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TIPS drawdown at staggered coupon rates
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JWR1945
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Joined: 26 Nov 2002
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Location: Crestview, Florida

PostPosted: Sat Mar 26, 2005 6:11 am    Post subject: Reply with quote

To peteyperson:

Thank you for this outstanding series of posts. Your ideas are exceptionally well thought out. They are easily adapted to satisfy each individual's needs.

You keep open the ability to take advantage of opportunities as they appear.

A TIPS ladder of ten years is ideal for such purposes. You get away from single-decision, high risk commitments that we see so often today. Your approach allows one to exploit the entire upside potential. Yet, it protects against the downside for a full 40 years if need be.

You even take taxes into account.

Thank you again.

Have fun.

John R.


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Norbert Schlenker
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PostPosted: Sat Mar 26, 2005 8:35 am    Post subject: Reply with quote

I'm not sure this is worthwhile, given the short remaining life of this board and your time zone, but here goes anyway.

peteyperson wrote:
Here you're talking both of yield-to-maturity and the price bought vs par value. Clearly one would purchase at a price where you were getting your money back - inflation-adjusted - down the line. With I-Bonds one does not buy them on the open market and so there is no issue with par value, yield-to-maturity and so forth. For me, these are more attractive.

How can someone in the UK buy I-bonds? Does a similar product exist there?

Quote:
The difference with TIPS in the UK is that the inflation uplift is not taxable but the coupon is. With I-Bonds neither inflation nor coupon is taxable but the coupon is 1.05%.

Even you have to admit that 1.05% is a meager return. It's also not true that "neither inflation nor coupon is taxable". It's just tax deferred and taxable on being cashed at full marginal rates. Last, the annual purchase $ limits make them not exactly ideal.

Quote:
I would rather take the risk of a solid government not repaying me than the risk of an insurance company not being able to continue to pay the annuity. The risks there are totally different. I wouldn't trust any portfolio to a pension provider or insurer running an annuity.

Of course solid governments have AAA credit ratings, unlike most (perhaps all) insurers. In return, you get 1% real returns. It's a trade of return for security and everyone gets to specify what they're comfortable with.

Quote:
What if life expectancy boosts up to 140? If one only has 20% in TIPS, then you still have 80% in other assets. It is not going to be a disaster.

For someone who is convinced by jwr's numbers, it seems a little odd to me that you would restrict your TIPS fraction to only 1/5 of the portfolio. If jwr is right, then the SWR out of the 80% is ~2.5% and the SWR out of the 20% is ~4%, combining the two gives you an SWR of ~2.8%. That's a substantial haircut when it comes to retirement income. Why would you sit still for that haircut if you are convinced jwr is right?

Please don't think I'm trying to talk you out of a diversified portfolio. 20% in indexed bonds is pretty close to my standard recommendation to my own clients, so I think it's an absolutely brilliant thing for you to be doing. However, I can make that sort of recommendation only because I believe something quite contrary to "only ~2.5% per year is possible out of the equity piece".

Quote:
I haven't seen anything in your argument that really disputes the claim on living off TIPS or I-Bonds.

Let me try once more then. You buy 1.7% TIPS. JWR's tables say you can take 4%+ a year for 30 years from these TIPS with no problem.

Real rates go to 4% over the next year and stay there. You lose 20%+ of your capital. This part of the portfolio will not survive another 29 years if the withdrawal rate isn't reduced.



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peteyperson
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PostPosted: Sat Mar 26, 2005 9:40 am    Post subject: Reply with quote

Hi NS,

I-Bonds are different in the UK.

Nothing is taxable. There is no tax deferred.

I-Bonds are only 1.05% real returns on the surface and if that was all they provided then I would agree with you. Due to the ability to plan to spend them down over 40-years (not 30) and the lack of volatility in the redemption price, one can be assured of a 3-4% return. The real return is artificially boosted by merit of the fact that you can spend them down over a long timeframe and you can remove volatility unlike with stocks. You can call it a quirk of the investment setup if you like, but as I explained to John, one needs as paramount the shorter term in order to avoid needing to sell at various market prices along the way. This is the only way to have a reasonable idea what your drawdown returns will be. Otherwise you're in exactly the same boat as someone who owns the S&P 500 index. This is why I feel 30-year TIPS won't work. You would have to sell on the open market, returns would vary and with a 3%-4% w.r rate via the drawdown plan, you do not have room to mess about. It is only by merit of the unique qualities of I-Bonds/TIPS that such a plan is even possible. Otherwise I would agree with you that the returns are dismal but still better than nominal bonds which here have delivered zero real returns over time. I personally dislike bonds, I think alternative assets provide similar income and real returns.

