Fixed Income Strategy for Beating Inflation

[Running_Man]

This post is not a recomendation of 100% Fixed Income Allocation. I always reccomend at least a 25% holding of stocks to even the most conservative of investors. However I have seen many posts that a fixed income portfolio dooms one to not being able to keep up with inflation and that inflation is the killer of fixed income.

My thesis is this is incorrect, because as in stocks it is the percentage of the portfolio draw that will cause failure to meet inflation. Additionally, as inflation increases yields increase so that if inflation increases to 8 percent in a year from 4 percent and the 30 year bond moves from 4 percent to 8 percent as well, the increase in interest income is 100 percent while spending needs only increase by 8 percent a 12.5 leverage. The question is how to take advantage of this advantageous math. The following calculations are all necessary to occur in a tax-deferred account. In a taxable account the taxes register these calculations invalid.

Attached is a spreadsheet with inflation statistics from the US government and the 30 year treasury yield for each year from 1977(with 10 year yields for the 3 years of no issue of 30 year treasuries). My initial quest was to see if a 4 percent draw and increasing the withdrawls by the inflation rate over 30 years could have been me looking back over the past 30 years.

Any additional funds earned in a year were added to a new 30 year bond the following year, creating an ever increasing income stream. To succeed every years spending needs would need to be met by income received so that no sales of bonds would be necessary.

The answer to my intial interest of a 4 percent withdrawl starting 30 years ago adjusted for inflation was yes and an original portfolio of $100,000 in 1977 would be $208,335 today and the spending of $14,413 would be met with income of $16,106 today, with no need to cash in any of the bonds. However I noted this is not valid today with rates available.


In entering other years I noted that the key though is to hold initial spending to no more than 50 percent of the starting income received. This allows the portfolio time to accumualate the additional savings to meet inflation needs. This would have allowed a draw in 1981 of 6.75 percent but today you would be limited to a 2.3 percent withdrawl rate as the safe rate due to the drop in interest rates. The higher the initial interest rate, the higher the amount of draw.

So currently this is not a very feasible strategy unless you were EXTREMELY conservative, but if rates do head up, and particularly as the 30 year gets much above 7.5 percent, this would be a strategy that would allow you to determine how much of your fixed income portfolio you could draw while meeting inflation in that portfolio, for a tax deferred account.

This was an experiment I wanted to run to see if this could hold up for 30 years, if inflation were to shoot up rates again like the 70's, and I was surprised to see how well it worked no matter what year from 1977 on you key in, so long as you hold to 50 percent of the original interest. You can change the year and the spreadsheet will calculate each years activity your ending 2007 balance, the inflation adjusted value of that balance at 12/31/2007, starting withdrawl and inflation adjusted spending needed in 2008. For years past 2008 it will assume the 2008 data goes on forever.

[RockOn]

[quote=Running_Man;685967]
quote]

I am interested in looking into your idea. Can you simplify the overall concept a little? You are losing me in the details.

[Texarkandy]

Running Man,

I have a situation might be somewhat related to your thesis.

I have a tax-deferred federal TSP account (like a 401k) currently in the G-Fund (special short term treasuries at medium/long term rates as I understand it). I was diversified till April 07 when I got nervous about the emerging subprime mortgage & other financial news & plopped it all over to the G-Fund.

As a prospective early retiree (age 49) I would like to leave my TSP account alone till 59.5 - this might not be possible for me however (financially) & I may need some of those monies prior to age 60.

The TSP has a feature whereby TSP will give me a 72t type distribution upon my early retirement. (substantially equal monthly payments based on life expectancy)

Under your thesis above - will my TSP give me a payout & hold it's value (vis-a-vis inflation) over the long term if I decide exercise this 72t type option & leave it in the G-fund (special treasuries) instead being diversified in the C-fund (S&P 500) & other funds?

(p.s. - For my ER plan, I don't have to increase it's value, just maintain it.)

[Htown Harry]

Interesting.

Looks valid to me on first look, but I see the mean interest > inflation differential is about 3.8% during the 30-year period. About 4 years were negative and about 6 were around double the mean.

Seems to me your method is fundamentally based on that gap. And, to a lesser extent, on the distribution of the "good" and "bad" years of interest rates staying above inflation.

One risk test would be to see if the 30-year interest > inflation relationship you used is similar to the trend over a longer historical period.

[d]

it seems to work because both 1) the initial interest rate and 2) the interest/inflation differential were relatively high during this period, both declining over the longer term. i wouldn't expect these conditions very often.

[cute fuzzy bunny]

Firecalc will do this for you with very little trouble, just select 0% equities and 30 year treasuries.

