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An analysis of a TIPS dominated retirement income strategy
Old 01-30-2014, 09:44 PM   #1
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An analysis of a TIPS dominated retirement income strategy

A lot of you read Wade Pfau's blog, so you've probably seen this.

Wade Pfau's Retirement Researcher Blog: Guest Post: A Recent Retiree Considers Safety-First Retirements

The author funds 25 years through a TIPS ladder (using 78% of their portfolio - all in T-IRA) and places the rest of his portfolio (ROTH) into an equity fund (15%). He then answers some very good question that his fee-only FA posed.

Interesting reading even if that's not your plan.
Enjoy!
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Old 01-30-2014, 10:22 PM   #2
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Quote:
Originally Posted by walkinwood View Post
A lot of you read Wade Pfau's blog, so you've probably seen this.

Wade Pfau's Retirement Researcher Blog: Guest Post: A Recent Retiree Considers Safety-First Retirements

The author funds 25 years through a TIPS ladder (using 78% of their portfolio - all in T-IRA) and places the rest of his portfolio (ROTH) into an equity fund (15%). He then answers some very good question that his fee-only FA posed.

Interesting reading even if that's not your plan.
Enjoy!
Sounds good, all it takes is a lot of money, LTC covered, pensions, SS, Roth IRA, Gold, cash, no kids, no big bills. Actually, it's pretty easy if you are already on "easy street".
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Old 01-30-2014, 10:54 PM   #3
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Our retirement plan is simple - we just try for 1% real return overall in which TIPS will play a large part.

We don't want to trade job stress for investment stress in our retirement. We're okay with not making a killing in the stock market. We'd rather just not lose what we worked to hard to accumulate over a life time. Instead of trying to make more from investments we focus more on how to live well but with low expenses. We can control our expenses but not the stock market.
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Old 01-31-2014, 03:02 AM   #4
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As a conservative fixed income approach. I certainly like it better than just buying bonds or CDs. I think he has it well thought out.

I think it works better for a 70 year old than a 60 year old, and it could be down right concerning for 50 year due to reinvestment risk.

Consider my case. In 2000 after retiring I was looking at something more conservative than equities and small amount of muni bonds. At the time TIPs bonds had real yields between 3.5% and my best was 3.93%. Unfortunately either the government was not selling 30 year TIPs time or Schwab didn't have in inventory. So I had to make due with 10 years, TIPs I bought 2008,2009, and 2010 TIPs.

Fast forward to 2010 and find that instead of getting 3.5% real return I'd barely be getting 1%. That would be huge drop in income if I retire assuming 3% but only get 1% years down the road. Now in his case his bond ladder runs out at 85, plus rates can't go much lower,plus he in theory has other assets. So I expect he'll be fine.

But if TIPs rate go back up to 3%, adopting the same strategy at say 50 is setting your self up for running out of money in your 80s.
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Old 01-31-2014, 09:36 AM   #5
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The challenge with building a TIPS ladder is in the execution. TIPS are in demand. If you look at the Treasury list of TIP auction results, you find that the actual interest they are paying is close to zero. So, to build the ladder you will have to go on the secondary market to buy the bonds. I believe that if you call someone's bond desk and get quotes, you will find that the returns they quote will in many cases be negative.

I was fortunate enough to buy one 30 year TIP in 2002 with a coupon of 3 3/8. As the shorter term TIPS I bought at the same time have matured, I have replaced them with TIPS that basically pay nothing except for the inflation adjustment.

I don't like negative returns.
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Old 01-31-2014, 10:01 AM   #6
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Originally Posted by daylatedollarshort View Post
Our retirement plan is simple - we just try for 1% real return overall in which TIPS will play a large part.
Have you elaborated on your approach in another thread? I'd like to read it if you have.

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As a conservative fixed income approach. I certainly like it better than just buying bonds or CDs. I think he has it well thought out.

I think it works better for a 70 year old than a 60 year old, and it could be down right concerning for 50 year due to reinvestment risk.
That's my feeling too - being in my early 50s. But it is an approach I would consider later in life.
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Old 01-31-2014, 11:16 AM   #7
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Have you elaborated on your approach in another thread? I'd like to read it if you have.
Thirty year TIPS have been, on average yielding ~1.5% real plus inflation this past year and we have based our retirement plan on an average 1% real long term, 0% real for the next few years. I just use a spreadsheet instead of Firecalc, and validate my spreadsheet numbers against the most conservative portfolio in the Fidelity RIP.
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Old 01-31-2014, 11:35 AM   #8
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As a conservative fixed income approach. I certainly like it better than just buying bonds or CDs. I think he has it well thought out.

I think it works better for a 70 year old than a 60 year old, and it could be down right concerning for 50 year due to reinvestment risk.

Consider my case. In 2000 after retiring I was looking at something more conservative than equities and small amount of muni bonds. At the time TIPs bonds had real yields between 3.5% and my best was 3.93%. Unfortunately either the government was not selling 30 year TIPs time or Schwab didn't have in inventory. So I had to make due with 10 years, TIPs I bought 2008,2009, and 2010 TIPs.

