FIRECalc and Tips

[MJ]

I have been very pleased with FIRECalc but as I get closer to ERing (5 to 6 months away), I am beginning to question some of the calculations.
Being conservative, I had planned to keep 75% to 80% of my assests in Tips. The results has always given me 100% survival but I questioned how much money I really would have available, the 1st 10 years of my ER.
I decided to enter a what if scenario, I removed SS and any future expense reductions

Starting portfolio 1,000,000
Lifespan of Portfolio 40
SS 0
Withdrawal 1 & 2 0
Stocks in portfolio 0
Tips @ 2.5
Expenses 0
Inflation PPI

The maximum SWR was calculated @ $26,900.

1) During the 1st 10 years, I would only get $25,000.
2) Assuming that the inflation was at 3% for the 1st 10 years, I would be paying taxes on the additional $30,000 (3% of principal).
$55,000 ($25K + $30K)
$10,000 (tax deductions)
$45,000 (taxable)
$ 7,650 (US and state tax about 17%)

That would leave me with approx. $17,350 (after taxes).

Am I missing something?

MJ

Quote:

Am I missing something?

I'm not really sure I understand what your question is. But if it is Why do I only get $17,350 instead of 26,900? I think that you have to remember that FIRECalc eats into Principal, while your manual calculation lines your grave with $1 Million.

If that is not your question maybe you could clarify, or one of the genuses of this forum can help you out.

[Hyperborea]

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That would leave me with approx. $17,350 (after taxes). Am I missing something?

FIRECalc (and just about all the other retirement calculators) work in pre-tax dollars. *The individual variation in the tax situation is huge. *There is no way for it to take taxes into account without either a monumental amount of work and constant updating or some vague approximation that wouldn't apply to most people.

[MJ]

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Starting portfolio 1,000,000 Lifespan of Portfolio 40 SS 0 Withdrawal 1 & 2 0 Stocks in portfolio 0 Tips @ 2.5 Expenses 0 Inflation PPI SWR $26,900

I guess what I am saying is that FIRECalc gives you a false sense of income for at least the 1st 10 ER years, when you are heavily invested in Tips, because
1) you are taxed on both the interest and the yearly inflation derived addition to your principal, giving you a much smaller after tax income
2) It gives you an unrealistic SWR $26,900, when during the 1st 10 years you can only withdraw $25,000 using the above quoted scenario.
3) If you include SS payments of $20K starting in year 8, it raises the SWR to $49,600, again giving you an unrealistic SWR during the 1st 7 years of ER.

My calculations are based on getting in to Tips about the time I ER.

I know for me (56) it would be very important that to do those things like adventure travelling, hobbies, great food, etc. that I would be able to do physically during the 1st 10 years of ER.
Those things would cost MONEY.

It looks like Tips are safe and great if you need minimal income and want to leave your children with a nice chunk of money. I'm single and I want to spend most of mine and only leave a small portion to charity.

Am I of the track on this?

MJ

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I guess what I am saying is that FIRECalc gives you a false sense of income (security) when you are heavily invested in Tips, because you are taxed on both the interest and the yearly inflation derived addition to your principal. That leaves you with a rather small yearly income. It looks like Tips are safe and great if you need minimal income and want to leave your children with a nice chunk of money. I'm single and I want to spend most of mine and only leave a small portion to charity. MJ

If you invest in other financial instruments such as Stocks, you also have to pay taxes on any growth, whether it is from inflation or profit. So no way to escape the tax man.

No one says you have to have to leave money when you die just because you are investing in TIPS! You can spend your principle on a sliding scale. I am planning on having my principle about 2/3 gone by the time, or if I hit 90 years old.

[cute fuzzy bunny]

I think the difference is that with stocks, you have access to the principal growth if you want it. With TIPS you dont until they mature...generally in 20 years.

One of the reasons why I'm still leery of TIPS. The returns look great but you dont get 3/5ths of them until you're a little older.

Did anyone ever answer why firecalc gives different results if you change the tips %, even though tips wasnt selected? I dont think a solution was ever posted.

