Put some spending cash in CDs or in I bonds?

[Nords]

At the risk of beating a dead horse, I'm trying to find a heuristic or even an algorithm for deciding which is a better rate.

Here's the situation of the month: we invest our retirement portfolio in equities (no bonds) but we keep two years' expenses in cash. One year's worth of that dwindles in a MM account (to pay the bills) and the other year's worth is in a one-year CD that matures in three weeks.

Each year I cash in enough equities for another year's expenses and deposit it in the money-market account. The second years' cash usually continues to sit in the CD. But I wonder if there's a better way to keep that stash?

We already have more than enough volatility risk and I'm not necessarily interested in chasing yield. This money is only intended to be tapped during subsequent years of a sustained downturn-- for example, 2002 or 2003. In fact, by the time we suspected that we'd need to tap into that second year's cash stash, we'd probably be cutting back on expenses to stretch it over a third year.

I would expect this situation to arise once or maybe twice a decade (ouch!) and thus it seems a waste to keep rolling over a one-year CD when it could be invested for a longer term. However we also have to consider taxes and early-redemption penalties.

For example, we could buy an I bond currently paying a tax-free 3.67% (and perhaps more). Its early-redemption penalty is three months' interest until the fifth year.

At that yield in our 15% tax bracket, a higher-paying CD would have to yield more than 4.3% and would have to have an equivalent early-redemption penalty. PenFed is offering 4.65% on a four-year CD but of course there's no inflation protection (which is perhaps not an issue for a four-year note). However their penalty is six months' interest. Interest rates are as high as 5.15% on their 7-year CD but again there's inflation risk and the penalty always applies (not just until the fifth year). I'm not aware of another credit union or bank that can even approach PFCU's rates.

It doesn't seem worth chasing less than 100 basis points of yield to assume the risks of inflation & early-redemption penalties. Right now I'm leaning toward the I bond. Can anyone share how they analyzed a similar situation, or how a big financial institution does it?

 

[cute fuzzy bunny]

You cant really figure this out unless you know what inflations going to be.

Given that I feel that the CPI is more or less directly manipulated to keep it low, I dont expect to see it higher than 3.5% for the next 5 years.

That having been said, a 4.5%+ CD with a cheap bailout option is a better buy. Digital Credit Union offers a 4.61% 5 year jumbo (25k).

Or split the difference and put half in ibonds and half in the 5 year cd's.

Remember to split your cd's up into the smallest denominations needed to get the good rate so if you need cash you only have to bail out of one small one instead of a large one.

 

[charlie]

Nords, "answers will vary" but I have a different
take on inflation than TH. Why take the risk of
higher inflation? You can cash the I-bond after
1 year with 3 month penalty. I think it likely that
the current 3.67% yield on I bonds will go up at
the next reset. After all, inflation is currently
running about 3.26% year over year. With the
real yield remaining at 1% you would beat a
1 year CD at 3+% with no risk.

Cheers,

Charlie

 

[dex]

This is an interesting question. In my mind (2nd glass of wine warning here) it is a cash flow and allocation question.
All funds in equities except for 1 year of expenses in a mm fund and a second year of expenses in a CD.
Would it be possible for you to do the following:
1 year of expenses =
+ $x of dividens from equities
+ short term bond fund dividends - see below
+ $x of cash in Emigrant savings account @3%

2nd year of expenses (actually invested for year 1 + 2nd year)
Short term bond fund - invests in bunds with a maturity of 2 years or less. Inflation would not greatly affect this fund and you would have time to sell and move the money to the Emigrant savings if you wanted.

Does this work better than your current plan?

 

[cute fuzzy bunny]

That depends on what your bund return rate is

Sorry, best I can do...I have a baby on me taking up most of my visual space and making it very hard to type...

 

[Nords]

Would it be possible for you to do the following:
1 year of expenses =
+ $x of dividens from equities
+ short term bond fund dividends - see below
+ $x of cash in Emigrant savings account @3%

2nd year of expenses (actually invested for year 1 + 2nd year)
Short term bond fund - invests in bunds with a maturity of 2 years or less.  Inflation would not greatly affect this fund and you would have time to sell and move the money to the Emigrant savings if you wanted.
Does this work better than your current plan?

Well, the first year of expenses (in a MM) already includes dividends from two ETFs (Dow Dividend, DVY, and S&P600/Barra Small-cap Value, IJS) plus a small amount of divs/CGs from Tweedy, Browne Global Value (TBGVX). At the end of the year (after all the distributions) we just sell enough to refill the MM account for the coming year. The NFCU MM is currently paying a weenie 1.5% but that's a sacrifice for the flexibility of moving money around.

