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ER Costs Investment Hedges
Old 08-12-2004, 08:29 PM   #1
 
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ER Costs Investment Hedges

I'm curious whether anyone has anyone seen any research or publications regarding equity investment allocations/strategies that best hedge against ER living costs increases?

As an example, I have started to purchase more energy stocks and health care stocks due to concerns regarding future costs. I haven't figured out how to hedge college education for my kids (tuition definitely goes up more than inflation).

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Re: ER Costs Investment Hedges
Old 08-13-2004, 12:44 AM   #2
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Re: ER Costs Investment Hedges

Quote:
I haven't figured out how to hedge college education for my kids (tuition definitely goes up more than inflation).
See to it that they learn to play and play well, some marching band instrument. My brother is a high school band leader, and he has sent quite a few kids on to Ohio State with band scholarships. Any highly motivated kid can do it, and it's a lot easier on the knees than football.

Plus the kids have a ball all through school.

My sons studied string instruments, and although they became quite skilled, no scholarship money for them.

Mikey
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Re: ER Costs Investment Hedges
Old 08-13-2004, 03:57 AM   #3
 
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Re: ER Costs Investment Hedges

Mikey makes a lot of sense. My oldest daughter played
no instrument but had a lovely singing voice. She
"auditioned" for the Music Director at the school of her
choice hoping for a scholarship. I thought maybe they
would send us a letter re. their decision. After she finished he said "You're in!" It was a great help with
the cost of school.

John Galt
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Re: ER Costs Investment Hedges
Old 08-13-2004, 08:02 PM   #4
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Re: ER Costs Investment Hedges

Familywu: In his book "The Single Best Investment" Lowell Miller has several tables demonstrating that high yield stocks raise their dividends faster than inflation, allow for a high withdrawal rate for ER's, and are less volatile than most "asset allocation portfolios". Hank Joy
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Re: ER Costs Investment Hedges
Old 08-14-2004, 06:05 AM   #5
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Re: ER Costs Investment Hedges

I have both - balanced index and dividend stocks.

Dividend stocks are not a total bed of roses - the reason I've had an 8.49% take out the last ten years - dividend cuts, spin offs, mergers, etc. - the survivorship bias is horrendous.

With 'dividends' being rediscovered by Wall Street, lowered tax on div.'s, and projected lower stock returns going forward - the picking could get chewy.

That said - I intend to soldier on with my Mergent's Handbook of Dividend Achievers and a few side bets on fallen angels.
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Re: ER Costs Investment Hedges
Old 08-14-2004, 09:20 AM   #6
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Re: ER Costs Investment Hedges

Familywu,
I have not read this yet, but Zvi Brody has a book out espousing a concept about matching assets and liabilities in retirement using fixed income or swaps types of instsruments, and only then investing in stocks with anything left over after you've locked in flows to cover all your expenses in perpetuity.

Trouble is, these instruments don't really exist yet, but I understand he is working with a financial firm to try to bring them out. I just keep being skeptical of credit risk from anyone besides the US govt -- what company could you trust to bring you your payments for 80 more years? Sort of the same problem I have with annuities so I may be an outlier since I know lots of people do buy annuities.

If you get the book, let us know what you think of it.

ESRBob
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Re: ER Costs Investment Hedges
Old 08-14-2004, 09:22 AM   #7
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Re: ER Costs Investment Hedges

ESRBob, that does sound a bit weird and I'm not sure I'd be very confident in the instruments either. Someone has to pay and if they lose too much money, you lose too.

I like the idea of hedging your bets a bit with investing - so I have some commodities, some health care, some energy, etc.

Education - maybe U of Phoenix?
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Match liabilities with zeroes.
Old 08-15-2004, 10:28 AM   #8
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Match liabilities with zeroes.

Bloomberg's "Wealth Manager" magazine had an article on this a few months back. (WM is a free paper subscription and an invaluable insight into the "thinking" of financial "managers".) The title was along the lines of "Hey, we beat the S&P500 but I can't pay my bills!" You can implement the strategy now.

