Today’s Alternatives

In February, I spoke of the Many Alternatives available to a retiree. Now he has even more.

Many Alternatives

The Traditional Approach

Traditional safe withdrawal rate studies focused on liquidation strategies. They sold shares as needed to maintain a steady income stream (in terms of buying power). Most studies used a portfolio lifetime of 30 years.

The traditional approach maintains a fixed stock-bond allocation through annual rebalancing. It assumes, incorrectly, that there is no meaningful way to take advantage of valuations. Rebalancing reduces volatility. Fixed allocations underperform during times of high valuations. Click on the Year 30 SWR and Year 15 SWR buttons on your left to reach Retirement Risk Evaluators. They show you the effect of valuations, stock allocation, TIPS interest rates and ending balances. They present a complete picture. The show not only what is safe, but also what is likely and what is almost certain to fail.

In today’s market (P/E=29), the Year 30 Safe Withdrawal Rate is 2.8% (plus inflation) with 80% stocks (S&P500) and 20% TIPS at 2% (real) interest. Today’s Year 30 Safe Withdrawal Rate is 3.5% (plus inflation) with 50% stocks and 50% TIPS at 2% interest.

TIPS

A TIPS-only portfolio makes a great baseline. It is surprisingly competitive. In recent times, TIPS have been available with (real) interest rates that vary between 2.0% and 2.5%.

A TIPS-only approach assumes only that TIPS will continue to be available. If you build a TIPS ladder, you avoid possible losses from selling before maturity.

You build a ladder over several years. You purchase TIPS of all maturities up to a maximum length, perhaps 10 years, possibly 20 years. Each year, as older TIPS mature, you remove any principal that you wish to withdraw and reinvest the rest at the longest maturity of the ladder. This way, you almost always get the best interest rate available. [The exception is when there is an inverted yield curve.]

The TIPS Table button on the left fills in the details.

With 2% TIPS, you can withdraw 4.0% safely for 35 years before running out of money. You can withdraw 4.46% for 30 years before running out of money.

Switching

Switching is a liquidation strategy that varies stock allocations in accordance with stock valuations. It increases income dramatically. Satisfactory measures of valuation include P/E10, P/D10 and Tobin’s q.

NOTE: You can use the Stock Return Predictor to convert P/E10 into current S&P500 prices.

The Retirement Risk Evaluators include optimized switching programs. (Click on the Year 30 SWR and Year 15 SWR buttons on your left to reach the Retirement Risk Evaluators.) Switching Option A has a minimum stock allocation of 20% and a maximum allocation of 80%. Its current Year 30 Safe Withdrawal Rate (P/E10=29) is 4.1%. Switching Option B has a stock allocation that can vary from 0% to 100%. Its current Year 30 Safe Withdrawal Rate is 4.2%.

Dividends

With a dividend based strategy, you never sell any shares. You live off stock dividends and any interest that you are receiving from other investments.

Dividend based strategies deliver a continuing income stream that (almost always) grows faster than inflation. There are now high quality, dividend focused Exchange Traded Funds (ETF) that yield 3.0%. There are high quality companies that pay dividends exceeding 4.0%.

The key is to purchase individual stocks slowly, applying price discipline at all times. At any instant, expect to find only a handful of stocks that pay outstanding dividends. Over the course of a few years, there will be dozens, as prices dip momentarily.

With care, expect to receive a continuing withdrawal rate in excess of 4.0%.

Dividend Blend

A dividend growth strategy starts at a lower initial withdrawal rate, but it grows much faster than inflation. A high yield approach starts with a much higher yield, but which grows slowly, if at all, possibly falling behind inflation. A blended dividend strategy combines these two and adds a cash equivalent account (such as TIPS, CDs or money market funds) on the side to steady the income stream (after adjusting for inflation).

It is easy to identify the initial dividend yield of a stock or an Exchange Traded Fund (ETF). It can be difficult to estimate the dividend growth rate accurately.

I use Josh Peter’s investment goals in the Morningstar Dividend Investor to identify what is reasonable to expect. Using the low end of his (nominal) dividend growth rate requirements, such a blend produces a continuing withdrawal rate of 5.5%.

Finding a suitable high yield asset can be difficult. Typically, it requires a Master Limited Partnership, a REIT or another investment with unusual characteristics that includes the return of capital. But do not despair. I have found that even a fixed mortgage (6% interest, 20 or 30 years) can meet the need.

Before investing, I recommend that you read the Morningstar Dividend Investor newsletter and Ben Stein and Phil DeMuth’s book “Yes, You Can Be a Successful Income Investor!”

Delayed Purchase

A delayed purchase strategy starts with one approach, often TIPS-only, and switches to an alternative, often a dividend strategy, when valuations become favorable.

The combination of a delayed purchase and a regular dividend strategy lifts the continuing withdrawal rate to 5.4% (plus inflation). The combination of a delayed purchase with a Dividend Blend lifts the continuing withdrawal rate to 6.1% (plus inflation).

Building on Success

As a rule, I allow for a 10% probability that any analysis will fail, regardless of how well done. I recommend limiting withdrawals to 5.0% (plus inflation) during the first five years to protect against being blindsided. Valuations are likely to be much better by that time, allowing an initial purchase of shares at reasonable valuations with good dividend yields.

Have fun.

John Walter Russell
April 28, 2007