While we appreciate Bernstein's wisdom on bonds, we don't do them to boost returns or to reduce volatility risk. (We ignore volatility by keeping a couple years of expenses in cash.) I agree that a smaller cash allocation and a bigger equity allocation produces higher volatility, but our experience (admittedly limited) has been higher returns as well. We'd love to see more research on cash/equity allocations without bondage.

So I hesitate to bring in a short-term bond fund because of its fluctuating NAV (we already get that in the stock market). The bond fund wouldn't be affected that badly by inflation but it'd sure get hammered by the Fed's response. I'm clueless on short-term bond fund returns-- can we expect at least 4.3% after taxes & expenses? Because if that gets complicated, then we'd go back to the I bond.

I'm going to have to look into ING & Emigrant for the MM options. Laziness has been the only thing holding me back. OTOH I don't want to encounter huge hassles for just a 1.5% boost...

 

[John Galt]

Well, here is my 2 cents.

My investment ladder is missing all of the middle rungs,
i.e. I either have very liquid short-term stuff (MM, CDs
under a year), or I have bond funds or long term bonds
(maturity from 12 to 25 years). Normally, I only have
my credit cards at the ready to back us up. With the rates they are offering (zero in many cases) and
very large availability, I feel quite comfortable with this
arrangement.

JG

 

[johnblake]

I'm clueless on short-term bond fund returns-- can we expect at least 4.3% after taxes & expenses? Because if that gets complicated, then we'd go back to the I bond.

Hi Nords,
Vanguard's Short Term Investment Grade Fund is yeilding 3.4%. +no redemption penalty -some NAV fluctuation. I don't think that the NAV fluctuation is a big issue if you plan to hold for a year or more.

I think the 4.3% # is off. IBonds are exempt from state taxes, but you still have to pay fed taxes (I assume that the 15% num quoted is the fed tax rate.) .

 

[Nords]

I think the 4.3% # is off.  IBonds are exempt from state taxes, but you still have to pay fed taxes (I assume that the 15% num quoted is the fed tax rate).

Well, once again I've succeeded in verifying my bond idiocy. Ouch, thanks, John, yeah, I knew that. Sure.

I guess the only tax "advantage" is long-term deferral if we don't need to cash in the sucker. My pension isn't taxed by Hawaii but we converted a chunk of IRA this year so we may start paying a little there too. But our state taxes will dwindle away when the conversions are finished (in 2013?).

NFCU is offering 4.64% today on a five-year $20K CD with a 0.25% kicker for being a 25-year customer. (Thanks, I think.) PFCU is offering 4.88% but with only a $1000 minimum, and they offer 5.02% on a seven-year CD. I like the idea of having many smaller CDs if we need to bail. If it comes to that, I guess we could also buy smaller chunks of I bonds.

Both CUs are likely to re-evaluate their rates near the end of the month. I agree that inflation is going to be "controlled" to less than 3.5% for a very long time so this points to the CDs as the better deal...

*Sigh*. Back to the drawing board. Might as well pass the time filling out a PenFed application.

 

[cute fuzzy bunny]

Better than the paperwork needed to convert vanguard accounts to joint accounts

I had actually never heard of a medalion signature guarantee, and neither had anyone at the local bank until the bank manager found his stamp and remembered that this was something he could do.

Some guarantee. He was in "the atm cage" at the time and couldnt come out...so he just signed and stamped all the relevant pages without seeing us at all or observing us applying our signatures...

 

[KB]

I've had to have a number of banking documents 'signature guaranteed' and had to show my drivers license and sign in front of the person as well. Kind of like signing in front of a Notary.

 

[brewer12345]

While we appreciate Bernstein's wisdom on bonds, we don't do them to boost returns or to reduce volatility risk.  (We ignore volatility by keeping a couple years of expenses in cash.)  I agree that a smaller cash allocation and a bigger equity allocation produces higher volatility, but our experience (admittedly limited) has been higher returns as well.  We'd love to see more research on cash/equity allocations without bondage.

.

Nords, maybe you can shed some light on this, but I am a bit perplexed. As I understand it, you have a military pension that I suspect covers more than a little of your monthly nut, and you likely will get some SS down the road. Is there some particular reason you are reaching for higher returns by maintaining a very high equity allocation? I would imagine that the risk of having to slash expenses/go back to work would outweigh the possible rewards of a little excess return, no?

If I were in your shoes, I would have more like 4 or 5 years expenses tucked away, but I suppose its a case of different strokes.