The concept is to set aside funds for large liabilities-- mortgage, retirement expenses, college, LTC, new roof, new cars, new appliances, whatever-- and then save what's left over after you've taken care of the liabilities.

One family was quoted as projecting 2010's college costs as $150K. Instead of 529s or student loans or other financial aid programs, they bought zeroes for that amount and stopped worrying about it.

It's a worry-free approach as long as you can afford it. For some it may be the capital-accumulation difference between an exciting ER and a boring traditional retirement age. The article used another example of a wealthy ($100M) couple who felt their absolute minimum annual expenses would be $1M. Their advisor put $33M in a bond ladder and they were able to use the rest of their portfolio on gifting & charity. Of course this is a SWR question with considerable leeway to reduce expenses, but...

TH has pointed out before that retirement portfolios should be self-sustaining-- big enough to throw off your inflation-adjusted living expenses (including capital costs like a new roof) in perpetuity. Works for me.
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Re: ER Costs Investment Hedges
Old 08-15-2004, 11:02 AM   #9
 
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Re: ER Costs Investment Hedges

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retirement portfolios should be self-sustaining-- big enough to throw off your inflation-adjusted living expenses (including capital costs like a new roof) in perpetuity.
Are you saying here 'Never touch Principal'? - If so I disagree.
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Re: ER Costs Investment Hedges
Old 08-15-2004, 11:47 AM   #10
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Re: ER Costs Investment Hedges

Well, if your port doesnt throw off enough to live comfortably on, with most future capital and expense items considered, then you have no choice.

However, at 43 (birthday last week, wedding tomorrow, yay) and a gene pool that includes plenty of 90-somethings, I cant afford to eat my principal.

My thinking is most people can live well on 30-40k a year. Most people are probably not going to retire on less than a mil a year (yes, we know John). If you cant figure out how to get a portfolio that throws off 3-4% dividends and also has a couple of percentage points of capital appreciation per year to hedge against inflation...maybe ya oughta keep working!

Wellesley fund throws 3-4% or more (historically) and has had an annual capital appreciation averaging 6% on top of that for a total return of over 10%. No expensive growth stocks, no long term bonds, no consecutive losing years, no double digit losing years. Over a 30 year span. .20 expense ratio for admiral shares. Boom, you're done.

I'm sure a target retirement sort of thing or a consolidation of 50% large cap value and 50% intermediate muni bond funds would produce roughly the same numbers, but the target retirement funds dont have a long track record, and putting together all those asset class returns over a 10-20 year period is too much like work.

You can certainly take on more risk, and potentially improve your returns or terminal portfolio sizes, but unless you're unhappy with the quality of life the dividend throw off provides, why?

As far as the original question, the only bugaboos are inflation and long term low returns (like 1965-1980). You can somewhat conquer inflation with commodities a la PCRIX, timber which a number of large portfolios are adding in 3-10% amounts (smartmoney this month highlights two purish timber plays, I cant remember their names), and tips. Raddr over on his web site did a long term firecalc sort of analysis using tips, cash and commodities and showed that commodities provided the best hedge against inflation, especially in large doses. The fact that some of the commodity funds like PCRIX leverage TIPS as the financial instrument as assurance against the commodity futures means you get tips returns + tips inflation protection + commodity returns. Not very tax efficient though. Oh yeah, and you could lose enormous chunks of principal although the fund is well hedged and quite diverse.

As far as long term weak returns, load up on your dividend paying stocks (but dont overdo it and lose your capital on flakey companies) and a variety of bonds, and dont go crazy on high PE stocks or indexes that are loaded with them until valuations soften up.

My kids college plan hasnt been fully fleshed out. My first inclination was to not fund one at all and let her figure it out on her own, but leave her my retirement principal nestegg as a 'surprise', somewhere in her 40's is when I'll probably expire...letting her ER without planning her life around a windfall. But I've lately thought about just buying a chunk of ibonds (if the interest rate gets up to 1.5%) and then using their inflation protection + 1.5% (tax deferred and tax free if you use it for educational expenses) to fund at least part of a basic college education and letting her fill in the rest. But I havent really thought it through.

