Expanded Allocator Insights E

I continue to investigate the effect of inflation.

Conditions

I took the optimal condition from Taken At Face Value. Here is a summary:

Investment A: 3.5% initial yield with an 8% per year nominal growth rate.
Investment B: 6.1% initial yield with a 2% per year nominal growth rate.
TIPS: 2% real interest rate.
Inflation: 3% per year.
Initial allocation: 15% Investment A, 85% Investment B, 0% TIPS.
Withdrawal rate: 5.590% plus inflation.

This time, I looked at the full range of dividend growth rates. Investment A has a range of 8% to 10% per year nominal growth. Investment B has a range of 2% to 4% per year nominal growth.

The higher growth rates can compensate for inflation, at least, in part.

Choosing an Inflation Rate

Here are January CPI values for the past half century plus. I have taken them from Professor Shiller’s database.

1950 23.5
1955 26.7
1960 29.3
1965 31.2
1970 37.8
1975 52.1
1980 77.8
1985 105.5
1990 127.4
1995 150.3
2000 168.8
2005 190.7

Here are the annualized inflation rates by decade.

Year 10-Year inflation rates
1950 start
1960 2.23%
1970 2.58%
1980 7.48%
1990 5.06%
2000 2.85%

I decided to use 5.0% as my high inflation rate.

The reason is that I prefer not to go outside the range of the Morningstar Dividend Investor newsletter. For purposes of analysis, I have used the current yields of its existing portfolios as they are. The highest yielding investment (Investment B) has an initial yield of 6.1%.

If inflation were as high as 6%, I would need to model a higher initial yield. I am confident that, if the inflation rate were as high as 6%, there would be many investments yielding more than 6.1%.

Results

Investment A: 3.5% initial yield with an 8% per year nominal growth rate.
Investment B: 6.1% initial yield with a 2% per year nominal growth rate.
TIPS: 2% real interest rate.
Inflation: 5% per year.
Initial allocation: 15% investment A, 85% investment B and 0% TIPS.
Withdrawal rate: 4.110% plus inflation.

Investment A: 3.5% initial yield with a 10% per year nominal growth rate.
Investment B: 6.1% initial yield with a 2% per year nominal growth rate.
TIPS: 2% real interest rate.
Inflation: 5% per year.
Initial allocation: 15% investment A, 85% investment B and 0% TIPS.
Withdrawal rate: 4.665% plus inflation.

Investment A: 3.5% initial yield with an 8% per year nominal growth rate.
Investment B: 6.1% initial yield with a 4% per year nominal growth rate.
TIPS: 2% real interest rate.
Inflation: 5% per year.
Initial allocation: 15% investment A, 85% investment B and 0% TIPS.
Withdrawal rate: 5.310% plus inflation.

Investment A: 3.5% initial yield with a 10% per year nominal growth rate.
Investment B: 6.1% initial yield with a 4% per year nominal growth rate.
TIPS: 2% real interest rate.
Inflation: 5% per year.
Initial allocation: 15% investment A, 85% investment B and 0% TIPS.
Withdrawal rate: 5.590% plus inflation.

Observations

Simply going to the high end of the Morningstar Dividend Investor newsletter’s growth rate goals is enough to compensate for an increase in inflation from 3% to 5%.

NOTE: I use the Morningstar Dividend Investor newsletter as a guide as to what is reasonable.

The big payoff was from improving the growth rate of the higher yielding investment.

Even if both Investments A and B do no better than meet the lower end of their growth ranges, the continuing withdrawal rate exceeds 4.1%.

Using the original growth rates, the continuing withdrawal rate falls from 5.590% plus inflation to 4.110% plus inflation. This is a reduction to 74% of the original withdrawal rate. It is very close to the worst case reduction of the S&P500’s real dividend (in the post 1950 period).

Keep in mind that these are growth rates of the NOMINAL dividend amount. I would expect nominal dividends to grow faster in the presence of inflation.

The fact that this approach simply manages the income stream is highly significant. There is never the possibility of running out of money. Outside of the TIPS account, there are no purchases. There are no sales. Failure is gentle, simply falling behind inflation. The loss of buying power—down to 74%--hurts, but not nearly so much as running out of money.

Have fun.

John Walter Russell
April 26, 2007