 

[charlie]

Nords, I would not get too entrenched in the idea
that a 3.5% inflation rate can be "controlled" in the
future. Greenspan confessed just yesterday to
being puzzled by the behavior of long rates, implying
that he has been expecting rates to go up. The
country is currently awash in cheap dollars and
the trade deficit is not getting better. Cost of
imports is under extreme pressure because of
the weak dollar and the cost of energy is putting
pressure on everything. We are a debtor nation
and there is pressure on the gov to cheapen the
cost of the debt by printing money. Higher inflation
is just a matter of when .... not if, IMHO.

Cheers,

Charlie

 

[haha]

We are a debtor nation
and there is pressure on the gov to cheapen the
cost of the debt by printing money.  Higher inflation
is just a matter of when .... not if, IMHO.Cheers,Charlie

Chuck, I think anyone who was an investor or householder from the 70s just believes in inflation. I'm that age, and I am always looking for the return of lots of inflation.

So much seems similar to me. Then Viet Nam and political strife. Now Iraq and political strife. Then the "Great Society", now exploding health care and retirement costs, not to forget all the costs that have been with us since the Great Society.

I don't know what odd set of circumstances has kept CPI inflation as low as it has been kept, but I suspect China has lot to do with it. Measuring techniques are worth something too, IMO. But in the 70s we had intense commodity inflation, and we sure seem to be getting plenty of that again.

It may be just old dog fears, but I see the conditions in place to allow heavy duty CPI as well as PPI inflation to reassert themselves.

If it turns out this way, I just hope Paul Volcker has a son or daughter ready to step in.

Mikey

 

[cute fuzzy bunny]

Just to be clear, I wasnt suggesting inflation wont come back, in fact I think its here. I was suggesting that REPORTED inflation via the CPI will be fought tooth and nail.

We have the most incredible case of "invisible inflation" going on. I see it every day. A lot of beer comes in 11.2oz bottles now. My fish and chips fish portion has gotten smaller twice in the last year and the free refills on drinks now cost 25c. Barbecue sauce at the rib joint I go to is now an extra 25c per cup. The dog food I've been buying has gone from 14oz cans to 13oz to 12oz.

And I think we're all familiar with "We are experiencing unusually high call volumes, but your call is important to us so please stay on the line...the current wait time is...59 minutes".

Besides the pressure to change the quality/quantity of goods and services to maintain price points, plenty of people I trust like Bill Gross have analyzed CPI and pointed out that its quite easily 1% or more underreporting inflation.

Considering my fish and chips example, while the price of that has stayed the same I'm getting about 1/3 less fish and my two drink refills now cost 50c. Hence the product is now 10% more expensive and I'm getting less for my money.

So while we might see 5-7% "real" inflation, I would highly doubt that we'll get anywhere near that number on the CPI and see that our "inflation protected" securities will actually provide that protection.

Thats why I feel a lot better about a 5% 5 year CD rather than a 1% ibond. I dont think that ibond will produce a true 5+% yield in the next 5, or even 10 years.

 

[Nords]

Nords, maybe you can shed some light on this, but I am a bit perplexed.  As I understand it, you have a military pension that I suspect covers more than a little of your monthly nut, and you likely will get some SS down the road.  Is there some particular reason you are reaching for higher returns by maintaining a very high equity allocation?  I would imagine that the risk of having to slash expenses/go back to work would outweigh the possible rewards of a little excess return, no?

If I were in your shoes, I would have more like 4 or 5 years expenses tucked away, but I suppose its a case of different strokes.

That depends on the definition of "risk".  You may be implying volatility risk which forces us to liquidate shares in a down market, but we're much more afraid of the next 50-80 years of inflation erosion.  We're 44/43, spouse's genes make her quite likely to exceed 100, and the guys in my family are pushing the same.  If we're wrong then we could endure working at age 60, but I'm gonna be mightily pissed off if I'm selling french fries to our great-grandkids at age 99.

My pension covers our taxes, mortgage (29+ more years), & groceries.  It's raised annually by CPI.  My spouse the Naval Reservist has been covering the IRAs, the military TSP, and the 12-year-old's college fund.  While it's been great so far, her gravy train is likely to end this Oct and she'll serve out her remaining time at no pay.  

The rest of our expenses come out of the retirement portfolio, and so far we've been closer to 3% than 4%.  But we'll withdraw more next year to cover our own personal "wage gap".

Call me a pessimist, but I think our Social Security will be small.  After correcting for military wage credits our age 62 benefits will each be about $8-9K/year (today's $$) starting 2022.  I think the "SS fix" will kill off wage indexing and put our combined SS under the equivalent of $10K/year.  But we'll be happy to take whatever's left.