Fast forward to 2010 and find that instead of getting 3.5% real return I'd barely be getting 1%. That would be huge drop in income if I retire assuming 3% but only get 1% years down the road. Now in his case his bond ladder runs out at 85, plus rates can't go much lower,plus he in theory has other assets. So I expect he'll be fine.

But if TIPs rate go back up to 3%, adopting the same strategy at say 50 is setting your self up for running out of money in your 80s.
You are thinking like an income investor. In this case though, as I understand it, there is no reinvestment risk because he is consuming the TIPS as they mature. Eventually, he'll run out of TIPS and will rely on pensions, and SS, and his small equity stake to pay the bills.
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Old 01-31-2014, 01:19 PM   #9
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You are thinking like an income investor. In this case though, as I understand it, there is no reinvestment risk because he is consuming the TIPS as they mature. Eventually, he'll run out of TIPS and will rely on pensions, and SS, and his small equity stake to pay the bills.

I understand he is consuming the principal of the TIPs each year. I am little confused what happens after 25 when the 60 year person turns 85. I guess they have sufficient equities and income they probably should be alright. Although 85 is the exact age that folks often need expensive nursing home care. Their LTC care insurance will pay for that.
So it is reasonable strategy for a normal retirement (other than large savings/ low spending needed to carry it out).

In the case of early say 50 year old retirement. There is a significant implementation problem they don't sell 40 or 50 year TIPs note so you do run into reinvestment risk. It is worth noting that 50 year old had 14% change of living to 100 (recent estimate for the UK)
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Old 01-31-2014, 01:33 PM   #10
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I understand he is consuming the principal of the TIPs each year. I am little confused what happens after 25 when the 60 year person turns 85. I guess they have sufficient equities and income they probably should be alright. Although 85 is the exact age that folks often need expensive nursing home care. Their LTC care insurance will pay for that.
So it is reasonable strategy for a normal retirement (other than large savings/ low spending needed to carry it out).

In the case of early say 50 year old retirement. There is a significant implementation problem they don't sell 40 or 50 year TIPs note so you do run into reinvestment risk. It is worth noting that 50 year old had 14% change of living to 100 (recent estimate for the UK)
Most reading I've done on LTC policies is that there is a front end period that you pay for and then the policy usually pays X$/day for only a few years. I think this is why folks tend to self insure rather than pay premiums for many years.
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Old 01-31-2014, 01:37 PM   #11
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I think it could work for a 50-year old if other sources of income come online later on, as seems to be the case here:

Quote:
Our strategy is to feel safe for the next 20-25 years with our TIPs ladder, then beyond that rely on wife's pension, husband's social security and wife's annuity income (most but not all inflation indexed), plus whatever the Roth has grown to in 25 years.
For a 50-year old with no pension and minimal SS, then I agree, this strategy has reinvestment risks.
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Old 01-31-2014, 01:51 PM   #12
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TIPS provide real return only if one doesn't factor inflation. If nominal return reaches 4% and one has a marginal tax rate of 25%, the real return is 0.

Quote:
Advisor Caution #6:
If we’re not careful we could be paying taxes on inflation adjusted principal on TIPs annually even though our principal isn't received until maturity.

My Response:

Yes, we need to make sure that we keep the TIPS in the IRA account where this is not a problem. The TIPS "shadow income" problem only applies to TIPS being held in taxable accounts.
Not so. Only holdings in a ROTH account are not impacted by taxes. Regular IRAs are subject to taxes when the funds are withdrawn. In a high inflation scenario an all TIPS strategy in a tIRA or taxable account would leave the retiree short of funds.
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Old 01-31-2014, 02:00 PM   #13
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TIPS provide real return only if one doesn't factor inflation. If nominal return reaches 4% and one has a marginal tax rate of 25%, the real return is 0.

Not so. Only holdings in a ROTH account are not impacted by taxes. Regular IRAs are subject to taxes when the funds are withdrawn. In a high inflation scenario an all TIPS strategy in a tIRA or taxable account would leave the retiree short of funds.

I wondered about that also. But to be fair that is true for any investment in a IRA not just TIPs. If stocks return 10% nominal a year, and inflation rises to 6%. You'll pay 2.5% on taxes for IRA withdrawals leaving you with an only 1.5% real return.

My guess is that he has figured out his tax liability. Something that I haven't done.
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Old 01-31-2014, 02:09 PM   #14
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TIPS provide real return only if one doesn't factor inflation. If nominal return reaches 4% and one has a marginal tax rate of 25%, the real return is 0.