I don't believe owning 50% in I-Bonds or TIPS is sensible because I would like more currency diversification than that. I plan to be living in a number of different countries while FIREd, not just in the UK. Whilst the UK Gov't may overborrow and the British pound be devalued - increasing the cost of imported goods & increasing inflation in the UK - I wish to ensure that the I-Bonds/TIPS return do not get "lost" along the way. It is possible that a higher return from higher inflation will net off with a currency devaluation while living as an expat, but who is to know? It is also true as you have pointed out that things can change and indeed if enough things did change it would make the I-Bonds/TIPS plan void. I don't think this will happen due to the popularity of inflation-linked securities with larger insititutional investors who'll have some sway but it is prudent to not overload on any one investment strategy even if you think it is solid gold. I am happy with the merits of the work John & Rob have done - and have tried to add my own thoughts to take their work a little further - but one cannot afford to be too wedded to a single strategy.

I try to make sure that I do not have more than 40% in the portfolio in British pounds - in other words I try to avoid too much homefield bias. As it is this is 4x the British GDP vs Global GDP but one consideration there is the availability of cheaper investment products and/or ones I have more data on. Also some asset classes in the UK are the cheapest around at present and I'm having to avoid most of the US due to problems with valuations & the US dollar which is wrecking havok for int'l investors.

I am not sure if I am misunderstanding you, or you are misunderstanding me with regard to rates and source of returns. The interest coupon on TIPS over 40 years is 0.97% that gets used. Capital drawdown is 2.5%, making 3.47% total. Given that the 0.97% coupon is taxable here (but not the capital portion - I-Bonds are tax free but not TIPS), the interest rate is the smallest component of returns. A halving of that would not make much different to the total return. You would still have 3%. I believe you are suggesting that one would suffer capital loss due to rising interest rates - rates rise, bond values fall. My understanding of bonds is that whilst this is true, bonds return to par value upon redemption. In the case of TIPS, par value + inflation uplift over the term as indexed to UK RPI. So as long as one is clear what yield-to-maturity and redemption value one would receive for a market purchase of a TIPS bonds (not a new one at UK Treasury auction) then I am unclear why you think an investor holding individual bonds would suffer a loss? Perhaps you are thinking of a bond fund that aims to maintain a certain maturity? The whole purpose of buying individual TIPS is to ensure one knows what you'll get over the complete investment, laddered 1/10th coming due a year, providing sufficient (mostly) tax-free income/return of capital. An upward rate movement is immaterial to the investor who holds individual TIPS bonds thru the entire period.

Petey

Norbert Schlenker wrote:
I'm not sure this is worthwhile, given the short remaining life of this board and your time zone, but here goes anyway.

peteyperson wrote:
Here you're talking both of yield-to-maturity and the price bought vs par value. Clearly one would purchase at a price where you were getting your money back - inflation-adjusted - down the line. With I-Bonds one does not buy them on the open market and so there is no issue with par value, yield-to-maturity and so forth. For me, these are more attractive.

How can someone in the UK buy I-bonds? Does a similar product exist there?

Quote:
The difference with TIPS in the UK is that the inflation uplift is not taxable but the coupon is. With I-Bonds neither inflation nor coupon is taxable but the coupon is 1.05%.

Even you have to admit that 1.05% is a meager return. It's also not true that "neither inflation nor coupon is taxable". It's just tax deferred and taxable on being cashed at full marginal rates. Last, the annual purchase $ limits make them not exactly ideal.

Quote:
I would rather take the risk of a solid government not repaying me than the risk of an insurance company not being able to continue to pay the annuity. The risks there are totally different. I wouldn't trust any portfolio to a pension provider or insurer running an annuity.

Of course solid governments have AAA credit ratings, unlike most (perhaps all) insurers. In return, you get 1% real returns. It's a trade of return for security and everyone gets to specify what they're comfortable with.

Quote:
What if life expectancy boosts up to 140? If one only has 20% in TIPS, then you still have 80% in other assets. It is not going to be a disaster.

For someone who is convinced by jwr's numbers, it seems a little odd to me that you would restrict your TIPS fraction to only 1/5 of the portfolio. If jwr is right, then the SWR out of the 80% is ~2.5% and the SWR out of the 20% is ~4%, combining the two gives you an SWR of ~2.8%. That's a substantial haircut when it comes to retirement income. Why would you sit still for that haircut if you are convinced jwr is right?

Please don't think I'm trying to talk you out of a diversified portfolio. 20% in indexed bonds is pretty close to my standard recommendation to my own clients, so I think it's an absolutely brilliant thing for you to be doing. However, I can make that sort of recommendation only because I believe something quite contrary to "only ~2.5% per year is possible out of the equity piece".