Success rate is 37%.

Add the 25% equities component back in and your success rate more than doubles.

And yeah, looking at the last 30 years, a fantastic bull market period for bonds...might not reasonably be reproduced over the next 30 years.

Right now it looks like real rates for bonds will run somewhere between zero and 2% for the foreseeable future

[Independent]

If you want to test this for more than one year, this site claims to have 30 year treasury rates since 1947

30-year T-bond Yield; copyrighted by Bridge Commodity Research Bureau

[Marquette]

Swedroe was proposing a theoretical portfolio that was something like 70% bonds/TIPS and 30% EM/commodities. (I'm off on the allocation and percentages, but it was basically a bunch of base and a small supercharged engine for growth).

[cute fuzzy bunny]

Pretty much an extreme version of the bucket strategy and not far from Naseems black swan approach.

[Bikerdude]

Quote:

Originally Posted by cute fuzzy bunny And yeah, looking at the last 30 years, a fantastic bull market period for bonds...might not reasonably be reproduced over the next 30 years. Right now it looks like real rates for bonds will run somewhere between zero and 2% for the foreseeable future

I agree. A possible reason that Psst!... Wellesley could struggle going forward.

[cute fuzzy bunny]

Most certainly a challenge, as I mentioned in my first post in that thread.

However the 35% in LCV helps boost things along.

The short answer is that if bonds return 0-2% over the CPI, every bond heavy strategy will suffer. Which would make now a rather bad time to turn to a 80%+ fixed income strategy.

There are some other folks with a perspective of the returns of stocks and bonds going forward from here. Philip Greenspun seems to feel that corporations are so rife with thieves and balance sheet BS artists that equities simply cant be very profitable as they have been in the past. I dont recall if he's recommended any alternatives. Gillette Edmunds has proposed that US equities may squeak out a .5% excess return over US bonds going forward. His recommendations that I read about 6 years ago were to go to oil, precious metals, foreign equities and bonds, etc.

So making next to nothing on bonds or cash and having your earnings stolen by criminals posing as company executives is a pretty bad outlook.

Lets hope the reality is a little bit better than that. Some of these doom and gloom scenarios start sounding to me like the equivalent of the guy thats so scared of what might happen to him that he never leaves the house. Ends up arriving safely at his demise with nothing bad, nor anything good, ever happening.

[Running_Man]

[quote=RockOn;686167]

Quote:

Originally Posted by Running_Man quote] I am interested in looking into your idea. Can you simplify the overall concept a little? You are losing me in the details.

The overall concept is

1. Determine safe withdrawl rate for 100% fixed income portfolio.
2. Highest level of safety of principal - US government.
3. Match time horizon of spend to investment - 30 years.
4. Insure withdrawls could be increased by CPI without principal withdrawls.
5. Final portfolio value was not an important factor but is calculated.
6. Assumes investment in a tax-deferred account.

The advantages to this method are:

• Show fixed investments can be used over long periods to fund spending even with inflation.
• Have a method to determine what a risk-free fixed income investment withdrawl rate could be to compare to other investments.
• Calculates a specific dollar amount needed to fund spending over 30 years in the safest method possible.
• Show the cost of a low risk investment clearly in the low levels of safe withdrawls at today's interst rates.

To Cute Fuzzy Bunny's point on Firecalc, I do not think the calculations are the same. This is different from the Firecalc calculation in this involves direct purchases of bonds maintained at fixed rates and involve only spending of interest income and not bond funds. And the rate of withdrawl is dependent on the current amount of interest income available.

After looking at Htown Harry's very valid claims I added the data available from website listed in Independent's post, back to 1946.

At 50 percent withdrawls several years had failures but at 45 percent initial draw all years from 1946 were successes. (I ignored 2 years with a couple hundred dollar shortfall in the 30th year).


My takeaways from this are:

• Present interest rates make present 45 percent initial withdrawl rate too low at 2.07 percent [4.66 *0.45 = 2.07] for me right now.
• Method show the real impact of inflation, the worst time period was 1966, by the end of 30 years withdrawls needed to increase by 500 percent to meet required spending needs. However the portfolio did end with 15 years of principal in the bond account at the end of 30 years.
• At various points in the 1980's withdrawl rates could have exceeded safe withdrawl rates of the stock market. 1981 would allow for a 6 percent withdrawl. To me this indicates the fear of inflation can become at times overdone by investors in pricing bonds.

As for Texarkandy's question, I do not think this is comparable to your situation. Your potential retirement timeframe is much longer than what I looked at here and your investments mixed maturities do not match what I looked at here. I would not at all reccomend this for you.

