Risk-Adverse Investor Needs Advice

[robert]

Hello,

I am 55 years old and would like to retire in 3 - 4 years. By that time my wife and I willl have about $1 million in liquid assets divided among our IRA accounts, savings bonds, cd's and stocks. We have no real estate. Our goal is for that $1 million to generate enough income to provide us with $25,000 per year, plus enough income to maintain the principle against the effects of inflation. We both have very little tolerance to risk. In this environment of ultra-low interest rates is our goal achievable, and if so, what is the optimal investment vehicle, or investment mix?

Thanks!

Robert & Maricel

 

[Nords]

Re:  OK, I'll jump in.

Theoretically that small a withdrawal (2.5%) could be handled by a portfolio consisting only of TIPS or I bonds. But there are problems with both of those approaches.

It sounds like you're trying to choose an asset allocation that supports your risk tolerance, which is straight out of Bernstein's "Four Pillars of Investing" book. We'll no doubt talk your eyes off with suggestions, but the principles & examples are found in that book.

 

[charlie]

Robert,

With all due respect to Nords, I don't think a 100%
allocation to TIPS would cut it. Vanguard's TIPS
fund pays less than 1% plus inflation which is
about 1.6% currently. If you took the whole 2.6%
each year, your principal would not grow with
inflation.

IMHO, a 40/60 stock/Bond allocation sounds about
right for you. 60% in something like Vanguard"s
GNMA fund would give you the $25K per year for
expenses. 40% in well diversified stock index
funds would give you about 4% overall growth if
past is prologue.

Treat ALL of your financial assets as one portfolio.

For tax efficiency, put your high yield stuff in your
IRA's as much as possible. If you wait until 59.5
to retire, you can withdraw from your IRA penalty
free. Vanguard's Total Stock Market Index is an
excellent choice for your after tax accounts. Then
add funds like Value Index, Small Cap Value, REIT
and some international funds to your IRA to bring
your total stock allocation to 40%. These may
sound risky but on average your total portfolio
will have higher return with overall lower risk. The
trick is to decide on a fixed allocation for each type
of fund then re-balance faithfully every year. This
will force you to "buy low, sell high".

If all of this sounds too complicated and you don't
have the stomach for re-balancing, then look into
Vanguard's balanced index funds like Balanced Index,
the Life Strategy series or the Target Retirement
series.

A lot of people would kill for a $1,000,000 poke.
You should be OK for a total withdrawal up to about
4%. Play around with the FIREcalc calculator at the
top of the page to run sanity checks.

Cheers,

Charlie (aka Chuck-Lyn)

 

[Cut-Throat]

Robert,

You did not mention if you wanted the $1Mil after you died. IOW - to leave an estate. If you are not interested in that 100% TIPS would do just fine.

$1 Mil divided by 40 years will yield 25K that is Inflation protected with Zero Growth! - Any return at all over and above inflation will make the money last even longer.

Even with a 1% return in TIPS your money would last over 50 years and be inflation protected. That would make you over 105!

 

[wabmester]

Vanguard's TIPS
fund pays less than 1% plus inflation which is
about 1.6% currently.

Just some alternative numbers for you:

10-year TIPS real yield as of 4/15/04 = 1.93%
Inflation for month of March = 0.5% (annualizes to 6.0%)

 

[Bob_Smith]

Robert, I'm with some of the other posters. TIPS would provide the $25,000 you seek with minimal risk. I think the biggest risks are these:

1. That your personal inflation rate will significantly exceed the CPI. Retirees paying for health insurance are at great risk here. I will be one of those and that's what keeps me away from a 100% TIPS allocation. Otherwise I'd be in with both feet.

2. There's a risk that the govt. will understate inflation. I think they're already doing that.

3. There's the risk of default, but if that were to occur, all bets are off anyway.

TIPS can be purchased on the secondary market today at 2.26% (yield to maturity) that mature in about 25 years. But the actual yield would be higher (the income you recieve periodically would be more than 2.26%) so if you were only spending $25,000, you'd need to find a place to reinvest the rest, and therein lies another small risk you'd face.

Although a 100% TIPS allocation has appeal, I have decided not to do that. I'll have a mix of TIPS (about 1/3) and the rest will be in the Total Stock Market/International Growth fund (about 40%), REITS (about 5%), and the rest in a mix of bond funds and CDs.

