Please Help Me Form a Portfolio for ER

[BunsGettingFirm]

I'm interested in ERing in 8-10 years when I'm 41-43. The thing is, like a lot of wage slaves, I have two nest eggs. I'm not too concerned with my tax-deferred accounts because they have been fully funded for the last 10 years and will be fully funded for the next 10 if all goes well, and I will be maxed out as far as S.S. benefits are concerned, so it makes no sense for me to work more in the hope of collecting more S.S.

What I'm concerned about are my taxable accounts. If I want to achieve a relatively conservative 50-50 stock-TIPS mix in 10 years, should I start buying TIPS now, or wait until I sell my house in 10 years and use the proceeds to buy TIPs? What do I do with my current taxable accounts? The mix is currently 20-80 stocks vs. cash/bonds in my taxable accounts. Please note that I plan to have my taxable accounts last the 17 years between my ER and my being able to tap my 401(k) and IRAs.

Another question is about TIPS. The term on TIPS is 10 years. How do I build a ladder using TIPS? Thanks!

[Bob_Smith]

BunsOfVeal,

Regarding the TIPS ladder - you can buy what you need on the secondary market. Here is what Vanguard's Brokerage has listed for TIPS right now. I've included the maturity date and the current offer yield:

04/15/2032 ----1.859
04/15/2032 ----1.841
04/15/2029 ----1.934 *
04/15/2029 ----1.915 *
04/15/2028 ----1.939
04/15/2028 ----1.924
01/15/2014 ----1.434
01/15/2014 ----1.4
07/15/2013 ----1.372
07/15/2013 ----1.333
07/15/2012 ----1.23 *
07/15/2012 ----1.228
01/15/2012 ----1.141
01/15/2012 ----1.134
01/15/2011 ----0.941
01/15/2011 ----0.938
01/15/2010 ----0.718
01/15/2010 ----0.706
01/15/2009 ----0.487
01/15/2009 ----0.476
01/15/2008 ----0.164
01/15/2008 ----0.132

I am waiting for a yield of 2.5%, or thereabouts. With rates so low I hate to jump in now. On the other hand, nobody knows if/when real rates will go up. I just bought a 4 year and a 5 year CD at 4.5% and 5.25% respectively at Penfed. There's a 6 month penalty for early withdrawal. You could park the money in a 5 year CD and wait. If TIPS yields go up, take the penalty and move to TIPS. Even if you pull out at the end of the first year, you'd still yield over 2%, even with the penalty. If TIPS yields don't go up, 5.25% isn't too bad right now considering the alternatives. Beats sitting in cash. Just a thought - someone else may have a better solution.

[Nords]

I don't mean to preach-- you sound like you know what you're doing-- but at the risk of repeating what you already know I'll cover the entire subject for those who haven't seen it all before.

As much as I've questioned his conclusions, Bernstein's "Four Pillars of Investing" is a wonderful summary of all the other dozens of books & papers that I've read in the last 10 years. It also contains a couple "how to" examples at the end with taxable & non-taxable scenarios. He doesn't have a lot of charity for TIPS, for example-- http://www.efficientfrontier.com/t4poi/Ch1.htm

You can find more by entering a search at Google and limiting it to Bernstein's website. For example, try entering "site:efficientfrontier.com TIPS" in the Google box.

Conventional wisdom says that TIPS shouldn't be held in a taxable account because you'll pay annual taxes on the "phantom income" imputed by their annual inflation adjustments. That means most individual TIPS are being bought for retirement accounts, but you can't do that by yourself for your own conventional IRA and custodians charge a lot of money for the privilege, so most TIPS investors end up buying TIPS funds for their IRAs. (I don't know about other tax-deferred account rules.) Sure hope it works out OK.

Another option is I bonds. You build your TIPS/I bond ladder from Treasury Direct (http://www.treasurydirect.gov); details are at http://www.publicdebt.treas.gov/mar/martdibond.htm . Unfortunately I bond purchases are limited to $30K per SSN (e.g., $60K per couple) per year and they're 30-year bonds. If you sold them on the secondary market during rising interest rates you'd get hammered.

A TIPS ladder would consist of buying these 10-year notes every 6-12 months at Treasury Direct. Details are at http://www.publicdebt.treas.gov/sec/seciis.htm You link your checking account to the U.S. govt, they suck out a bunch of money and e-mail you a receipt, and you're an "investor". It's a simple as that!

