Current Research A

Fundamental Breakthroughs associated with TIPS

Latest update: June 16, 2005.

I wrote this right after the NoFeeBoards closed. The site has reopened, but in a limited form and a committee runs it now, not ES by himself. It no longer features the SWR Research Group discussion board. Peteyperson is a respected poster who participates on several discussion boards related to early retirement. Rob Bennett is the writer of Passion Saving, which will be available soon. I have reviewed a draft copy. It is an excellent book with many insights. Rob has opened a web site called passionsaving.com.)

I find it unfortunate that the NoFeeBoards closed just as Peteyperson was making major advances into the planning of retirement portfolios. We will continue to take advantage of his research. I am looking forward to recovering his contributions from the SWR Research Group archives that ES is putting together. We were making major advances even during the final hour of the NoFeeBoards.

The NoFeeBoards were the single bright spot on the web. They were the only place suitable for my research. It is horrible that ES was treated like trash.

Because we have looked into TIPS, we made three fundamental breakthroughs for retirement portfolios, with the latest from Peteyperson.

This is Rob Bennett’s major contribution: he built a real-life portfolio without any stocks.

He discovered that it can make sense to invest in something other than stocks. Although he will point out that his circumstances were unique, I consider his findings to have a wide range of applicability. A real-life portfolio without any stocks can be superior to a traditional portfolio with a heavy allocation into stocks.

He discovered this in spite of our having very little information about the effect of valuations on Safe Withdrawal Rates. He knew that prices affect stock returns and that stock prices were exceptionally high, already into record territory.

Here are some new calculations. They are subject to a host of modeling limitations, but they are accurate enough for making comparisons. Rob Bennett’s 3.375% TIPS have a Safe Withdrawal Rate of 4.00% that lasts for 56 years. Compare this with a traditional portfolio with a high stock allocation. Its Historical Surviving Withdrawal Rate is 4.0%, but only over 30 years. Its Safe Withdrawal Rate is considerably lower. With a 4.0% withdrawal rate, the traditional portfolio has about a 60% chance of making it past 30 years. This does not mean that it will fail. This means that its 30-year survival is a coin toss. It is not safe.

My own contribution has been using a TIPS-only portfolio as a baseline. TIPS at zero percent real interest rate (i.e., a cash equivalent that matches inflation) permit you to withdraw 1/N of your initial (real) balance for N years. The mortgage formula, suitably modified, allows us to calculate withdrawal amounts with actual interest rates.

This baseline makes it clear that you never have to accept any portfolio that fails to guarantee at least 3.33% over 30 years, 2.50% over 40 years or 2.00% over 50 years. With interest rates around 2%, a withdrawal rate of 4.00% lasts 35 years.

This last calculation doesn’t make a traditional portfolio with its high stock allocation look nearly as attractive as is claimed. It has only a 30-year Historical Surviving Withdrawal Rate of 4.0%. When stock prices are high, as they are today, its Safe Withdrawal Rate is much lower.

Now we have Peteyperson’s contribution: he has introduced TIPS planning into the day-to-day planning to create real-life portfolios. He has introduced the TIPS ladder, holding 10-year TIPS to maturity instead of treating TIPS as a trading vehicle. He has thought though a host of details including taxes and international availability. He does not treat his TIPS allocation in the mechanical fashion of our computer models. For example, he does not automatically rebalance his TIPS holdings. In real-life, you must consider availability and costs.

There are many details to work out in real-life as opposed to academic studies. I have been able to recover these paragraphs that Peteyperson wrote. “What one has to bear in mind is two things. Firstly one lost around 1.5% of real return due to selling underwater stock during past studies, even with bond diversification. The above 2.86% gordon equation result takes today's valuations, mean reverts them over three decades, but assumes no loss due to selling underwater from your starting FIRE position. This of course is not realistic as the studies do show. You lose something to having sell something every year for expenses. We can be smarter about allocations and avoid selling more often as I have indicated and more diversified portfolios work to that end, but you'll still lose something. Being very generous we could say we only lose 0.50% instead of 1.5% for selling underwater. This reduces the S&P 500 real return over next 30 years to 2.36% real. This also assumes me don't have any high inflation periods where companies struggle to obtain the 1.8% real growth - we skirt over that possibility too. Also ignores fees. So overly optimistic assumptions and real returns a sad 2.36% real (pre-tax)….”

“Just as an aside, TIPS over 30 years using 10-year TIPS and reinvesting get an estimated 4% real with little taxes and cuts out volatility due to holding to redemption. This is why I think this is attractive as one asset in a collection of assets. I would drawdown over 40 years to ensure they lasted the remainder of my lifetime, but given market levels TIPS/I-Bonds certainly have attractions on a returns-basis. Down the line we may again see value investments posting near or double-digit real returns but as things stand today we should pick assets in the distribution phase that give the best return for a given level of risk. On a risk-adjusted basis (whether you consider risk to be volatility or risk to capital), TIPS are very attractive held individually (not in a fund) and spent down.”

