A Special Kind of Investment

This looks at a special kind of investment: high income producers that return capital. As part of a blended strategy, it lifts the income stream to 5.8% of the original balance (plus inflation).

High Income Producers

ADVDX has created a sensation. It has also caused a tremendous amount of confusion. It has not been around long enough to characterize accurately. I have chosen to use its best and worst features, whether accurate or not, to define a Special Kind of Investment.

The key findings of this study also apply to many Master Limited Partnerships and other Income Investments.

My mythical Special Kind of Investment produces a reliable, high income stream. It also consumes capital.

I have assumed that the Special Kind of Investment has a lower Total Return than the S&P500 index. This is a worst case condition. Actual investments are likely to perform much better.

Definitions

Investment Return = initial dividend yield + dividend growth rate (annualized).

Speculative Return = capital gains or losses associated with changes in multiples (price to earnings ratios).

Total Return (approximately, at Year 10, after adjusting for inflation) = Investment Return + Speculative Return – Inflation.

Characteristics

I refer to my Special Kind of Investment as Investment B when using my TIPS Income Stream Allocator B.

Investment B

Yield = 13%
Growth = -5% per year (annualized)
Inflation = 3% per year (average)

Investment Return = 13-5-3 = 5% (annualized)

Speculative Return = not directly relevant, likely to be negative because of the consumption of capital (i.e., the negative growth rate).

Compare with today’s S&P500

Yield = 2%
Growth = 5% per year (annualized)
Inflation = 3% per year (average)

Investment Return = 2+5-3 = 4% (annualized)
Long Term Speculative Return = 1% per year (annualized), actually 0.7% per year.

Total Returns

The Total Return of the S&P500 is very close to the Investment Return of Investment B. Because Investment B consumes capital, it has a lower Total Return than the S&P500 index.

Growth Kicker: Stock A

Yield = 4%
Growth = 6% per year (annualized)
Inflation = 3% per year (average)

Investment Return = 4+6-3 = 7% (annualized)

TIPS
Interest Rate = 2%

Investment Return = 2% (annualized)

Data Summary

These are my results using the TIPS Income Stream Allocator B.

Allocation: 50% Stock A, 50% Investment B, 0% TIPS.
Withdrawal Rate: 5.7% real.

Allocation: 45% Stock A, 45% Investment B, 10% TIPS.
Withdrawal Rate: 5.6% real except 5.2% in Years 32 through 38 (full recovery to 5.6% in Year 39).

Allocation: 45% Stock A, 55% Investment B, 0% TIPS.
Withdrawal Rate: 5.7% real except 5.3% in Years 35 through 39 (full recovery to 5.8% in Year 40).

Allocation: 55% Stock A, 45% Investment B, 0% TIPS.
Withdrawal Rate: 5.8% real.

Allocation: 60% Stock A, 40% Investment B, 0% TIPS.
Withdrawal Rate: 5.8% real.

I have place pictures (Microsoft Word Documents showing truncated spreadsheets) into the “Income Stream Pictures J” file of the “Allocators” folder at my Yahoo Briefcase. You can download them for free.

Yahoo Briefcase

Data Analysis

The Special Kind of Investment did an excellent job of increasing the withdrawal rate. As part of a blended strategy, it lifted the income stream to 5.8% of the original balance (plus inflation). The strategy produces a continual income stream with eventual growth because of Stock A, the “Growth Kicker.”

The TIPS are used for smoothing cash flows. Investment B produces excessive income in the early years, which is directed into the TIPS account. Later, the TIPS account fills in the void as Investment B loses ground and before Stock A has reached its full growth level. Eventually, Stock A produces almost all of the income stream.

Investment B lifts the Investment Return of the overall portfolio as compared to using nothing more than TIPS and Stock A. The smoothed income stream comes close to matching the Investment Return of the overall portfolio.

Conclusions

The Special Kind of Investment does not need to be a superior investment when it is part of a blended strategy. It only needs to be similar to others to offer a tremendous income boost for retirees.

These results are much, much better than the 3.6% and 3.0% 30-Year Safe Withdrawal Rates associated 50% and 80% fixed stock allocations at today’s valuations (i.e., when using the S&P500 and 2% TIPS).

Have fun.

John Walter Russell
March 3, 2007