If I have a gripe with Bernstein, it's his "bonds-bonds-bonds" rant. I get asset allocation, I really do, but I'm reluctant to buy even a short-term fund (and pay its attendant expenses) in an environment of low interest rates that can rise "any day now". The effect of rising rates from 5% to 6% isn't too terrible, but the effect of hiking rates from 1% to 2% would be pretty harsh. (Admittedly by a factor of five!) But I haven't seen any studies on that rising-rates problem and I suspect Bernstein hasn't either.

What I want to see is a study examining the effects of an equity portfolio leavened with not bonds but good ol' fashioned cash. The alternative I'm considering is a ladder of five-year CDs. As Bob_Smith has pointed out, PenFed is paying 5% and so is the behemoth NFCU (http://www.navyfcu.org/). You could buy a five-year CD every year and keep rolling them over, or you could buy a series of 1-5 year CDs and keep rolling them into five-year CDs. Either way you'll do far better after taxes than TIPS' 2%. Since you're renewing a five-year CD every year, you don't run much risk of rates (or inflation) going over 5% before your CD is up for renewal...

So over the next 10 years this program could slowly work our retirement portfolio from 100/0 stocks/cash to 90/10. Maybe by then I'll have made up my mind about small growth, too, but that's another subject.

[Brat]

I have TIPS in IRAs, IMHO that is where they belong because the holder will be paying taxes on the interest along the way. They are not tax efficient. Don't hang your hat on an index Uncle controls, keep diversified.

Find a tax efficient index fund, or an exchange traded fund. As I look over the "Callan Periodic Table of Investment Returns" the Russell 2000 Value index appears to provide steady growth with few stinky years.

Realestate investment trusts have had a huge run-up the last year, I think they are too expensive now.

For mutual funds check out http://www.brill.com/wwwboard/

and

http://www.fundalarm.com/wwwboard/wwwboard.html

[Bob_Smith]

Quote:

That means most individual TIPS are being bought for retirement accounts, but you can't do that by yourself for your own conventional IRA and custodians charge a lot of money for the privilege, so most TIPS investors end up buying TIPS funds for their IRAs.

Sure you can. You can buy TIPS on the secondary market for your IRA. There is a nominal one-time charge for the trade, plus an annual account fee to maintain the brokerage account. Costs would be less than the annual expense ratio for Vanguard's TIPS fund. In fact, lower costs are one of the advantages over a fund.

[charlie]

Nords,

I have been enjoying your posts very much. I probably
misunderstood you but there are a couple of points
I would like to make.

1) I-bonds are not available on the secondary market.
If you sell an I Bond, you sell at the face value plus
growth due to inflation.

2) A short duration bond fund like Vanguard Short
term corporate currentlly has a duration of 2 years.
This means that if interest rates rise 1%, the fund
will lose only 2% of the NAV. Intermediate term
bond funds generally have a duration of 4-6 years.
Thus they would lose 4-6% for a 1% rise in rates.

You probably aready are aware of this but I felt like a
clarification might be helpful to others.

Regards,

Charlie

[BunsGettingFirm]

Thanks to Bob, Nords, and Charlie. I did learn something! I got the idea that TIPS is suppose to be a great investment from the FIRECalc, but it doesn't appear to be so great for the accumulationg phase of my ER plan.

I think I'll slowly build up my Vanguard Total Market Index after having sold couple of managed Fidelity funds. I'll work my way up to 70-30 equites vs. cash and bonds over the next 5 years, with the 1/3 the cash in a 4-year CD ladder, 1/3 in Vanguard Short Term Corporate, and 1/3 in and Orange Savings Account as an emergency fund.

BOV,

You are on the right track. Nords mentioned it, but you should read Bernstein's "Four Pillars of Investing Also!" It will solidify your plan.

[charlie]

Buns,

I get the impression that you are in your early
30's thus a 70/30 asset allocation is appropriate.

Your choices sound great. Vanguard's Total
Stock Market fund is an excellent choice for
both taxable and sheltered accounts. Your
bond/cash choices are sound as well.

Remember that keeping your ratio constant is
very important. This forces you to sell high and
buy low. Most folks recommend rebalancing yearlly.
Since both your equity and bond funds are at
Vanguard, you can do this with one phone call.

Regards,

Charlie

[charlie]

Buns,

P.S. The experts recommend that you should
treat all your financial assets as one portfolio,
regardless if they are taxable or sheltered.

Thus rebalancing of your total portfolio should
be done by shifting funds within your sheltered
account. This will avoid causing "taxable events".

Forgive me if this is all obvious.