[Bob_Smith]

Long Term TIPS purchased on the secondary market throw off more than the yield to maturity, because they have higher coupons than the current rate. Some that I purchased just a few months ago throw off about 3.2%, even though the yield to maturity is only a little more than 2.5%. Of course some of that is principal (kind of), but you need not sell any bonds to get that level of income. In other words, you aren't limited to the YTM if you buy some of the older higher yielding bonds. Of course, you won't end up with your full inflation adjusted principal when they mature, but I'd rather have more income over the next 25 years, and less principal in the end, without the hassle (and expense) of selling bonds as I go. That's one of the reasons I purchased on the secondary market.

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Did anyone ever answer why firecalc gives different results if you change the tips %, even though tips wasnt selected? I dont think a solution was ever posted.

No, I don't think there was an answer. That is something I'm interested in knowing too.

[JWR1945]

mj

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Am I missing something?

Your numbers are wrong. It may be that you used a 0.25% TIPS interest rate instead of 2.5%. [I cannot be more specific because I have a computer glitch that prevents me from recreating your calculations on FIRECALC.]

If you owned TIPS with an interest rate of 0.00%, you could safely withdraw 2.5% per year for 40 years. Your final balance would be zero.

There is a timing mismatch that shows up with FIRECALC. The timing of the interest coupon does not align exactly with the inflation adjustments of withdrawals. This causes a slight variation in the number of years that an all-TIPS portfolio survives.

This timing mismatch would disappear if you were to adjust your actual withdrawals to match the coupon payments instead of the inflation index. You already do this with your paycheck (if you get cost of living adjustments).

TIPS calculations are very similar to calculating mortgage payments. There is a closed form solution. If TIPS provide an interest rate of r for N years, then they can provide payments equal to r / [1 - (1 / [1+r]^N)] times the initial balance for N years. At the end of N years, the final balance is zero. [To make such calculations, it is necessary to assume that some of the TIPS are sold at par throughout the years. That is, you receive no capital gains and incur no capital losses when you sell.]

Using the formula, TIPS at 2.5% interest provides an income stream of 3.98% for 40 years. This is in terms of real dollars (that is, with adjustments for inflation).

Your observations about taxes are worth noting. Ibonds avoid the immediate taxation of increases in principal caused by inflation, but their interest rates are lower.

Have fun.

John R.

[retire@40]

Quote:

1) you are taxed on both the interest and the yearly inflation derived addition to your principal, giving you a much smaller after tax income.

You are not taxed on inflation. The tax code has a built-in inflation factor to prevent taxes on inflation in most cases. That is why there are yearly increases to the standard deduction, exemptions, and the tax bracket levels.

[cute fuzzy bunny]

Actually you ARE taxed on the inflation adjustment component of TIPS, every year, for the amount of the inflation adjustment. You just dont get to HAVE that money until the bond reaches maturity.

From the treasury web site; where they say "principal of your tips grows", that is the CPI inflation adjustment factor that is added in.

"Like other marketable Treasury securities, TIPS are exempt from state and local income taxes, and subject to federal income tax. As for federal taxes, here's one other matter to consider: In any year when the principal of your TIPS grows, that gain is considered reportable income for that year even though you won't receive your inflation-adjusted principal until the security matures. If you hold your TIPS in TreasuryDirect, we send you two tax statements each year: an IRS Form 1099-INT showing the interest we paid you and a 1099-OID showing the increase or decrease in the principal value of your security."