These are some powerful words.

Rob has made it clear that his discussion boards are a few months away. I am sure that he would allow me to post my research here if it made sense to do so. The problem is that it does not make sense. My research frequently includes detailed tables with numbers. Such tables are natural at a discussion board, but not in a typical setting. That may point me toward doing something different. I like the idea of using a newspaper model at a website. And Rob has a background in journalism.

I am unwilling to enter an environment that allows the mindless flame wars that took away the fun and honor that ES deserves. In this sense, I differ from Rob and ES. They want to build up a community. I want to keep the rabble out.

Request for ideas

Peteyperson’s Idea about Withdrawals and Should We Rebalance Portfolios?
Peteyperson’s Idea about Withdrawals.

A TIPS Ladder Example

This example should help you take advantage of a TIPS Ladder in your retirement planning.
A TIPS Ladder Example

From the NFB TIPS Ladder Thread

I posted A TIPS Ladder Example at the FIRE board at the NoFeeBoards web site. I had looked at a 40-year retirement in my example. Here I examine 50 years.
From the NFB TIPS Ladder Thread

Using a TIPS Ladder

A TIPS Ladder gives us wonderful flexibility. Now, how do we use it?
Using a TIPS Ladder

A TIPS Ladder Survey

I built a series of calculators to learn about TIPS Ladders. This is what I learned.
A TIPS Ladder Survey

UPDATE

I have extracted this from my TIPS Ladder Survey:

We need to change our statement about what kills retirement portfolios. It is selling stocks at depressed prices during the short-run that kills retirement portfolios.

Over longer periods of time, you are better off adjusting your allocations in accordance with the intrinsic value of your holdings. In our investigations into switching stock allocations, we found that P/E10 is the best among several good indicators of intrinsic value over the intermediate-term.

In this case, you should add to your stock holdings when P/E10 is low and/or dividend yields are high. You should reduce your stock holdings when P/E10 is high and/or dividend yields are low.

But you should look for good prices when you make your shorter-term changes. Allow yourself two or three years to get a reasonable stock price. Stay away from panic selling. Wait for prices to recover to a reasonable level, but possibly substantially lower than when you started.

What you are trying to do in the short-term is to get something close to an average stock price (when measured over one or two years). You are not demanding a good price. You are only avoiding a bad price. By waiting a year or two, if necessary, you are taking advantage of volatility in the market. You are waiting for prices to recover somewhat.

Your are not demanding that they recover completely.

TIPS Ladders and Safe Withdrawal Rates

Today’s Safe Withdrawal Rate would be 4.4% if we could buy TIPS with a 2% interest rate. The Calculated Rate would be 5.12%. Today’s actual rates are lower, around 1.6% (ten-year TIPS) to 1.8% (20-year TIPS).
Safe Withdrawal Rates with Switching

We should come close to getting today’s full potential Safe Withdrawal Rate (which would be slightly less than 4.4%) by building a TIPS Ladder with an intermediate maturity.

We should be able to increase our Safe Withdrawal Rate (by an unknown amount) by taking advantage of Peteyperson's idea to coast through shorter periods (lasting up to 3 or 4 years).

Traditional bond ladders with intermediate lengths never lost money (year-to-year without adjusting for inflation) during the last century. They did exceptionally well. They captured almost all of the (average) gains of longer ladders.

Ed Easterling of Crestmont Research has posted several articles about bonds and traditional bond ladders at his web site. They are well worth reading.
Crestmont Research
Crestmont Research Interest Rates
Crestmont Research Bond Ladders

TIPS Ladders for Today

We can reach a 4.0% Safe Withdrawal Rate over 40 years at today's valuations and in today’s marketplace. We are likely to do better.
TIPS Ladders for Today

Switching Safe Withdrawal Rates with 1.8% TIPS

Today’s Safe Withdrawal Rate for Switching is 4.3% with TIPS with a 1.8% interest rate. The Calculated Rate would be 5.05%. The effect on TIPS ladders with Switching is minimal, as expected.
Switching Safe Withdrawal Rates with 1.8% TIPS

Switching Safe Withdrawal Rates with 1.0% TIPS

This continues looking at the sensitivity of today’s Safe Withdrawal Rate when we use a switching approach as we lower interest rates. Even if TIPS interest rates were to fall to 1.0%, you could withdraw 3.8% safely.
Switching Safe Withdrawal Rates with 1.0% TIPS

Have fun.

John Walter Russell