Regards,

Charlie

[wabmester]

Quote:

He doesn't have a lot of charity for TIPS

I missed the part where Bernstein didn't like TIPS. Could you elaborate?

Quote:

Conventional wisdom says that TIPS shouldn't be held in a taxable account because you'll pay annual taxes on the "phantom income" imputed by their annual inflation adjustments.

Slightly less convential wisdom says TIPS are state-tax free and that "phantom income" is identical to reinvested interest, so if you're in a high-tax state or you don't need to spend all of your bond income, then a taxable account is A-OK.

Quote:

Unfortunately I bond purchases are limited to $30K per SSN (e.g., $60K per couple) per year and they're 30-year bonds. *If you sold them on the secondary market during rising interest rates you'd get hammered.

These days up to $60K per SSN for bond i-bonds and ee-bonds. Both of them are essentially 5-year bonds that you can let mature for up to 30-years and for as little as 1-year (with small penalty). There is no secondary market, but the bonds are really a great deal compared to other 5-year treasuries.

Quote:

But I haven't seen any studies on that rising-rates problem and I suspect Bernstein hasn't either.

Please don't take offense, but I think this is simply a misunderstanding of how bonds and bond funds work. There's nothing to "study" as far as I know. Basically, you'll get the yield you signed up for if you hold a bond to maturity or if you hold a bond fund for the average maturity of the fund. It's all (relatively) simple present value calculations -- bond behavior is utterly predictable given any interest rate move.

Bernstein and others have looked at bond correlations with equities over time periods that include both rising and falling interest rate periods, and his recommendation to include bonds in your portfolio is perfectly sane. They will reduce volatility without reducing returns over time -- free lunch!

[wzd]

Quote:

Bernstein and others have looked at bond correlations with equities over time periods that include both rising and falling interest rate periods, and his recommendation to include bonds in your portfolio is perfectly sane. They will reduce volatility without reducing returns over time -- free lunch!

yes, that is true in general, but I agree with others that an investment that has little upside and major downside may not make as much sense as the general rule indicates. I like the short term interest instruments others have mentioned (like penfed) better. This may be playing the market....but when I can't find the downside of it compared to the passive strategy, I think I will do it.

If you look at PenFed 5 year rates, and calculate the cost of cashing in early, you will find that the 5 yr CD is a good deal. I posted calculated rates for early redemption earlier on one of these boards.

For inflation adjusted instruments, I agree with your I bond sentiments.

Wayne

Hello Wayne! Re. bonds in general, as long as they pay
the interest, it ain't a loss unless you sell it. Sooooooooo, absent default or a forced sale there is no downside, other than missing
a POSSIBLE run-up in stock prices/interest rates. I can't run my ER
based on what might happen. Cut-Throat is right in that we have less control
over our lives than we like to think. Removing
uncertainty is a useful ER tool.

John Galt

[wabmester]

Wayne, I'm also a market timer who loves PenFed I loaded up the truck with their 6%-ers last year and the 5.25%'s this year.

Bernstein and others recommend a total market approach to income, which basically means that when you need cash, you sell an appreciated asset. CD's can't appreciate (or depreciate), which is why they aren't as suitable for asset allocation a la Bernstein.

John Galt, holding and selling bonds is kind of strange. If your bonds lose value and you continue to hold to maturity, that basically means you're making a decision not to buy a higher yielding instrument at that time = opportunity cost. Conversely, if you sell at a loss, you don't really lose anything as long as you use the proceeds to buy a new bond at the market rate. Your yield rises which directly offsets your capital loss.

[Brat]

For folks in the accumulation stage and willing to go the index fund route there is a tool out there that will recommend investments in and out of IRAs to meet retirement goals. Look at www.financialengines.com

[Nords]

OK, everyone, it's clear that I haven't spent my ER learning about bonds. My apologies to those who may have been misled by my second-hand info. Let me try to elucidate (or at least elaborate.)

Although I guess you can buy just about anything on the secondary market, I hesitate to pay the spread on a low-interest bond when you can accomplish the same goal from the originator. I know the secondary market helps build a bond ladder, but I'd work around it to accomplish the same objective at a lower cost (although perhaps over a longer time with more hassle). So I don't know squat about the secondary bond markets, as I ably demonstrated earlier. If I ever did buy a bond, I'd buy it from the cheapest source possible-- probably the issuer-- and hold it until maturity. But I still don't think you can buy your own TIPS for your own IRA. I think your custodian has to do that for you, of course with a fee. That one-time fee is lower than paying annual expense ratios, but the fee is still higher than doing it via Treasury Direct.