T-minus 16 hours until I'm not single...THATS something I'm thinking about!
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Re: ER Costs Investment Hedges
Old 08-15-2004, 12:31 PM   #11
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Re: ER Costs Investment Hedges

Wellesley is a middle aged version of the old time 'classics' in the tradition of Wellington, Dodge and Cox balanced - with a lower value stock component and more bonds - well before index funds. Worked fine then and works now. More than one way to skin a cat.

The most modern twist of this method (less yield) is 50% Wellesley/50% Dodge and Cox Balanced - no down years since 95 (Dick Young).

I've owned Wellesley in a past life (80's and very early 90's) before balanced index. Great way way to go - IF it fits your particular ER.
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Re: ER Costs Investment Hedges
Old 08-15-2004, 01:03 PM   #12
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Re: ER Costs Investment Hedges

Dodge and cox balanced is a good fund, i've owned it. Fared well over the last 5 years. Similar to Wellington, at a slightly higher management cost.
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Re: ER Costs Investment Hedges
Old 08-15-2004, 01:32 PM   #13
 
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Re: ER Costs Investment Hedges

Quote:
Wellesley fund throws 3-4% or more (historically) and has had an annual capital appreciation averaging 6% on top of that for a total return of over 10%.
TH,

If I get a total return of over 10% my Principal will be Growing! , - I just think that this a bit rosy

However I am only planning on a 3% real return, and that plan does eat into principal (but will still last me to well over 100 years of age!)
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Old 08-15-2004, 02:42 PM   #14
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Re: ER Costs Investment Hedges

My portfolio throws off, in rough numbers, 2.5% interest/dividends, but earns on average (backtested and personal experience) 9% nominal a year. Much of the interest/dividends is in the 401k/iRA portion so I don't actually get at it there. My federal income tax bracket is 10% and my dividends/capital gains are taxed at 5%. So I am very comfortable selling 'winners' during my semi-annual rebalancing to pull out cash, and pay the 5% on those capital gains, so that I don't have to pay taxes on other interest/dividends. In other words, I am selling principal all the time but I don't view that I am 'eating into it' as so often appears to be the worry, as the overall portfolio grows nicely.

Inflation, however, does eat into the portfolio, and I believe should be the biggest worry. Even a bond ladder isn't necessarily keeping up with inflation -- it is just smoothing out the risk of swings in the rate at which you get to reinvest principal.

I am rambling, and what I really wanted to say is: TH Congratulations on getting Married and don't think about us or your Portfolio for a good long while -- enjoy the greatest day of your life with your new family!!!

But back on topic, I would not put much faith in the ability to spend interest/dividends simply because they feel like 'earnings on the portfolio'. they are not ensuring that my principal is inflation indexed, and they are often tax inefficient. Instead, stick with an SWR approach from a diversified pool of assets invested at low cost, and take the money from wherever you can most tax efficiently -- cap gains, divs, interest whatever. (As a practical matter, though, the numbers work out roughly the same, and TH's dividend approach is probably conservative, in that it would withdraw something like 3% a year - its the guys who start buying junk and REITs and then spending those coupons that I worry about.)

btw, the timber REIT is Plum Creek (PCL) and another, Rayonier, that I haven't researched. The Plum Creek was mentioned on IndexInvestor.com a few months ago and looks very credible. (I also own PCRIX, QRAAX, Vanguard Oil, FBR Nat Gas Index and even some physical gold -- gifts from my Chinese mother in law -- for a total of about 4% of the portfolio in commodities)

Seriously, TH -- have a great wedding -- I think I speak for all of us when I say we are very happy for you and wish you a lifetime of happiness together!

ESRBob
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Re: ER Costs Investment Hedges
Old 08-15-2004, 02:56 PM   #15
 
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Re: ER Costs Investment Hedges

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T-minus 16 hours until I'm not single...THATS something I'm thinking about!
OK, where's the Honeymoon and are we invited
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Re: ER Costs Investment Hedges
Old 08-15-2004, 03:25 PM   #16
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Re: ER Costs Investment Hedges

We're having the cheapest wedding in history. In fact, 90% of the cost is the new suit I bought and the nice set of earrings I got her when she managed to find a serviceable wedding dress for $20.

