Bill Sharpe Plan

[Jacey]

Has anyone heard about or tried the Bill Sharpe Plan that says the 4% rule doesn't work? He recommneds purchasing zero coupon risk free bonds to give consistent returns rather than trying to ride the ups and downs of the market. The article is 24 pages long and a bit complicated for my small brain cells. Here is the link:

http://www.stanford.edu/~wfsharpe/retecon/4percent.pdf

 

[Gone4Good]

I guess by "zero risk" he conveniently assumes an inflation rate of zero . . . which is pretty much the most you could financially handle if you want to retire on current treasury yields.

 

[HFWR]

Sounds alarmingly like the Rob Bennett plan...

 

[ziggy29]

"Zero coupon" and "risk free" are two phrases that should not be used in the same sentence, at least according to what I know. Zero coupon bonds are the MOST risky bonds in terms of interest rate risk because they don't have regular income to cushion the price fluctuations.

 

[FIRE'd@51]

I skimmed the article, but I think the essence of Sharpe's argument can be illustrated as follows:

Suppose you retired with $1 million and wanted an inflation-adjusted 40K per year, i.e. a 4% SWR. A 30-year interest-only TIPS (a TIPS with the maturity payment stripped off), would generate a SWR of 4.46% at a 2% real YTM. Thus you would purchase this interest-only TIPS with 897K (1 million x (40/44.6)) to provide the 40K for 30 years, and invest the remaining 103K in a "risky" stock-bond portolio. From 1925-2008, the real return on the S&P 500 has been 6.4%. If the 103K were invested 100% in stocks for 30 years at 6.4%, it would have an expected residual vale of 103 x (1.064)^30, or 662K. This would be your fund to "fight off" longevity risk (or leave to heirs), and it would be pretty substantial, since at 40K per year, it would last another 16 years even if earning a 0% return.

I think Sharpe is saying that this would be a more efficient way of generating the required inflation-adjusted expense stream, as the failure rate (for 30 years) would be 0%. Because the 103K piece would be immune from withdrawals, it would be very likely to earn close to the average expected return (6.4%).

 

[ziggy29]

Ah. Stripped TIPS held to maturity. That does make a little more sense.

 

[TromboneAl]

If I can go back to April 2008 and get on the plan then, sign me up.

Can someone explain this:

A retiree using a 4% rule faces spending shortfalls when risky investments underperform, may accumulate wasted surpluses when they outperform,
​

1. "Spending Shortfall" does he mean you spend less in down years? That's now how the standard 4% system works.

2. "Wasted surplus" If I have more money than I need, why is it wasted?

 

[FIRE'd@51]

Can someone explain this:

A retiree using a 4% rule faces spending shortfalls when risky investments underperform, may accumulate wasted surpluses when they outperform,
​

1. "Spending Shortfall" does he mean you spend less in down years? That's now how the standard 4% system works.

2. "Wasted surplus" If I have more money than I need, why is it wasted?

The standard 4% system (which according to Firecalc has a 5% chance of failure) says you spend the same inflation-adjusted amount every year. You don't cut back.

The "spending shortfall" occurs, when it appears (or actually occurs) that you are going to run out of money. If you cut back when risky assets underperform you may be making unneccesary cutbacks (your path may still be among the 95%). This results in a "wasted surplus" (the future value of the unneeded spending cuts). That's the way I interpret it.

Sharpe's method is to lock in the 4% SWR for 30 years using stripped TIPS, and rely on the risky investments to generate surpluses.

 

[haha]

The standard 4% system (which according to Firecalc has a 5% chance of failure) says you spend the same inflation-adjusted amount every year. You don't cut back.

The "spending shortfall" occurs, when it appears (or actually occurs) that you are going to run out of money. If you cut back when risky assets underperform you may be making unneccesary cutbacks (your path may still be among the 95%). This results in a "wasted surplus" (the future value of the unneeded spending cuts). That's the way I interpret it.

Sharpe's method is to lock in the 4% SWR for 30 years using stripped TIPS, and rely on the risky investments to generate surpluses.

Unless I missed something, you would probably want these coupons held in an IRA or Roth IRA?

It seems to me that there might be much to recommend this approach.

Do you know what kind of spreads or fees would be levied here?

Ha

 

[FIRE'd@51]

Unless I missed something, you would probably want these coupons held in an IRA or Roth IRA?

It seems to me that there might be much to recommend this approach.

Do you know what kind of spreads or fees would be levied here?

Ha

So far as I know, these stripped TIPS don't currently exist in the market place. However, all issued TIPS are eligible for stripping. It's just that, to the best of my knowledge, no broker-dealer has stripped them yet. Perhaps Sharpe's paper will generate interest in doing so.

