return of capital as far as he is concerned.

This is a clever trick. It is a good idea for someone with a long time frame.

Have fun.

John R.

Well again, that is an overly optimistic hope with TIPS. Any plan should be based on current rates and what is possible in a reliable manner rather than thru trading or tactical positioning.

Your point on 40 year drawdown being 2.5% of the principal per year is well taken. As long as one does not overweight TIPS from one country and TIPS in general, they do provide approx. 3% w/r rate with capital spent at the end. Not sure how one can ensure that though. The key is no volatility on returns and yet only owning 40-year TIPS would provide theoretical assurance of the return level and how much could be drawdown to achieve that. For the 40-year retirement - age 60 thru 100 - this instrument has yet to exist. US TIPS max out at 30 years, the UK too. So you can lock-in today's rates for that time period. Even if one was willing to take a flyer with that, how can only redeem the 20- and 30-year TIPS bond without incurring fees and capital loss with volatile market pricing? You are no longer holding 10-year TIPS with automatic redemption. If you were you would lose the forward knowledge of investment returns with that. You're back to the basic problem with living off the S&P 500 index. The volatility in pricing each year markedly impacting the historical return achievable for people FIREd. Chicken and egg situation, no?

Presumably on a 40-year drawdown the majority of the return using your numbers is in the capital drawdown aspect and not the yield (diff. when yields were 4%!). Less than 22% is provided by the yield (0.67% into 3.17%). This would call for buying the (long-term yield not-assured) 10-year TIPS and not the long-term TIPS. This would ensure the automatic redemption aspect (albeit with higher fees for reinvestment over the timeframe) but - this is key - remove price volatility from the plan. With 10-year TIPS being 100% of your portfolio (not suggesting this allocation), 10% would fall due annually and today you would receive 1.7% approx. in current income on the starting total of TIPS bonds owned. You would then receive approx. 11.7% in total return, only a small part of which is taxable as you say, take your 3% w/r and reinvest the remainder in more 10-year TIPS. So very tax-efficient, market independent (unless market gets closed due to war), way to get returns from an asset class. If one chose to completely buy into the plan, one could own 50% in TIPS returning circa 3% over 40 year FIRE and need 50% in other assets that can deliver 5% real to get the balanced 4% w/r rate. This altered plan would ensure enough capital falls due to mitigate volatility in the stocks in the 50% part - much like my diversified portfolio plan with the 20% allocation to TIPS using 2% of it a year in bad years - and so protect strongly from market. This may allow one to take aim at value and small cap value in the US and internationally which should boost returns enough to provide the 5% needed. Grantham currently has Int'l ScV at 4.6% real and EM at 5%, to give you some idea on that score. Of course if one owned REITs, Timber and other dividend stuff, one could even isolate more from capital gain requirements with the first 50% if one can still get net real returns high enough on income-bearing assets.

With UK I-Bonds I am somewhat less concerned with the changing real rates because rates are only 1.05% today, tax-free. It is therefore difficult to see rates being cut too far below that and as per above, coupond being 1/5th of the return means even a halving of the real return would not make too much difference on the w/r rate achievable.

Petey


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