Good luck!

 

[cute fuzzy bunny]

I'm with this bunch. Although rather than piecemealing it, I'd go with lifestrategy income, target retirement income, or if you like the managed funds, either vanguard wellesley or dodge and cox balanced funds.

The latter two have low volatility and their weakest 3, 5 and 10 years returns over the past 20-something years exceeds your withdrawal requirements. Both focus on large cap value stocks and short to intermediate term high quality bonds.

Of the two index funds of funds, lifestrategy income and target retirement income, lifestrategy is more aggressive, containing stock and bond components but also using the target allocation fund that swings holdings between stocks and bonds when those markets are favorable, and it holds a big chunk in the short term corporate bond fund. Collectively this will give you a higher return with a small but manageable increase in volatility.

Target retirement has a smaller potential stock component, includes TIPS for inflation protection, and should have lower volatility than the lifestrategy. It hasnt been in existence long enough to create a track record like the other three, but its probably the "safest", "least volatile", and will certainly throw off enough to pay the withdrawal you seek and keep up with inflation.

Fund costs are .22, .27, .20 and .54 for target retirement, lifestrategy income, wellesley (admiral) and dodge and cox respectively. Dirt cheap.

I'm in the wellesley fund right now. Cheaper than some indexes, never had two losing years in a row, never had a double digit loss, always recovered from a losing year in the next years gains, always paid more than a 3% net dividend yield. Probably going to take a losing year this year or next due to impending likely interest rate hikes, but it should be under 10% and it should recover the next year.

 

[charlie]

Wabmester,

I was surprised by your TIPS numbers, so I looked
up Vanguard's TIPS fund data. The fund currently
pays 0.90% "real" interest plus inflation. The
inflation rate is some sort of rolling average but
I seriously doubt that the average is 6% currently.
The stated yield to maturity is currently 1.1%. The
difference between 1.1% and 0.9% is the fund
expenses (approximately). Of course you can
buy 2.5% coupon TIPS bonds ion the market but they
will cost you more than the issued price. Pay your
money and take your choice.

As far as a 100% commitment to TIPS, I ran the
numbers using FIREcalc. For a 50 year period, his
portfolio had a 66.7% survival with an average
terminal value of $712,466. This was using an
initial withdrawal of $25,000 and a 0.18% expense
ratio. Unless I am confused about the terminal value,
that is in today's dollars. At 3% inflation for 50 years
the terminal value would actually be worth only
about $162,518.

For 40 years, there is a 95.5% survival with an average
ending value of $942,971,

Cheers,

Charlie (aka Chuck-Lyn)

 

[wabmester]

Charlie, there are two ways to interpret the Vanguard numbers:

1) Avoid bond funds because you can't trust their stale numbers.

2) Avoid bond funds because your yield will be better with direct ownership of bonds.

Both are true  

I believe Vanguard gives you the "SEC Yield" which is basically an annualized version of last month's yield less expenses.   Rates have gone up quite a bit since last month.   The number I gave you was the most current yield of the 10-year, and has nothing to do with the bond's coupon.

Likewise, I gave you an accurate inflation number as computed by the same guys who compute the CPI.  Whether it is useful to annualize the inflation seen in March is debatable, but you can be sure that the next published annual CPI number will be much higher than the last value.

The terminal value given by FIREcalc is pretty useless.  It is an average of terminal values for all periods examined, with inflation of those particular periods factored into each end value.   So, it's not in present dollars, it's not in "real" dollars, it's in some meaningless unit that is impossible to interpret.

 

[charlie]

Wabmester,

That sound you hear is me eating humble pie.

I looked up the numbers on "Treasury Direct" and
found you are exactly correct. The 10 year issued
on 4/15/04 had a 2% coupon and showed a
current price of $102.189 per $100 at the time
they posted the numbers.

This is not the first time I have been fooled by
Vanguard's numbers. On another thread I
complained bitterly about the REIT numbers and
even wrote the chairman but got no response.

Thanks for setting things straight.

Cheers,

Charlie (aka Chuck-Lyn)

 

[JWR1945]

For Robert & Maricel: I think that it is clear cut that you can count on getting your $25K (plus inflation) at virtually no risk.