Once they are stripped, I would guess that the "interest-only" piece could be held in a taxable account, since it would be only coupons. I would think the phantom interest tax would apply to the maturity payment (i.e. the thirty-year zero coupon principal repayment). After all, this is where the inflation adjustment takes place. Certainly those who bought this piece would probably want to hold it in an IRA, or some other tax-sheltered account

 

[Bimmerbill]

One of my finance instructors presented a plan to fund college for our kids by buying strips. I had forgotten about it until now, I'll have to look for his handout.

 

[Independent]

Has anyone heard about or tried the Bill Sharpe Plan that says the 4% rule doesn't work? He recommneds purchasing zero coupon risk free bonds to give consistent returns rather than trying to ride the ups and downs of the market. The article is 24 pages long and a bit complicated for my small brain cells. Here is the link:

http://www.stanford.edu/~wfsharpe/retecon/4percent.pdf

I think there is good stuff here, but also a lot missing.

The good is the simple comment that someone who wants to spend a risk-free constant real dollar amount shouldn’t assume that stocks are the best investment. Why would you start with something as volatile as stocks if you want a constant income? First, do the calculation with TIPS, then compare every other investment strategy to this result.

He also says that real people are probably willing to vary spending with market returns. If so, they need to factor that willingness explicitly into their plans. In the economists’ language, the 4% rule, taken literally, assumes a very unusual “utility function” – all dollars up to the 4% are equally valuable, all dollars above the 4% are “wasted”. Real people have smoother utility functions.

One of the “missing” pieces is that he acknowledges this problem, but doesn’t really address it. All of his analysis assumes the all or nothing rule. He suggests that somehow his analysis can generate numbers which would help someone make more realistic decisions, but he doesn’t give any examples of how that would be done.

The other “missing” piece is that he assumes you know you will die in exactly 30 years. By his definition, if you used the TIPS strategy, and if you were to die sooner, any balance in your account would be “wasted”. Furthermore, living even 31 years would be a “failure” in the TIPS strategy. But he never mentions this, much less give any advice on how to deal with it.

The "good" is that he correctly states that retirees need to recognize the uncertainty of investment returns when they are making financial plans, but the "missing" ignores the equally important uncertainty of when they will die.

 

[FIRE'd@51]

The other “missing” piece is that he assumes you know you will die in exactly 30 years. By his definition, if you used the TIPS strategy, and if you were to die sooner, any balance in your account would be “wasted”. Furthermore, living even 31 years would be a “failure” in the TIPS strategy. But he never mentions this, much less give any advice on how to deal with it.

I don't think he assumes this. See my post #5 above for a numerical example. While the result you talk about is possible, it's very unlikely using Sharpe's method, since the non-TIPS portion of your portfolio needn't be touched for 30 years. If you die sooner than 30 years, nothing is wasted since you will have met your spending goal while alive. It is perfectly legitimate to have a surplus when you die. What you don't want to have to do is cut your spending below your original SWR. It is when you cut your spending below your original SWR and still end up with a surplus when you die that you have "wasted surplus". At least, that's my interpretation.

 

[Independent]

I don't think he assumes this. See my post #5 above for a numerical example. While the result you talk about is possible, it's very unlikely using Sharpe's method, since the non-TIPS portion of your portfolio needn't be touched for 30 years. If you die sooner than 30 years, nothing is wasted since you will have met your spending goal while alive. It is perfectly legitimate to have a surplus when you die. What you don't want to have to do is cut your spending below your original SWR. It is when you cut your spending below your original SWR and still end up with a surplus when you die that you have "wasted surplus". At least, that's my interpretation.

I can see your idea, it's a two-bucket strategy where the first bucket is 30 years long. I didn't see this in the paper, though. Maybe I was skimming instead of reading.

 

[heyyou]

25 years ago, during high inflation, STRIPS/zero-coupon bonds were available from high fee financial outfits. One business was chided for selling with a fee on the 30-year maturity value, not sized to the initial value of your purchase. STRIPS are a fine idea, but carefully watch who is marketing them.

 

[youbet]

I like the predictability of the Sharpe plan.

When I started ER, I went with a plan which FireCalc backtested as surviving 100%. However, I am somewhat uncomfortable with the prospect of residual 30 yr ending values, all of which survived, that varied tremendously from near zero to huge amounts equal to a multiple several times what I started with in real dollars.

With Sharpe's plan, the only significant variable is how your small equity portion, untouched for 30 years, will do.