So no big honeymoons either. Neither of us feels like going anywhere, we were both big travellers before we met. She's got this month off and of course, so do I...we're just going to relax, slug around, and spend a lot of time walking the dogs.

Honeymoon is at my house, or if we feel racy, we can go to her house between when the tile guys leave and the painters show up.

Thanks for all the kind words, I found a good one. She's gorgeous, sensible, and takes all my crap without much trouble, which is a tough thing to do sometimes.

Cut-throat: wellesley returned almost 11% from 1970 (inception) to current. ~10% for the last ten years. ~8% for 1 and 5 year periods. Considering its first 10 years were fairly horrible times for stocks AND bonds, and the last 10 years saw a lot of 'conservative' funds perform poorly, I'm pretty comfortable with 6-8% including a 3.5% yield going forward. As long as I see the yield plus a 3% capital appreciation I wont worry too much about inflation.
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Re: ER Costs Investment Hedges
Old 08-15-2004, 04:06 PM   #17
 
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Re: ER Costs Investment Hedges

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Cut-throat: wellesley returned almost 11% from 1970 (inception) to current. *~10% for the last ten years. *~8% for 1 and 5 year periods. *Considering its first 10 years were fairly horrible times for stocks AND bonds, and the last 10 years saw a lot of 'conservative' funds perform poorly, I'm pretty comfortable with 6-8% including a 3.5% yield going forward. *As long as I see the yield plus a 3% capital appreciation I wont worry too much about inflation.
How much of your portfoilo is Invested in this fund? -- I thought you were telling us that it was only around 5%- If so, where would you make up the Difference?
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Old 08-15-2004, 07:35 PM   #18
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Re: ER Costs Investment Hedges

80% of it until about four months ago when I chickened on the interest rate hikes and moved about 40% of the holdings into the short term corp fund.

Which was stupid...Wellesley dropped about 1% around the first quarter point hike and then bounced back to even by the day after the second one. In other words the half point kick was already priced in.

So I put part of it back in, bought some Wellington (which is the same strategy only upside down stock:bond ratio) and a few other dollops of pure stock funds. Mostly because we're going to be living largely on the wifes income going forward so I can take a longer horizon and dont need as much current income.

But without a working wife, I'd have kicked myself in the butt for twitching about the interest rates, put it all back in, and left it there.
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Congratulations, th.
Old 08-16-2004, 09:38 AM   #19
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Congratulations, th.

Geez, a spouse & a kid in the same year. You really know how to screw up a "good" ER.

The IRS has specific rqmts on ownership of bonds for tax-free educational purposes. IIRC you have to own the bonds in your name and your kid's name can't be on them except as an inheritor/beneficiary. No doubt you & spouse can enjoy debating this during your first married/honeymoon conversation about money management...

Cut-Throat, I think you can chew into principal as much as you want if you're willing to die when it runs out. Hopefully the former occurs before the latter. If not you can always find some boarding-house landlord who'll exchange shelter for your SS check...

But seriously, I feel a significant number of "ERs" are undercapitalized and risking an "early return" to the workplace. Every time I read a post about "Who can afford vacations" or "What % of pre-retirement expenses will I see in retirement" or "Where can I find a good 10% yield" I think "Save another $100K..."
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Re: ER Costs Investment Hedges
Old 08-16-2004, 09:46 AM   #20
 
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Re: ER Costs Investment Hedges

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Cut-Throat, I think you can chew into principal as much as you want if you're willing to die when it runs out. *Hopefully the former occurs before the latter. *If not you can always find some boarding-house landlord who'll exchange shelter for your SS check...
If you want to die with your Principal Fully Intact, that is up to you. Our plan calls for having the principal 2/3 gone by the time we reach 100. (And that is a Big If)

By not planning on spending Principal, you are shortchanging your lifestyle and dying with too much money.

In fact, my idea of perfect financial planning is that the checks to the undertaker bounces
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