FIREcalc's handling of TIPS

[wabmester]

I remember reading that FIREcalc handled TIPS a little oddly, but what exactly does it do?

I ran a sanity check:

withdraw $20,000/yr from a $1,000,000 port (i.e., 2% inflation adjusted)
assume 100% TIPS real yield is 2%, expenses 0, inflation = CPI

My naive expected results were that the portfolio value would remain constant in inflation-adjusted dollars, since I was just withdrawing 2% of the inflation adjusted principal.

However, FIREcalc had the remaining portfolio value fluctuating wildly with values as low as $500K and as high as $10M.   What's up?

 

[JWR1945]

I don't know for sure. It is not unique to FIRECalc. It also happens with the Retire Early Safe Withdrawal Calculator.

I think that you are seeing a timing mismatch in terms of the TIPS and the adjustments in withdrawal amounts. [The same CPI is used for both the TIPS and withdrawal amounts. The TIPS interest rate is a fixed percentage of its principal (which increases with inflation).]

As a practical matter, I think that a real retiree would live off the interest coupon when he receives it (possibly with some sales if needed). That would get rid of any timing mismatch unless he went out of his way to look up the CPI.

Have fun.

John R.

 

[wabmester]

Hmm, after looking at the data, I discovered a couple of things:

1) 1874 would have been a very bad time to buy TIPS.  I didn't realize there were such long periods of deflation in US history.

2) The terminal value given by FIREcalc is inflation-adjusted (nominal).   This renders the value meaningless since each sequence has a different set of inflation factors.  It seems to me that the terminal value would be more useful if given in real dollars.

 

[wabmester]

Eh, there is still something weird going on beyond the effects of deflation.

By default, FIREcalc makes the coupon payment and inflation adjustment at the end of the year and then subtracts the inflation adjusted withdraw from principal. In theory, it shouldn't be possible to run out of money if you're withdrawing 2% from a portfolio of 100% TIPS with a 2% coupon.

Somehow, FIREcalc runs out of money after 92 years in this scenario.

 

[cute fuzzy bunny]

SWAG, and in this case the S stands for stupid.

These bonds adjust inflation by the pricing of the bond, and you have to pay taxes on that repricing, although you dont get the benefit until you sell the bond or it matures.

Hence during times of high inflation, your 2% would shrivel to nothing or less, but you'd get the inflation adjustment back when the bond matured and was sold or given back for its inflation adjusted face value.

Certainly makes modeling these things a little entertaining.

 

[wabmester]

As far as I know, there are no taxes in FIREcalc-world. You're supposed to include taxes as part of your withdrawal, which I didn't for this sanity test.

 

[JWR1945]

I cannot look at the FIRECalc's code, nor can I read it. I can look at the code in the Retire Early Safe Withdrawal Calculator and I can understand it. It is in an Excel spreadsheet.

Here is what happens:
1) Row 190 has the inflation index numbers. The ratio of two adjacent years equals (1+inflation).
2) Row 180 calculates [the TIPS interest rate*(1+inflation)+inflation]. That is, it multiplies the number in cell H8 (written as $H$8 ) and the ratio of two index numbers in row 190 and adds the inflation rate. The code looks awkward at this point. Inflation equals the ratio minus 1. In the first part, the code calculates [1+(the ratio-1)]. The number in cell H8 is a percentage. In the second part, the code converts the inflation to a percentage. It takes the ratio, subtracts 1 and then multiplies by 100%.
3) Row 183 has the interest rate of the fixed income component. It is the same as row 180 when TIPS is selected.
4) Reported balances are those for December 31st. It is at the bottom row for a specified sequence. The January 1st balance of the following year is the identical. It appears in the next column. It is at the top row of the same sequence.
5) The first withdrawal is calculated from the calculator inputs. With FIRECalc, you would enter the dollar amount. With the Retire Early Safe Withdrawal Calculator, it multiplies the withdrawal rate by the initial balance. [And it allocates the withdrawal into two parts according to the user specified input. One part is applied at the beginning of a year and the other at the end, after all portfolio gains and losses for that year.]
6) The first withdrawal has no adjustment for inflation from December 31st of the first year to January 1st of the following year. The withdrawal amount is multiplied by ratio of the index numbers found in row 190 in subsequent years, but not in the first year.
7) The TIPS interest rate includes an inflation adjustment from the first year to the second. That is, it does not know about January 1st or December 31st. It only knows about the inflation index numbers.

For example, in the 1871 sequence, the inflation rate for 1872 is 1.53% (as seen in row 187). With 2% interest, the TIPS interest for 1872 is 3.56% as seen in row 180 (and in row 183 if TIPS has been selected). The TIPS interest for 1872 is 3.56% times the (TIPS) bond balance on January 1st, after the first withdrawal and after allocating the balance between stocks and bonds. The withdrawal amount for 1872 is calculated based on the initial balance, which is the December 31, 1871 balance. It is also the January 1, 1872 balance. If you withdraw the TIPS interest rate, you withdraw 2%, not 3.56%. [It is then applied in two parts, one in January and the other in December.]

I think that FIRECalc treats TIPS the same. [However, it does not break withdrawals into two parts.]

Have fun.

John R.

 

[dory36]

FWIW, Firecalc uses the same approach as the Excel calculator on REHP.