Quote:
I haven't seen anything in your argument that really disputes the claim on living off TIPS or I-Bonds.

Let me try once more then. You buy 1.7% TIPS. JWR's tables say you can take 4%+ a year for 30 years from these TIPS with no problem.

Real rates go to 4% over the next year and stay there. You lose 20%+ of your capital. This part of the portfolio will not survive another 29 years if the withdrawal rate isn't reduced.


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ben
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PostPosted: Sat Mar 26, 2005 9:52 am    Post subject: Reply with quote

Hi Petey,
Very Happy With only 20% in the TIPs how is anyone gonna live of 4% of that only? Lets say total nest egg is $1M. That is 200k in TIPs - creating 8k/year for 30 years . Petey; are we talking a $3M portfolio?

Quote:
laddered 1/10th coming due a year, providing sufficient (mostly) tax-free income/return of capital



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Norbert Schlenker
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PostPosted: Sat Mar 26, 2005 9:53 am    Post subject: Reply with quote

peteyperson wrote:
I-Bonds are different in the UK.

Nothing is taxable. There is no tax deferred.

Are they actually called I bonds in the UK? (Indexed bonds in the UK aren't TIPS - they're index-linked gilts - so I realize you could be using the terms in a generic sense given the nationality of much of the audience here.) I'm very interested in such a product. If you could provide the actual name of the product or a pointer to a webpage that describes them, that would be terrific.

Quote:
Otherwise I would agree with you that the returns are dismal but still better than nominal bonds which here have delivered zero real returns over time.

That may be true in the UK. In North America, very long run real returns on bonds are ~3% a year.

Quote:
but one cannot afford to be too wedded to a single strategy.

Hear hear!

Quote:
I am not sure if I am misunderstanding you, or you are misunderstanding me with regard to rates and source of returns. The interest coupon on TIPS over 40 years is 0.97% that gets used. Capital drawdown is 2.5%, making 3.47% total. Given that the 0.97% coupon is taxable here (but not the capital portion - I-Bonds are tax free but not TIPS), the interest rate is the smallest component of returns.

I think it's just that I don't know the details on UK I-bonds. If they work as you describe, I am very interested. So would many others be.



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peteyperson
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PostPosted: Sat Mar 26, 2005 10:03 am    Post subject: Reply with quote

JWR1945 wrote:
To peteyperson:

Thank you for this outstanding series of posts. Your ideas are exceptionally well thought out. They are easily adapted to satisfy each individual's needs.

You keep open the ability to take advantage of opportunities as they appear.

A TIPS ladder of ten years is ideal for such purposes. You get away from single-decision, high risk commitments that we see so often today. Your approach allows one to exploit the entire upside potential. Yet, it protects against the downside for a full 40 years if need be.

You even take taxes into account.

Thank you again.

Have fun.

John R.

Hi John,

Well it is really yours and Rob's idea. I just added my spin to it.

It is a sufficiently different idea that I feel it is a paradigm shift and most people will find it difficult to grasp. I have the approach with investing of taking several passes at something I do not understand the first time through or would like to feel more comfortable with before considering an allocation. I had the experience with a UK real estate company that I didn't grasp their returns right away but went back over it a couple more times and it is now my strongest pick. I think of it like the multiple pass process that desktop scanners use!

I think that 10-year TIPS provide more flexibility (as do 5-year I-Bonds here). It would allow movement to a different strategy if something became more appealing or the investment model no longer applied. I do like to stay flexible with my approach and committment to different investment ideas. This is the way you refine your thinking. Only today I read a piece about the scientists who discovered DNA who said they were not the brightest going after the problem, there was a woman in Paris who was far smarter but she insisted on working alone. They deliberately worked with others from disparate fields of study to gain more insight and by pooling knowledge, made their discovery before she did and subsequently won the Nobel Prize. Indeed, it has also been found in studies that the smartest person who works alone will not win out over the team who pools their collective knowledge to solve a problem even if none are as bright as him. So there is a price to be paid in thinking you know everything or that others know less and have nothing useful to add. For these reasons I stay open to different idea. The only difference here is that I just cannot get along with those people who believe all markets are efficient, cannot be beaten despite mountains of evidence to the contrary and believe in convincing others of the same.