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mj Your numbers are wrong. It may be that you used a 0.25% TIPS interest rate instead of 2.5%. [I cannot be more specific because I have a computer glitch that prevents me from recreating your calculations on FIRECALC.] If you owned TIPS with an interest rate of 0.00%, you could safely withdraw 2.5% per year for 40 years. Your final balance would be zero. There is a timing mismatch that shows up with FIRECALC. The timing of the interest coupon does not align exactly with the inflation adjustments of withdrawals. This causes a slight variation in the number of years that an all-TIPS portfolio survives. This timing mismatch would disappear if you were to adjust your actual withdrawals to match the coupon payments instead of the inflation index. You already do this with your paycheck (if you get cost of living adjustments). TIPS calculations are very similar to calculating mortgage payments. There is a closed form solution. If TIPS provide an interest rate of r for N years, then they can provide payments equal to r / [1 - (1 / [1+r]^N)] times the initial balance for N years. *At the end of N years, the final balance is zero. [To make such calculations, it is necessary to assume that some of the TIPS are sold at par throughout the years. That is, you receive no capital gains and incur no capital losses when you sell.] Using the formula, TIPS at 2.5% interest provides an income stream of 3.98% for 40 years. This is in terms of real dollars (that is, with adjustments for inflation). Your observations about taxes are worth noting. Ibonds avoid the immediate taxation of increases in principal caused by inflation, but their interest rates are lower. Have fun. John R.

I don't think so John. *I'm getting the same numbers as he was. I even plugged in 0% for Tips return and only got $17,000 withdrawal amount which would be about 1.7%. I am more confused about TIPS now than I ever was.

Maybe some genius on this forum can help us

[MJ]

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mjYour numbers are wrong. It may be that you used a 0.25% TIPS interest rate instead of 2.5%.

I left the default of 2.5 alone but I did found the problem. Being very risk sensitive I always change the safe rate to 100%. This gave me the $26,900. If you leave the default of 95%, the SWR returns $34,600. Doesn't that reinforce my premise that if Tips are purchased through the Treasury, this amount at least for the 1st 10 years is some what misleading since a $1,000,000 in Tips start earning $25,000 the 1st year and will slowly increase yearly as the principal increases with inflation.

This also raises the question if Tips are 100% secure why would FIRECalc be concerned with safe return. In fact, if you set the safe rate to 0%, it returns a SWR of $160,000. Only if that were real.

MJ

[cute fuzzy bunny]

If only it were true that tips provide 100% safety or even "real" dollars.

Given that many people have ripped CPI's accuracy in calculating inflation and found that it may be anywhere from 1-3% short of reality...I would say that tips offer neither 100% safety nor "real" returns.

In case anyone missed the dialog on CPI, the index leaves out some rather important items, allows for "substitution" of items (for example, if steak gets too expensive, it allows a substitution of hamburger), and it includes "mystery" changes where an items value can be hand adjusted higher to compensate for other expenses going higher. For example, even though computers have gotten cheaper, CPI calculations for those have been fudged to show a 30% higher "benefit" due to the computers being faster this year than last. Pretty bloody unlikely.

Check out these links to Bill Gross' analysis on CPI:
http://early-retirement.org/cgi-bin/...697752;start=1


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"TIVO probably wouldn’t help much when it comes to the con job perpetually foisted on the American public about the low level of inflation. “Inflation under control” – (ex food and energy of course) shout the carnival barkers. “The CORE is running at just under 2%,” the barkers shout with glee because a low CORE number tells us that we can continue to run monetary policy with negative real interest rates and fiscal policy with $400 billion dollar deficits. A low CORE number allows us to pretend that American productivity is the best in the world, that the dollar should be strong, and that the markets, by golly are going up. No matter that a gallon of gasoline is over 2 bucks or that a half gallon of milk will set you back $3.69; the CORE is under 2%. Still as Todd Heft, a 44-year-old salesman recently quoted in The Wall Street Journal said, “People have to buy groceries and drive to work. It’s not realistic to strip out food and gas prices.” Ah the core, the core, the core. Semper Fi to low inflation, I guess.



