NFB TIPS Ladder Thread

I posted A TIPS Ladder Example at the FIRE board at the NoFeeBoards web site. Here is a link to the thread.

NFB TIPS Ladder Thread

I looked at a 40-year retirement in my example. I was asked about a 50 years.

This is my response.

I use real returns and real rates in the following. That is, all of my numbers are what remains after adjusting for inflation.

Just going through the motions mechanically, this is what I find.

1) The 50-year withdrawal rates are 2.55% when the interest rate is 1.0%, 2.86% when the interest rate is 1.5% and 3.18% when the interest rate is 2.0%. Drawing down principal over 50 years accounts for 2.0% in these withdrawal rates.
2) Next, we replace the original 3.34% rate from TIPS (for 40 years of withdrawals with 1.5% TIPS) with 2.86% (for 50 years of withdrawals with 1.5% TIPS).
3) When the TIPS allocation is 20%, TIPS now provide withdrawals of 0.20*2.86% = 0.572% times your portfolio’s initial balance. Previously, TIPS were providing 0.20*(3.34%) = 0.668% of your portfolio’s initial balance.
4) This leaves a deficit of 4.000% - 0.572% = 3.428% that needs to come out of stocks.
5) Since your stock allocation is 80%, stocks must return 3.428% / 0.80 = 4.285%.
6) Your investment return must meet this requirement. Assuming that the earnings growth is 1.5% to 2.0% (as has been the case historically), your stocks must produce a dividend yields of 2.285% to 2.785%. This is doable.
7) In times of stress, the principal from your 10-year TIPS Ladder will provide 2% of your portfolio’s initial balance (plus inflation). Stock dividends must provide the remaining 2%.
8) I will assume that your stock dividends have kept up with inflation. (Typically, you can do better, but not always from one year to the next.) Your stocks are 80% of your portfolio and they must throw off 2% of your portfolio’s initial balance during times of stress. Your stock dividends must equal or exceed 2.0% / 0.80 = 2.5%.
9) Your dividend yield must be between 2.285% and 2.785% to meet the requirement to match the investment return. Your dividend yield needs to be 2.50% or more for your withdrawals to equal 4% of your initial portfolio’s balance (plus inflation). Actually, it can be a little bit less since you also receive interest income from your TIPS Ladder.

Continuing, looking at a 40% stock allocation, this is what else I find.

1) With a 40% TIPS allocation, a 50 year lifetime and a 1.5% interest rate, TIPS will be providing of 0.40*2.86% = 1.144% times your portfolio’s initial balance.
2) You must get the remaining 4.000% - 1.144% = 2.856% from your stock holdings.
3) Since your stock allocation is 60%, your stocks must return 2.856% / 0.6 = 4.76%.
4) For your stocks to have an investment return of 4.76%, they must have a dividend yield between 2.76% and 3.26% provided that earnings continue to grow between 1.5% and 2.0%.
5) These numbers are still doable even with today’s low yields. You must select stocks with higher than average dividend yields. Fortunately, you can still buy quality stocks at these yields.

Now lets pay a little more attention to cause-and-effect and understanding what is going on and away from the numbers themselves.

The reason for the TIPS Ladder is to weather long periods of declining stock prices. If your portfolio can make it to year 40, it is highly likely that your stock portfolio has become very large. In fact, it is highly likely that you will have been able to increase your withdrawal amount safely. There should be some excellent stock buying opportunities in the next 50 years. After all, the long-term (real, annualized) return of stocks has been 6% to 7%, which is much higher than the 4% to 5% returns that we are seeking.

Behind this assertion is my early observation that portfolio failures can usually be spotted within the first 11 years of retirement. Either the portfolio will have grown enough to be completely safe by that time or it is likely to be in trouble. Historically, we have found that very few cases remain uncertain by year 11.

This leads me to believe that, if you can reach 40 years safely while withdrawing 4% of your portfolio’s initial value (plus inflation), your can reach 50 years as well. The difference is when you can comfortably increase your withdrawals above 4% (plus inflation).

Let me add a couple more factors. If you really believe that holding stocks right now is hazardous because of valuations and if you are right, you are better off to reduce your stock allocation and wait until valuations improve. This is where my analysis of switching (i.e., varying stock allocations according to P/E10) comes in. Alternatively, you might prefer to adopt a dividend-based strategy since it reduces your need to sell shares.

We do not know exactly what will happen. History helps us make preparations.

Have fun.

John Russell
I wrote this on 4-29-05.