August 29, 2007 Letters to the Editor

Updated: September 24, 2007.

Preferred Stock

I received this letter from Jim.

Thanks for all the great ideas.

Wouldn’t preferred stock give a better, consistent dividend? Could I also ask why you do not talk about Bonds for a fixed consistent income?

HERE IS MY RESPONSE

Thanks. You have asked an excellent question.

Preferred stock and corporate bonds do very well as the high income portion of a dividend blend portfolio. They can do well on their own, provided that you are willing to reinvest a portion of your income to keep up with inflation.

Common stocks offer the advantage of growth. Their dividends CAN rise fast enough to keep up with inflation or even faster. However, there are no guarantees.

A dividend blend is the combination of a high yielding investment, which may be a preferred stock, and a stock with a rapidly growing dividend.

I went to Quantum Online to learn what is reasonable in the way of yields from preferred stocks. Registration is free.

Quantum Online

Several of JPMorgan Chase issues yield close to 6.7%. (JPM-W was 6.94%. JPM-P was 6.68%. JPM-S was 6.73%.)

First BanCorp Series E FBP-E yielded 7.63%. Freddie Mac FRE-H yielded 6.02%. Ford Motor Company F-S yielded 9.14%.

I brought up my Expanded Allocator. You can download it for free from my Yahoo Briefcase.

Yahoo Briefcase

Using today’s TIPS interest rate of 2.4%, 3% inflation and a constant preferred stock yield of 6.7%:

You could withdraw 4.0% of the original balance (plus inflation) for more than 50 years.
You could withdraw 4.5% of the original balance (plus inflation) for 35 years.
You could withdraw 5.0% of the original balance (plus inflation) for 24 years.

This assumes that you reinvest all excess income into TIPS, eventually drawing money out of TIPS. (This reflects a limitation of the Income Allocator. Most likely, you could do better by reinvesting in more preferred stock.)

Consider what happens when you include a high quality dividend grower. Johnson & Johnson JNJ has a current dividend yield of 2.7%. It has long history of rapid dividend growth, faster than a 10% per year increase in the dividend amount.

I combined a fast dividend grower with the preferred stock. The dividend grower had initial dividend yield of 2.7% and a 10% per year dividend growth rate. The high yielding preferred stock had an initial yield of 6.7%. Its payments remained constant.

With a 50%-50% allocation, the combination allowed you to withdraw 4.6% of the original balance (plus inflation) indefinitely.

With a 30%-70% allocation favoring the high yielding preferred stock, the combination allows you to withdraw 5.1% of the original balance (plus inflation) indefinitely.

NOTE: The TIPS interest rate is not overly important. At a TIPS interest rate of 2.0%, the 30%-70% allocation also allows you to withdraw a fraction less, but still more than 5.1% of the original balance (plus inflation) indefinitely.

Notice how well these results compare to the traditional studies. They restricted the withdrawal rate to 4.0% of the original balance (plus inflation) in order to survive for 30 years. Preferred stocks by themselves do better than that.

John, I am perplexed what to do

I received this letter from Sonja.

I am 65 yrs old, and have never been exposed to the stock market. I have invested instead in real estate, and I am now in the process of liquidating what I own (at bargain prices) in order to set up some sort of Trust fund for my son, who has special needs. I have cancer, and may not make it, so I am very worried about providing for my son.

I just don't know how to approach setting up a portfolio, as current evaluations are too high, and I know it would be foolish for me to just "buy in" at current PE's, and yet I need to set up an "income" stream for him. I wanted to split it between dividend stocks and other income vehicles, like preferreds, reits, bonds etc.

When I finish selling off my rentals, I should have in the neighborhood of around $1,600,000. I have no 401 K's and only a small Ira. How can I achieve this "initial portfolio" for him that makes sense? Most financial planners want to ignore the current evaluations, and just divide it up in the usual asset allocation classes. Any help would be much appreciated.

HERE IS MY RESPONSE

Thank you for your letter. May God bless you.

Understand that I am not a financial advisor. I do not have the relevant professional credentials. Take my comments as suggestions from a friend.

You should be able to generate a substantial, continuing income stream that grows faster than inflation, even today. The biggest issue is that everything must work on automatic.

You will need a trust structure, administered by someone whose faithfulness and judgment you respect. This would not necessarily be a professional.