Here's what I was surprised to learn about I bond purchase limits at the Treasury Direct website (http://www.publicdebt.treas.gov/sav/sbilimit.htm):
"You can purchase up to $30,000 worth of paper I Bonds in your name and Social Security Number each calendar year. In addition, you can purchase up to $30,000 in I Bonds through TreasuryDirect. In a co-ownership situation, the issue price of the I Bond applies toward the annual purchases of the co-owner whose name and Social Security Number appears on the bond. The purchase limit for I Bonds isn't affected by the purchases of Series EE Bonds. I Bonds purchased as gifts using your own Social Security Number (because you didn't know the recipient's) won't count towards your annual purchase limit; however, they will count towards the annual purchase limit of the gift recipient." So technically a married couple could acquire up to $120K I bonds in one year, more if you don't put the recipient's SSN on them.

I included a link to Bernstein's "Four Pillars" book with a comment about TIPS. There's no specific quote in that linked Chapter 1 regarding my opinion of Bernstein's evaluation of TIPS but here's a couple quotes from the book: "Some have recently argued that TIPS should also be considered riskless, in spite of their long maturities, because they are not negatively affected by inflation." "At a minimum, however, some commitment to TIPS in your sheltered account is probably not a bad idea." Those sure are a lot of qualifiers-- "some have argued", "in spite of", "some commitment", "probably not a bad idea"-- and they're a strong contrast to his writing in the rest of the book. I think that when Bernstein mentions TIPS, he does it as quickly as he can and he moves on. He certainly doesn't rave about them as he does his favorite stock categories and index funds. I didn't intend to imply that he doesn't like them-- I would have said that plainly. But I do believe that he favors other alternatives.

I agree that we all think we know what's going to happen to bonds & bond funds when interest rates start going back up. But I don't think we've raised rates from these 40-year lows under current market fluidity & volatility conditions, and certainly never with as much analysis capability & reaction speed as we currently have (which may or may not be a good thing). We've all seen what Greenspan & Snow & Rubin were able to do to the markets with poorly-timed remarks, and I'd hate to see the Fed overcompensate and lose control of inflation. When everyone can stampede for the trading exits at the same time with low transaction costs, like the LTCM squeeze, I suspect that the volatile swings in bond-fund NAVs and bond prices will be impressive. It'll be a blip on the long-term radar, sure, but it'll be a lot worse than the "last time" we did this. In other words, I'm essentially claiming that "this time it's really different". And I'm not joining the game.

I'd hold a bond to maturity, not a bond fund. But if I was going to hold a bond fund, I'd hold it for the duration. However Wab raises good points that would keep me from jumping into both bonds & bond funds. In addition, personally I can't stand paying mutual fund expenses-- bond fund expenses sound like the worst of a bad bunch. It's time for someone to do to bond expenses what Charles Schwab did for commissions and John Bogle did to stock-fund expenses.

So while many count on their bond income to supplement their other cash flows, we don't. We have a govt pension (with a COLA) supplemented by a 100% stock portfolio, so perhaps this approach isn't for everyone. We keep a two-year cash stash that's replenished from stock sales (at long-term cap gains rates), stock dividends, or stock mutual fund distributions. I've come to see the wisdom of Bernstein's SHORT-term bond philosophy on portfolio volatility, but I'm going to implement that with a ladder of five-year CDs. I think it's a lower-cost approach, it resolves a couple personal family issues, and it certainly gives the stock portfolio more recovery time from the worst that we've ever seen. Maybe Bernstein will discuss cash as a volatility-damper in his next book-- I hope so, because I think this is an exceptionally treacherous time for bonds. But again, I've demonstrated that I hold a lot of mistaken impressions in the bond area.

[ats5g]

I'm certainly not an expert on bonds either, but...

Why is everyone expecting interest rates to rise?

B/c they're at their lowest rates in 40 years? So what? There is no evidence of RTM in interest rates or bonds. Stocks are at their lowest yields (highest prices). Future returns are likely going to be lower. We'll just have to deal with that.

Everyone's fears and thoughts about rising interest rates and inflation are already priced into current bonds' yields. Here's a quote from a M* discussion I thought was very on point:

Quote:

It's been proven that predicting rate changes is just as difficult as predicting stock market changes. Even fed moves are impossible to predict - and if you think you can benefit, think again. Notice next time the fed moves, that interest rates the following day hardly move at all. Why? Because the move is priced in by the efficient bond market. Investors, gurus, media have been literally shouting about rate increases for - boy, at least 2 years. Guess what? They've been sitting in 1% bonds, while people ingnoring the noise are still getting 4%. No reason "now" is the time to move. Further, let's say rates do rise (SHORT TERM RATES - since that's mostly all the fed controls (though they can slightly move other maturities). So what? Tell me where it says that long bonds need to get killed in price - or fall in price at all. If anything this still steep yld curve will flatten a bit. And once that happens, who says investors won't move from short to long bonds since perceived risk is gone - actually raising long bonds.