My quarrel though is not just with those who are fixated on the core CPI or the core PCE, but with those who support what we know as hedonic adjustments. Talk about a con job! The government says that if the quality of a product got better over the last 12 months that it didn’t really go up in price and in fact it may have actually gone down! Why, we could be back to Bernanke deflation real soon if the government would quality adjust enough products. For instance, prices of desktop and notebook computers declined by 8% a year during the past decade, The WSJ reports but because the machines’ computer power and memory have improved, their hedonically adjusted prices have dropped by 25% a year since 1997. No wonder the core is less than 2% with computers dropping by that much every year. But did your new model computer come with a 25% discount from last year’s price? Probably not. What is likely is that you paid about the same price for hedonically adjusted memory improvements you’ll never use. Similarly, government statisticians manipulate the price increases for cars and just about any durable good that comes off an assembly line but find it difficult to extend that theory to underwear or a pair of shoes. Perhaps that’s next. Talk about Uncle Sam getting into your shorts!"

His relevant conclusion:
"Deceptive hedonic/substitution adjustments also serve a government burdened not only with hundreds of billions of annual deficits as far as the eye can see, but ladened with a demographically aging U.S. workforce rapidly approaching Social Security time. By fudging on inflation, they pay less and the amount could cumulatively run into the hundreds of billions over the next few decades. They disserve, of course, all of those who receive social security, as well as other private pensioners dependent on an accurate accounting of prices paid. They disserve buyers and holders of TIPS – inflation protected securities – which adjust inadequately to a faulty and near fraudulently calculated CPI that one day could total billions of dollars per year for TIPS holders. And they disserve all owners of U.S. Treasury obligations – including foreign central banks and institutions – who mistakenly assume that they are earning a real return over and above inflation, and that the dollar upon which they are denominated is justifiably strong because of GDP growth and productivity numbers that are pumped by hedonic magic to resemble the Arnold Schwarzenegger of 1980 instead of his verbal “girlie man” analogy of today."

[MJ]

I guess I was mixing up the difference between money that is secure (ie: guvment bonds) and money that will last long term.

MJ

Wow, this boggles my mind! I ran the detail for 100% 40 years 2.5%. Check out 1933, the worst-case year. In the first year, principal drops over $100K - severe deflation I assume? Also, in the 40th year the final $100K is consumed - the inflation-adjusted withdrawal I guess since I don't recall any deflation during the 1972 oil embargo!

But then look at the other extreme, 1947 - principal goes UP $175K in year 1 and continues rising steadily. After 40 years you have $6.3M!

I'm completely mystified that TIPS results could vary to that extreme. Could one factor be that the calculation ignores the guarantee of principal, since that would depend upon the timing of maturities?

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Wow, this boggles my mind! I ran the detail for 100% 40 years 2.5%. Check out 1933, the worst-case year. In the first year, principal drops over $100K - severe deflation I assume?

I guess that is my answer to why FIRECalc only gives you a 1.7% withdrawal for 100% TIPS @40years. - Deflation.

But if that is the case, there is a BUG with FIRECalc as I recall reading on the TIPS Site that Principle will never be reduced in the Case of TIPS. - We discussed this once before.

[JWR1945]

From cc

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I'm completely mystified that TIPS results could vary to that extreme.

FIRECALC balances are in NOMINAL dollars. That explains part of the discrepancy. Withdrawals are changed in accordance with inflation. They are in REAL dollars.

It may be that using the PPI instead of CPI has an effect. Most likely, it does not. But you never know with software.

Have fun.

John R.

Cut-throat, my understanding is that a deflationary year CAN reduce principal. The guarantee is only that the FINAL pricipal balance cannot be less than the original face amount.

[cute fuzzy bunny]

That is correct.

You are guaranteed to get at least your initial investment back, but tips can decrease in value with deflation and will continue to do so until you cash them in at maturity.

So...if we see 5% annual deflation, in the 20th year of the bond you will receive no interest as the principal will have been adjusted to zero, but then when you cash the bond in you'll get your original principal back. Theres probably some mistake in the math on that, but you get the idea.

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Cut-throat, my understanding is that a deflationary year CAN reduce principal. The guarantee is only that the FINAL pricipal balance cannot be less than the original face amount.

Yes that is the way that I understand it also.

But if this is true then for $1 Million @ 40 years with zero% on TIPS should yield $25K per year. *Shouldn't it? Instead of the $17K SWR FIRECalc gives?