I attached the spreadsheet with the updates attached.

[ziggy29]

Quote:

Originally Posted by cute fuzzy bunny Some of these doom and gloom scenarios start sounding to me like the equivalent of the guy thats so scared of what might happen to him that he never leaves the house. Ends up arriving safely at his demise with nothing bad, nor anything good, ever happening.

These scenarios are the times when people who have the capital and willingness to accept the risk can really make a lot of money insuring the risk-aversiveness of the cowards.

[RockOn]

Quote:

Originally Posted by ziggy29 These scenarios are the times when people who have the capital and willingness to accept the risk can really make a lot of money insuring the risk-aversiveness of the cowards.

DId you check the SP500 futures prices tonight? Maybe not so easy there ziggy and CFB.

[ziggy29]

Quote:

Originally Posted by RockOn DId you check the SP500 futures prices tonight? Maybe not so easy there ziggy and CFB.

There are almost always ways to structure insurance products to manage the maximum risk someone can expose themselves to. And in times like these a lot of scared people are willing to pay more than your maximum risk in exchange for their own security and certainty in a market that hates insecurity and uncertainty more than anything else.

[RockOn]

Quote:

Originally Posted by ziggy29 There are almost always ways to structure insurance products to manage the maximum risk someone can expose themselves to. And in times like these a lot of scared people are willing to pay more than your maximum risk in exchange for their own security and certainty in a market that hates insecurity and uncertainty more than anything else.

Very true, but the insurance might end up to be worth it. We really don't know, doesn't the market price insurance efficiently also?

[ziggy29]

Quote:

Originally Posted by RockOn Very true, but the insurance might end up to be worth it. We really don't know, doesn't the market price insurance efficiently also?

At any given time you could price a particular type of "portfolio insurance" with various combinations of options, for one thing. If you can price out the worst possible loss for you by purchasing the required bundle of options, you know how much you'd need to charge.

The problem, of course, is that when things are volatile and bearish put options become very pricey, which means you'd have to charge more to insure the risk. Of course, that keeps it in line with most insurance products anyway: the riskier the situation, the higher the "premium."

[haha]

Quote:

Originally Posted by ziggy29 These scenarios are the times when people who have the capital and willingness to accept the risk can really make a lot of money insuring the risk-aversiveness of the cowards.

I do not think people that see it this way should in any way be called cowards. They are people with high risk aversion, responding to a recent demonstration that risk abounds.

I don't know if this method is being promoted currently; but if it is it is likely a sign that decent rally iin equities is not far off.

Also, speaking to the underlying realities of the method, it is a dead cert loser at times like this when real interst rates on non-CPI treasuries are close to or at zero.

If a person has plenty of money- and I mean plenty, it could be implemented with TIPS, but at the risk of market quotes of your TIPS falling if real rates should rise, a not unlikely posibility. Also, it would take $4 million to throw off enough income to support a lower middle class lifstyle. Not very intere sting to the average person with $4mm!

Ha

[Marquette]

How to invest like an insurance company:

Attachment 4059

From here: https://www.allianzlife.com/AboutAllianzLife/Investments.aspx

a Cash and Cash Equivalents 10%
b Fixed Income 78%
c Equity Securities 0%
d Mortgage Loans 8%
f Investments Options 1%
g Loans to Affiliates 1%
h Real Estate 1%
i Other Invested Assets 1%

[Running_Man]

Quote:

Originally Posted by haha I do not think people that see it this way should in any way be called cowards. They are people with high risk aversion, responding to a recent demonstration that risk abounds. I don't know if this method is being promoted currently; but if it is it is likely a sign that decent rally iin equities is not far off. Also, speaking to the underlying realities of the method, it is a dead cert loser at times like this when real interst rates on non-CPI treasuries are close to or at zero. If a person has plenty of money- and I mean plenty, it could be implemented with TIPS, but at the risk of market quotes of your TIPS falling if real rates should rise, a not unlikely posibility. Also, it would take $4 million to throw off enough income to support a lower middle class lifstyle. Not very intere sting to the average person with $4mm! Ha

Two things, I am not promoting currently, I find it useful to show someone who wants to be ultraconservative with their money how little they can assuredly earn assuming virtually no risk.

As for the chance of failure, the way the math works if you start with 50 percent of the interest and limited the raise in your annual spending by the lower of the inflation rate or the next years 30 year treasury rate, you will never touch your principal. The current interest rate and relation to inflation has no impact on success or failure other than the starting draw as a percentage of portfolio.