If you cannot stand volatility in your bonds/fixed income (possibly b/c you're withdrawing from your portfolio in retirement) then things like ST bonds, CD's make a lot of sense. They're very good diversifiers of equities in a portfolio. There may be reasons to use bond fund over ind bonds. If you're going to use Corp bonds, muni bonds, mortgage bonds, and you don't have a lot of money, a low cost bond fund would likely be cheaper.

Having a whole lot of cash sitting in MM waiting for interest rates to rise is a bad move (IMO). You miss out on the higher interest rates (especially now with the yield curve so steep). Since the yield curve is steep, interest rates have to rise quite a bit for "the waiter" to make more money over time that the "non-waiter". Staying very, very short has large opportunity costs.

If interest rates never rise enough for your tastes, you may never invest in bonds again, and may be stuck with paltry MM returns. Just like waiting for stock prices to "come back down" - e.g. Ben Stein's strategy. What if this never happens? Future returns are likely to be low at these high prices and low yields. We're just going to have to accept that.

- Alec

[cute fuzzy bunny]

Re: buying more than the 'standard share' of bonds, I know that when I was a kid my dad bought his allotted share and then bought another equal share using both his and my names. So if you have kids, perhaps you can use the same strategy. Half of his EE bonds still bear my name as well as his.

Re: bonds. I think its probably inevitable we'll see some rate rise, if nothing else to give the fed more breathing room to cut if the economy stalls out again. At least a half point. But I doubt if it will happen this year.

With regards to the imputed banging of the bond funds, I admit it was a cursory look but even during what were considered "horrific" years for bonds most of the bond funds I looked at took a 5-10% ding, still paid their dividends, and got it all back and then some the following year. Clearly its best to buy in "at the low" if you can wait that long and/or figure out when that will happen for sure.

On the other hand, when you can buy a pretty darn good stock that pays a dividend in the 2.5-4% range, and find 5 year cd's with 4.5-5.5% interest rates, it makes anything except high yield and 30 year treasuries look like a bad bet...and the risk factor on high yields and 30 year treasuries doesnt match the return at this point.

Unfortunately 5% wont cut it for a SWR factor even with this paltry inflation rate. You'll be eating with fido before long if you go that route.

Almost makes a 100% equities stake seem like the best bet if it werent for the over value right now and the fact that a rising interest rate will smack stocks in the chops just as hard as bonds.

Perhaps keeping 5 years worth of core spending needs in these 5 year cd's (what...100k-150k for most of us?) and the rest in equities, especially if they're dividend yielding equities that can supplement the income, makes the most sense in the very long run? Then barring a great depression or 1970's type of long term hosing, you'd probably be fine.

I think I need to go cover my mouth with a dryer sheet and breathe normally until this passes. Dry erase markers work better but I dont want to start that old habit again.

Hello TH! Fully retired since 1998 with no common
stocks of any kind. Also no SS, no pension and no IRA withdrawals so far. Total net worth is up at least
25%. How do I do it? Partly smoke and mirrors, plus
some luck I admit. My real estate dabbling and a working spouse are a big help also.

John Galt

[BunsGettingFirm]

Quote:

Buns, P.S. *The experts recommend that you should * * * * treat all your financial assets as one portfolio, * * * * regardless if they are taxable or sheltered. * * * * Thus rebalancing of your total portfolio should * * * * be done by shifting funds within your sheltered * * * * account. *This will avoid causing "taxable events". * * * * Forgive me if this is all obvious. * Regards, Charlie * * * * *

Yes, the financial planner who works for my credit union told me that all of my assets should be treated as one portfolio. I heard this about 6 years ago back when I had no idea that ER is even a possiblity, but now that I have two different retirement horizons, one at 42, and one at 60, doesn't it make sense to treat the taxable and tax-deferred as two portfolios? I can see the advantage of putting investments with high current income in a tax-deferred account, but I plan to have my tax-deferred account mimic a freedom 2030 fund, while my taxable account mimic a freedom 2015 fund. Also, my house will account for about 50% of my ER fund, so doesn't that act like a bond fund?