Is an Annuity a good way to get over a SWR of 5%?

[JohnEyles]

Does anyone know if they strip TIPS into an interest-only and principal-only part, like they began doing with mortgages 20 years ago (IO's & PO's)? If they do, the interest-only part could IMHO be very useful to some of us. If that doesn't exist, is there a zero-coupon TIPS? It could be shorted against the regular TIPS to create the interest-only piece, and we would have a 30yr annuity at a fair price.

Take a 30-yr TIPS bought at auction with a 2.25% coupon for 100

PV of principal repayment for 30 yrs at 2.25% = 51.30

100 - 51.30 = 48.70 = cost of annuity

2.25/48.70 = 4.6% SWR

I'm not convinced this doesn't exist - I've seen stuff in some articles that alludes
to stripping of TIPS ...

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

but I don't quite understand how strips work. It looks like each individual
(biannual) interest payment is a separate security, rather than just buying
all the interest payments (without the principal return at maturity) in one
fell swoop like you imply. I guess it's simply a procedural thing, and you
just purchase a bunch of the interest payments with staggered maturities.

 

[FIRE'd@51]

I confess, I have not understood this thread since the imaginary product was introduced. I am a little dense on investment details but I suspect some other readers are as well, so humor me and explain this in simple terms. As I understand (or thought I understood) TIPS, you have a coupon rate (e.g. 2.5% over inflation) and a principle amount. At maturity, you are guaranteed to get your principle back plus an income stream for the entire period that = inflation + 2.5% of starting principle (i.e. portfolio). I don't see how you can turn that into a guaranteed 4.6% inflation protected return. Even if you liquidated your principle (to make it equivalent to an SPIA) the return on the principle would depend on the inflation rate - there is no mechanism to inflate the principle.

If what I outlined is not the case, please give me a TIPS basics lesson before tossing out numbers. I would like to understand what this product would look like if it really existed.

The mechanism that "inflates" the principal is inflation. Take your example of a 2.5% coupon, and assume you pay 100 for the TIPS. If inflation is 10% the first year, the adjusted principle will be 110. The 2.5% coupon is applied to the adjusted principal, so your interest payment the second year would be 2.75 (0.025 x 110), and so on. Both the principal and the interest payments are adjusted for inflation (the 2.5% coupon rate stays constant). So when the TIPS matures you get, in addition to the last interest payment, a maturity payment of the inflation-adjusted principal (this way the maturity payment has the same purchasing power as your initial investment). If you were able to sell off this maturity payment (it would be a zero-coupon TIPS), what you would have left would be just the interest payments. At a 2.5% YTM, the PV of a 100 payment 30 years out is 47.67, so the value of the stream of interest payments by themselves would be 100 - 47.67 = 52.33. Thus, your investment would be 52.33 and your current yield (not YTM) would be 2.5/52.33 = 4.8%. This would also be your SWR. So if you invested 100K in this "imaginary security", you would collect a SWR of $4800 annually for 30 years. There would be no maturity payment to you because you sold that off when you initially bought the TIPS. But you would have a guaranteed SWR of $4800 which would be adjusted for inflation each year.

In the example I presented earlier in this thread I used the current rate for a 30-year TIPS of 2.25%. The same analysis as above would provide a SWR of 4.6%, or $4600 per year on a $100K investment. I played around a bit with the Vanguard annuity calculator for a 60 year-old male. A life only SPIA (with CPI inflation adjustments subject to the 10% cap) that would provide $4600 per yeaar costs $92.8K (a 5% SWR). If you were to add a 30-year guarantee, the price rises to $113.7K (a 4% SWR). So the value of the 30-year guarantee is substantial, nearly $21K. The TIPS structure I was talking about would cost $100K. It has the 30-year guarantee, but does not have the extra protection should you live beyond 30 years, which appears to have a value of $13.7K (113.7 - 100). Of course, fees are also embedded in the price of the Vanguard SPIA, so we would need a separate calculation of what the "back-end" (years beyond 30) is worth to be able to extract the fees. It looks like there is enough information in the actuarial life table on the SS website to do this calculation, but I haven't done it yet. In any case, as was mentioned before, it seems to boil down to how a given individual looks at the trade-off of dying early vs living beyond 30 years, and how much he is willing to pay for that protection. All I'm trying to do here is present my thoughts on how to analyze the financial aspects of this decision. Whatever our decision, we don't want to overpay for it, if there is a cheaper way to achieve it.

I think we are all pretty much in agreement that, for those of us who want an annuity at age 70, delaying SS seems to be the best way to achieve it, given that we have already paid (overpaid?) for our SS benefits.

 

[FIRE'd@51]

Me too. My best guess is it either looks something like this...

...or sometihing like this.

More like this since the discounted maturity payment is about half the total PV