Not so. Only holdings in a ROTH account are not impacted by taxes. Regular IRAs are subject to taxes when the funds are withdrawn. In a high inflation scenario an all TIPS strategy in a tIRA or taxable account would leave the retiree short of funds.
I think it depends if he has included his tax liability in the TIPS ladder (which he should have since he seems to have little liquidity outside of the ladder to pay the taxes).
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Old 01-31-2014, 02:23 PM   #15
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I think they were only talking about the tax liability on the TIPS inflation adjustments being incurred without a simultaneous income bump to pay for it. Not the normal taxes on the income. Located in the IRA, there is no tax liability for anything but the income you take.
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Old 01-31-2014, 02:50 PM   #16
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I think it depends if he has included his tax liability in the TIPS ladder (which he should have since he seems to have little liquidity outside of the ladder to pay the taxes).

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I wondered about that also. But to be fair that is true for any investment in a IRA not just TIPs. If stocks return 10% nominal a year, and inflation rises to 6%. You'll pay 2.5% on taxes for IRA withdrawals leaving you with an only 1.5% real return.

My guess is that he has figured out his tax liability. Something that I haven't done.
Not saying this is a bad strategy, but it is being presented as safe. That safety depends in part on the ratio of real return to total return staying above his marginal tax rate. Once the real return % falls below the tax rate, real purchasing power declines. This can happen if either tax rates or inflation increase. I'm not betting that both of these happen, but I also wouldn't bet against them both.

The problem is not because the investment is in the IRA, it is because a commitment to 25 years of budget needs is being made to a single asset class, and there is little room to maneuver if things don't work out as expected.
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Old 01-31-2014, 03:25 PM   #17
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The problem is not because the investment is in the IRA, it is because a commitment to 25 years of budget needs is being made to a single asset class, and there is little room to maneuver if things don't work out as expected.

I agree it is an interesting trade off on safety..

In return for a very stable income for 25 year. He is taking on some other risk changes in tax policy and inflation as you mention. But the big one is just not having a lot of maneuver room and giving up the margin of safety that a more traditional plan generally has.

I'd also argue that is significantly more exposure to longevity risk than a traditional 60/40 AA.
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Old 01-31-2014, 06:56 PM   #18
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I agree it is an interesting trade off on safety..

In return for a very stable income for 25 year. He is taking on some other risk changes in tax policy and inflation as you mention. But the big one is just not having a lot of maneuver room and giving up the margin of safety that a more traditional plan generally has.

I'd also argue that is significantly more exposure to longevity risk than a traditional 60/40 AA.
Aren't you open to sequence of returns risk with a traditional 60/40 strategy?

“This is sequence of returns risk,” wrote Pfau. “People are more vulnerable to the returns experienced when their portfolios are larger because a given percentage change has a bigger impact on absolute wealth. A big portfolio drop at the end could possibly wipe out all of the portfolio gains from the first 25 years of one’s career.”

How to avoid sequence-of-return risk - Robert Powell's Retirement Portfolio - MarketWatch

William Bernstein now seems to recommends a similar strategy to the article in the original link -

"You want to end up with a portfolio that matches your liabilities, meaning the amount you'll need to spend in retirement. The rule of thumb I came up with, based on annuity payouts and spending patterns late in life, is that you should save 20 to 25 times your residual living expenses -- that is, the yearly shortfall you have to make up after Social Security and any pension.

This portfolio should be in safe assets: Treasury Inflation-Protected Securities, annuities, or even short-term bonds.

Anything above that, you can invest in risky assets. That's your risk portfolio. If you dream about taking an around-the-world trip, and the risk portfolio does well, you can use it for that. If the risk portfolio doesn't do well, at least you're not pushing a shopping cart under an overpass."


The worst retirement investing mistake - Sep. 4, 2012
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Old 02-01-2014, 01:43 AM   #19
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DLDS, I don't disagree with your points.
But what I'd said was this.

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I'd also argue that is significantly more exposure to longevity risk than a traditional 60/40 AA.
emphasis added.

I think for a 25 or even 30 years this strategy is less risky than a traditional 60/40 portfolio. He has done what Bernstein advocates. (Something that I personally haven't figured out how to fund my "minimum" lifestyle with safe assets yet.).

If you are 70, the odds that you live to 95 AND something really bad happens to your ROTH IRA so that you run out of money in your remaining years are very small. Their biggest risk medical expense is largely taken care by their LTC insurance. At 60 which is riskier is getting a bad sequence of events in your 60/40 portfolio or living more than 30 year? I am not sure.

At 50 I am positive that longevity risk is bigger than a bad sequence of returns.

To put it more simply. If we define longevity risk as having a retirement last more than 30 years, it is a percent or two for a 70 year and about 50% for 50 year old.

For a class of a regular retirees, I like his strategy; for early retirees not very much.
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Old 02-01-2014, 04:27 AM   #20
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... If you are 70, the odds that you live to 95 AND something really bad happens to your ROTH IRA so that you run out of money in your remaining years are very small. Their biggest risk medical expense is largely taken care by their LTC insurance. At 60 which is riskier is getting a bad sequence of events in your 60/40 portfolio or living more than 30 year? I am not sure.
...
I don't understand how you can count on LTC when you have no control of the increases in the premiums.
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