I will point to long-term TIPS purchased on the secondary market as an excellent starting point. It is important to consider taxes. Unless TIPS are held in a sheltered account, you have to pay taxes immediately on any increase in principal to match inflation. If not TIPS, you might choose ibonds, which have a more favorable tax situation outside of sheltered accounts.

But I don't want to end here. I suspect that you can further divide that $25K into a part that you absolutely cannot do without and another part for which you are willing to take a little bit of risk, but not much, in the hope of a substantially greater reward.

Having said that, I view the current opportunities for a substantial reward for any amount of risk to be bleak. You will find that many famous and successful investors cannot find anywhere to invest.

I expect things to change within a few years. The stock market usually has some very big swings, including swings opposite of any long-term trend. You will not find steady advances or declines.

For now, it is sufficient to be on the sidelines. This attitude is a radical change for me personally. I had previously been long-term buy-and-hold all-the-way. These days, I am slowly adding to cash.

Have fun.

John R.

 

[Bob_Smith]

As far as a 100% commitment to TIPS, I ran the numbers using FIREcalc.  For a 50 year period, his portfolio had a 66.7% survival with an average terminal value of $712,466.  This was using an initial withdrawal of $25,000  and a 0.18% expense ratio.

Charlie, I got a 100% survival rate for 50 years with TIPS at 2.26% YTM (which could have been purchased on the secondary market today). That would have been for TIPS that mature in 2029. Of course he would have had the reinvestment (and other) risks mentioned previously.

 

[Bob_Smith]

For now, it is sufficient to be on the sidelines. This attitude is a radical change for me personally. I had previously been long-term buy-and-hold all-the-way. These days, I am slowly adding to cash.

John, what is your exposure to the stock market presently? Are you in the process of moving to 0% or just lightening up?

 

[charlie]

Bob,

I guess I need a refresher course in Eco 101.

1) How do you calculate YTM on a TIPS bond when
you don't know the terminal value?

2) If I gave you $1000 to invest in TIPS bonds
How would you choose? It seems to me that
a new 10 year TIPS with a 2% coupon is equivalent
to an older TIPS with a higher coupon that costs
more because of the accumulated inflation and
yield premium.

IMHO, you should use 2% in FIREcalc for TIPS.

Please let me know where I am going wrong. It
won't be the first time (see profuse apology to Wab
upstream)

Cheers,

Charlie (aka Chuck-Lyn)

 

[Bob_Smith]

GDER, I suppose anything is possible, but they are non-callable, so if the treasury called them it would be tantamount to default. And you're right about reinvestment. At the moment you can lock in until 2032 - no longer.

 

[Bob_Smith]

1) How do you calculate YTM on a TIPS bond when you don't know the terminal value?

2) If I gave you $1000 to invest in TIPS bonds How would you choose?  It seems to me that a new 10 year TIPS with a 2% coupon is equivalent to an older TIPS with a higher coupon that costs more because of the accumulated inflation and yield premium.

IMHO, you should use 2% in FIREcalc for TIPS.

Charlie, I believe the YTM is the real yield one would get over the life remaining on the bond that has been purchased on the secondary market, but that only applies to those who actually hold to maturity. You're correct that there would be no way of knowing what the nominal yield will eventually be at maturity, but you can know what the real yield will be at maturity (unless there is a long deflationary scenario in which case the YTM could be higher - but not lower). Yesterday one could have purchased 30 year TIPS (with around 25 years remaining) for 2.26% YTM. So that's what I used in FIRECalc.

Regarding your second comment, I think you're right. The advantage of buying at auction is that it is free. But there are also a couple of advantages to the secondary market:
1) It's the only place I can buy long term TIPS, and that's what I want - if I can lock in at 2.5%.
2) I like the fact that the older TIPS with higher coupons throw off more income than the newer TIPS with lower rates. While the YTM on the two may be the same, I plan to spend around 3%-3.5% of my portfolio. So I'd rather have more of it in interest payments. It reduces the need to sell off bonds to meet income needs in my situation.
3) I can buy today, if I like the rates, without waiting for an auction.

 

[JWR1945]

Bob_Smith

John, what is your exposure to the stock market presently? Are you in the process of moving to 0% or just lightening up?

First, understand that I do not anticipate ever drawing from my stock holdings. My Federal Government pension (with the old CSRS system, not FERS) is more than sufficient to meet my needs.