Taxes are an often ignored large component of returns. The TIPS plan is very favorable in that respect. It also helps to balance other aspects of my planned portfolio. I would like to own 25% in global real estate, 10% in managed timber, 5% in absolute return and 40% in stocks. The real estate and timber are there to provide both real returns long-term and livable inflation-adjusted yields. This comes with high attendant tax implications when opting for high income over mostly capital gains and one wants to mitigate that somewhat. Owning TIPS over standard treasuries removes another higher income component for something far more efficient, and yet one receives a combined 3-4% spendable return from the TIPS/I-Bonds allocation. This strikes me as especially attractive and the best of both worlds. Ultimately most people forget that one should avoid owning an asset allocation that matches the status quo and instead to develop an asset allocation that suits your specific needs & objectives. Few actually do this even when presented with evidence that should move their position. A lot of psychological anchoring going on!

Petey


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peteyperson
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PostPosted: Sat Mar 26, 2005 10:14 am    Post subject: Reply with quote

ben wrote:
Hi Petey,
Very Happy With only 20% in the TIPs how is anyone gonna live of 4% of that only? Lets say total nest egg is $1M. That is 200k in TIPs - creating 8k/year for 30 years . Petey; are we talking a $3M portfolio?

Quote:
laddered 1/10th coming due a year, providing sufficient (mostly) tax-free income/return of capital

Ah Ben, you misunderstand me.

Over 40 years holding 10-year TIPS, one receives 2.5% return of capital and 0.97% in coupon returns (more interest in the early years when you still have more capital and less later).

In your example $20k comes due a year from TIPS. If you have a portfolio with a 2% dividend yield (ex-TIPS), there is your withdrawal rate. A 20% TIPS allocation in the first instance provides for 10 years worth of spending without needing to touch the remainder of your portfolio. If this happens one would rebalance when stocks had recovered, allowing your portfolio to live to another day. This was my initial position.

In terms of normal market years, of course, you live off your entire portfolio. Everything else you are aiming for inflation-adjustment on the capital value and to be able to withdraw 2% of capital a year, with 2% of income. You would only forgo that in bad years where you want to avoid selling stocks that have fallen to say P/E 7.5 like the 1970s. You can sidestep the decline and wait at least some of it out unaffected. A lot of investors use bonds for this purpose. It is also possible to sell bonds in order to buy more stocks when they are cheap, rebalancing to the original asset allocation. As I mentioned before it depends what stock valuations are like as to whether this would be smart or not. If markets are at the bottom of a bear where historically P/Es have been around 7, then it might be okay to lose some of your 10 year TIPS protection from the market but there is still some risk in that. It is also important to understand when you choose to retire and P/Es are in the 30s because this not only affects future expected returns but also what asset allocation & rebalancing makes sense later.

Petey


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peteyperson
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PostPosted: Sat Mar 26, 2005 10:33 am    Post subject: Reply with quote

National Savings Inflation-Linked Savings Certificates.

You could call them I-Certs but that would be a bit of a mouthful! It is a bit like how TIPS are actually Treasury Inflation-linked Securities in the US but the TIPS name caught on all the same!

I think they are only open to people from the UK, but I not certain. The FAQ will have such information I think.

I-Bonds guaranteed by the Treasury in much the same way TIPS are. Only difference is that the principal is guaranteed (even from deflation) and the price doesn't move. There is a tiered progression of how the inflation is applied to the balance but it seems to work out fine.

Bond returns have been better in the US, you are correct, but it is a mixed case globally. Some countries did 2-3% real pre-tax, pre-costs, some did not. Prof. Dimson of London Business School has published data for US Bonds from 1900-2000. 4.8% nominal, 1.6% real. Inflation 3.2%. Over most recent 75 years were 2.2% real; 50 years 1.9% real, and 25 years 4.9%. The latter being due to the high rates at the start of the period being analysed. So with US bonds it does depend largely on what period you consider, what the taxes would have been and the costs, as to whether they were positive real returns of any measure.

In terms of the UK I-Bonds, the return over 40 years is closer to 3% because of the lower return but is not much different due to lack of taxation. The product is not new. It has been offered for 37 years I believe.

http://www.nsandi.com/products/ilsc/index.jsp?section=overview

Tiered rates per year:
http://www.nsandi.com/products/ilsc/rates.jsp

Backed by H.M. Treasury (National Savings handle 17% of national debt):
http://www.nsandi.com/privacy/backedbytreasury.jsp

Welcome your observations on the product.

Petey


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ben
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PostPosted: Sat Mar 26, 2005 10:47 am    Post subject: Reply with quote

Ok got it! So you would in normal years use the 2% dividend and then get the remaining 2% from tips even if it means spending it down. In bad equity years all the money would come from the tips.

Basically you would use the tips as your cash buffer (others are talking about 5-6 years spending of cash buffer in CDs/short bonds as it will ensure that even in down years one will not have to touch the nest egg).

Cheers!



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