I think that you want to set up a modified bond ladder that dollar cost averages slowly into stocks and/or other income vehicles. To keep portfolio management expenses low, I recommend using dividend focused Exchange Traded Funds ETFs for your stock purchases. Be careful to select ETFs that focus on income from quality companies. Avoid the fancier, new products that use dividends in ways suitable only for the most sophisticated investors. Insist on quality, not yield alone.

Currently, DVY, the oldest dividend ETF is yielding 3.4%. It limits its holdings to quality companies. I use this as an example as to what is available, not necessarily as a recommendation. But it would be a good choice.

Consider allocating up to 20% each in dividend ETFs that yield 3% (or more), 4% (or more), 5% (or more), 6% (or more) and 7% (or more) at time of purchase. Even today, you could start out with an initial allocation of 20% and, over time, expect the dividend amount to grow faster than inflation. Any amount not meeting these criteria would be returned to the bond ladder. As a rule, never sell any stock routinely. Allow occasional sales to improve quality or to handle emergencies.

We can expect common stocks to become highly attractive within the next ten or fifteen years, but we do not know when. We do not know how far prices will fall. Since you must put everything on automatic, I suggest a bond ladder spread out over ten to fifteen years. As the bonds on the ladder mature, reinvest into dividend ETFs and/or other income products IF their yields are sufficient. IF NOT, extend the ladder.

I like including preferred stocks and REITS. If your administrator can find suitable choices, I would certainly include them. I would include some today to boost income in the early years. Bonds and preferred stocks never increase their income streams. REITS can. In this respect, REITS behave similarly to stocks, but with a different type of balance sheet.

Start out withdrawing 5% ($80000) of the initial balance (plus any inflation) annually. Return any excess income to your investments for five years. Adjust your withdrawal amounts every five years, as needed.

Dividend Growth and Bond Ladders
Dividend Growth and Bond Ladders Addendum

The Great Mistake

I received this letter from Rob Bennett.

I like the way your article "The Great Mistake" gets to the essence of things. I like the frankness of the language used too. That is much needed.

You say: "The 4% (plus inflation) safe withdrawal rate was a horrible mistake. It leads retirees to make bad investment decisions." That's so.

There's another side to the story too, though. I also agree with William Bernstein that the Old School SWR studies were "breakthrough research." The studies were a big step forward because they used an objective source of insights (the historical data) to help aspiring retirees form their investing strategies. If it hadn't been for The Great Mistake, we wouldn't have the wonderful material that you provide today at your web site. The Great Mistake ended up tarnishing this breakthrough when people became wedded to it and obstinate about acknowledging the analytical error.

The Old School SWR methodology was both a breakthrough and a Great Mistake, in my view. Both things are so.

Given how good a long-term investment choice stocks generally are, people have a hard time accepting how bad a long-term investment choice stocks become when we get to today's valuation levels. It is counter-intuitive to believe that the same investment choice could be so wonderful at so many times and so horrible at some other times. People have a hard time getting the "click" on this one, and an even harder time developing confidence in that click after they achieve it.

It is the job of the investing expert to explain why prices matter so much and to help people develop the confidence that what their confidence tells them about stock investing (that price matters when buying stocks, as it does when buying anything else) really is so. Our experts have let us down big time.

It takes us to a different topic to explore what we need to do to get a better class of experts in place. I see that topic as one that we need to explore in some depth in days to come.

As always, thanks so much for the wonderful work you do on behalf of the Retire Early community. Nobody does it better, it makes me feel sad for the rest.

HERE IS MY RESPONSE

Thank you for your kind words.

The early studies showed that something was needed. They identified the cause of the problem: selling too many shares in down markets leads to bankruptcy. Later, William Bernstein and others brought out the issue of the sequence of returns. It requires careful reading. But William Bernstein warned that the safe withdrawal rate at the peak of the bubble might have been as low as 2%.

William Bernstein and others have little passion. William Bernstein does not wish to retire. He has too much fun doing what he does.

True researchers extend their studies to deeper and deeper levels. Pride and laziness, combined with a lack of interest, has led some to abandon research, clinging to past glories. A vital area of research was frozen. Retirees suffered.

You were the one who asked about valuations. Your question makes so much sense that nothing short of an intense smear campaign could argue against it. Pride and foolishness has destroyed the early retirement discussion boards.

Our experts have really let us down. They were afraid to tell a story that nobody wanted to hear. Because they turned away from the problem, they missed out on the solution.

An income approach is simple, straightforward and timely. If the experts had been interested, they would have found it long ago. In fact, they would have found many attractive alternatives to the 4% safe withdrawal rate and total return strategies.

Letters to the Editor in 2007

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