I have examined each of my holdings. My basic question is whether a stock makes sense at current valuations and whether is would make sense if earnings doubled. For those that make sense even today, I am holding on.

For those that don't make sense even if earnings were to double overnight, I am selling gradually. I am willing to wait throughout the entire year, if necessary, to get a good price. I have already cut back to almost half of my original positions. I am willing to hold on to what remains if prices do not improve. But I would rather sell.

I have one stock which I have already written off mentally as being worthless. It did not hit zero, but it got close. I do not consider it to be worth the effort to sell it. As it happens, it has rallied quite a bit (with new management) and it may turn out favorably after all. But as far as my mental accounting is concerned, I still value it at zero. You might say that I think of it as a call option, which is likely to end up worthless but which might turn out to be spectacularly successful.

I bought some shares of Merck recently at what I consider to be an unusually favorable price. It is priced as if it will never replenish its drug pipeline.

I do not see a need to go to zero. I am willing to add when I think that I see an unusually favorable situation. My guess is that I will end up with about 40% to 50% cash.

Have fun.

John R.

 

[charlie]

Bob, thanks for your reply. I assume from your
comments that the YTM of an older TIPS with
a higher coupon is just the coupon rate divided
by the price paid plus commission. Right?

I am still a little foggy on why older TIPS pay
2.26% vs new TIPS paying 2.0% (approximately).

Is it because the market perceives that older TIPS
are more risky? Intuitively it seems that the risk of
longer term TIPS should be the same as shorter
term since inflation risk has been eliminated.

I guess it is in the eye of the beholder. For a person
who is certain to hold to maturity the extra yield is
a plus. For those who might have to sell prematurely
the premium compensates for the risk.

BTW do you have a good link where one can look up
current TIPS prices on the market?

John Galt would know all about this, I think.

Thanks again,

Charlie (aka Chuck-Lyn)

 

[JWR1945]

I assume from your comments that the YTM of an older TIPS with a higher coupon is just the coupon rate divided by the price paid plus commission. Right?

Close. It is a little bit more complicated. The principal at maturity is $1000 plus inflation. It does not include the premium that you must pay for the older TIPS.

Inflation is not the only factor affecting prices.

At any specified real interest rate, TIPS become more or less attractive as the (expected) return of other investments change. Since most returns are low at this time, people are willing to buy TIPS at similar, but low, real interest rates. In the future when real interest rates increase in general, people will demand higher interest rates from TIPS.

At the same time, bonds in general (and this includes TIPS) compete with other investments such as stocks. Stock prices are high these days. This limits their upward potential and it makes them less attractive than normal.

Of course, prices vary with the time remaining until maturity (i.e., the yield curve). Today's TIPS have maturities of ten years or less. To lock in a longer term, you must purchase older TIPS on the secondary market.

Have fun.

John R.

 

[Bob_Smith]

I am still a little foggy on why older TIPS pay 2.26% vs new TIPS paying 2.0% (approximately).  

BTW do you have a good link where one can look up
current TIPS prices on the market?

Hi Charlie,

The difference in the yield is largely due to the time left to maturity. The 2.26% bonds have more risk in that they have ~25 more years until maturity. The new TIPS are shorter term. Also, keep in mind that some of the older TIPS on the secondary market throw off more interest than the newer TIPS which have the same maturity date, simply because the coupon may be higher on the older bond/note. They may very well have close to the same yield to maturity, yet one throws off more interest. That is a small plus in my situation.

I check rates through my brokerage account at Vanguard. I just go to the "buy" page and the bond desk has current TIPS prices for various maturities. I don't know how often they refresh the prices, but they are a little off. If I want to know the YTM exactly, I must pretend that I'm buying one - it throws up a warning that the price has changed a bit and the amount. Then I can back out before completing the transaction.

If you don't have a brokerage account you can check here and get pretty close:
http://www.bloomberg.com/markets/rates/index.html

And by the way, John Galt is NOT a fan of TIPS. He has stated that here before, and although I have a lot of respect for John, this is an area where we disagree.

 

[charlie]

Many thanks, Bob

Charlie

 

[JustPassingby]

Risk-Adverse

It's Risk Averse. Not "Risk Adverse"

 

[cute fuzzy bunny]

Its entirely possible that he was talking about a fear of musical commercials.

But thank you, Mr. Language Person!