If I was following Sharp's plan, one change I'd make would be that if equities are flying high as you get to the 25 yr (or so) point, I'd begin moving some to fixed investments.

 

[BunsGettingFirm]

I see his plan as perfectly workable. The idea is not new. See the second action point on Consuelo Mack WealthTrack - February 2009 Action Points.

The problem is at the next bull market when most of us working stiff will be retiring, it will take every ounce of discipline to convert 66% much less 89% of your portfolio to treasury bonds. I just hope that I will be remember the bears of 2000 and 2008 vividly enough.

 

[haha]

Apparently TIPS have been disaggregatted to form both principle and coupon strips for some time. Here is an article.

http://www.riskglossary.com/link/treasury_strips.htm

I think I will check with a few brokers to see if they make markets in these. I am not interested right now, but may well be later. This Sharpe Plan would have some of the features of inflation-indexed fixed annuities.

Ha

 

[Koolau]

I see his plan as perfectly workable. The idea is not new. See the second action point on Consuelo Mack WealthTrack - February 2009 Action Points.

I agree that the article seems plausible. As pointed out in the article and here, it's currently not easily doable, but that could change if some enterprising investment house picks up on it. Still, any plan can come unraveled in a 30 year period if things change. In this case, hyperinflation coupled with (for instance) AMT taxation policy could ruin the plan I think.

I'll admit that I don't understand the original article that well. I think I understand the "self directed Index Annuity". The difference I see is that you have an inflation protected bond (AKA TIPS) in the original article and a bond investment "protected" for inflation ONLY by Mr. Market in the second. I may be off base here, but that doesn't seem like the same thing. What am I missing?

Possibly a more "similar" approach is the one by Zvea Bode (SP?) who used TIPS or equivalent to "guarantee" your basic needs and a stock portion for the fun stuff. That's way too simplified and probably less than accurate, but that's what I recall from reading the book 6 or so years ago. I realize the Bode book wasn't using "stripped" TIPS, "so there's that" as Mr. White would say in Breaking Bad - why do I love that show?

Not trying to be contentious here. Any potential plan which simultaneously addresses two of my investment fears - market volatility and inflation - is worth a look. I'm just trying to understand it and see if it might have application. Given my current commitment to "cash-like" investments, I could easily switch to something like this without taking serious losses. Those who are way down in the market already may not be willing to take the hit by switching at this time. YMMV

 

[Koolau]

And another thing (as JG) used to say, heh, heh.

It occurs to me that the "perfect" retirement plan would be to start with an annuity, "absolutely" indexed for inflation, to cover basic expenses and a (for example) S&P 500 index to provide some extras and an estate. I realize the annuity doesn't exist, but the OP plan doesn't actually exist, either - at least not in a packaged form. Personally, I'd prefer the annuity approach if it could ever be offered. The annuity addresses some of the issues of the OP's plan (e.g., paying too much for the "left overs" or running short at some point.)

This is all blue sky and off the cuff on my part. "Just saying..." as Jesse would say in Breaking Bad.

 

[Independent]

And another thing (as JG) used to say, heh, heh.

It occurs to me that the "perfect" retirement plan would be to start with an annuity, "absolutely" indexed for inflation, to cover basic expenses and a (for example) S&P 500 index to provide some extras and an estate. I realize the annuity doesn't exist, but the OP plan doesn't actually exist, either - at least not in a packaged form. Personally, I'd prefer the annuity approach if it could ever be offered. The annuity addresses some of the issues of the OP's plan (e.g., paying too much for the "left overs" or running short at some point.)

This is all blue sky and off the cuff on my part. "Just saying..." as Jesse would say in Breaking Bad.

I've thought the same thing. In practice, almost all of us already have a "pretty good" indexed annuity in SS. Just wait to start collecting until the benefits equal your basic expenses. I've done this calculation for the two of us and it works out pretty well.

There are (or at least were) SPIAs on the market that were CPI indexed. They could be added if SS weren't quite enough.

Then, I can assign a chunk of our assets to cover the time period between now and when we start SS. This chunk is in fixed investments, TIPS if the time period is fairly long.

I could carve out aother chunk if I thought the gap between CPI and my personal inflation rate will be "too big". There's no ideal place to put this, but it seems that US fixed assets probably aren't the best idea.

The rest is "fun money". In theory we could blow it all on an around-the-world cruise while we're healthy and still have the basics covered for the rest of our lives. Even if we don't blow it all at once, it's still okay to spend most of it early in retirement while we're still healthy. It's also okay to invest it nearly anywhere. Low risk/reward if we want to be pretty sure how much we'll have available for fun. High risk/reward if we're okay with the "fun" financing being pretty variable.