Spouse will pull down her own pension starting 2022 and hopefully it won't be ravaged too badly by the civilian-military wage gap before then.  In terms of today's buying power it'll probably be about half of my current income.

To analyze the retirement decision, we're hoping that long-term historical performance data is better than no data at all.  Based on that (blissful?) faith, long-term equities have outperformed bonds and consistently beaten inflation.  Having personally experienced "downward volatility" as high as 40% after 9/11, we know that we can tolerate several years of it in the expectation of a long-term payoff.

Our mortgage balance is a quarter of our total retirement portfolio.  The mortgage rate is 5.5%, and FIRECalc gives that balance in equities at least a 75% chance of breaking even over the next 30 years.  However when that balance is added to our portfolio then FIRECalc raises the odds to over 85%.  I'm pretty sure that my pension will last for 30 years so it seems worth the risk.  If our portfolio drops by 50% and we absolutely panic, then we'll be able to liquidate the college fund and our portfolio to pay off the mortgage (and go back to work).  But we're paying a fixed debt with depreciating dollars and the payoff rate really accelerates after the 15th year.  

Although I have a couple thousand shares of Nortel & Sun in a separate account, the equities in our retirement portfolio are hardly risky (not even that volatile).  35% is in Tweedy, Browne Global Value (TBGVX), 30% is in Berkshire Hathaway (BRK.B), 20% is in the S&P600/Barra Small-cap Value ETF (IJS), 10% is in the Dow Select Dividends ETF (DVY), and the rest is cash.  For the last year Tweedy has been rising faster than we've been selling.  And if value investing doesn't work for the next four decades then we might as well be buying bullion & shotgun shells.

As calculators overlook, we can reduce our expenses in a prolonged downturn.  When we launch the kid we hope to drop 20% without even changing our lifestyle.  Old-fashioned belt-tightening could really pay off, even if we had to ramp up to surfing three or four days a week...

As the years roll on and our income picture clears up, perhaps we'll become more conservative and keep a larger cash stash.  We might move further into dividend-paying stocks or even bonds.  Or, if our withdrawal rate gets down to 2-3% and our portfolio outperforms the mortgage, maybe we'll keep the equities until we're in our 90s.  But we'd rather deal with volatility risk now to beat inflation.

You're right, CDs vs I bonds is a pretty weenie issue in this bigger picture.  But again I'd rather be pushing a higher yield and risking a small penalty than to keep letting one-year CD rates lose out to inflation.

Just to be clear, I wasnt suggesting inflation wont come back, in fact I think its here.  I was suggesting that REPORTED inflation via the CPI will be fought tooth and nail.

Thats why I feel a lot better about a 5% 5 year CD rather than a 1% ibond.  I dont think that ibond will produce a true 5+% yield in the next 5, or even 10 years.

Me too.  I think I bonds will lose to actual inflation.

 

[charlie]

Methinks you guys are giving the gov too much credit
for being able to manipulate the "reported" CPI.

Please cite a credible reference so I can reset if
necessary.

Cheers,

Charlie

 

[charlie]

P.S. How are CD rates set in the first place? I
would imagine it is some weenie pouring
over the same data that is used to measure
current CPI and projecting in the future. Do
you mistrust TIPS as well? Those rates are
priced by auction with an implicit assumption
about future CPI made by the aggregate.

 

[Nords]

Anyone have a better CPI?

"Credible". Hmmm, I guess that leaves out Bill Gross' columns... at least until we see Dow 5000. Here's a summary rebuttal from Bloomberg columnist.

http://quote.bloomberg.com/apps/news?pid=10000039&refer=columnist_berry&sid=a7yZyxZ7nrPU

And here's a scary one backed by all the credibility of the federal govt. Its conclusion is "In summary, I believe that the hedonic method has a bright future within the U.S. statistical system and, eventually, throughout the world."

http://www.bea.doc.gov/bea/about/expand3.pdf

And here's one that summarizes everyone's problem of coming up with a better set of numbers: "I claim that the government statistics significantly understate the true inflation rate but I have not been able to back up my criticism with any real hard data due to the lack of an alternative inflation gauge. The lack of alternate data inspired me to create my own inflation index using price data from my own memory, the internet, old receipts, and old catalogs to see how it compares to the official inflation figure."

http://www.safehaven.com/article-1942.htm

 

[cute fuzzy bunny]

Charlie - do a search on here for Bill Gross, we had a thread where we linked to a couple of his articles and waxed on about this. Or go to the pimco site and look at his past writings. Others besides Bill have talked about this and come to similar conclusions.

Besides the manufacturers diluting their products and services (seen the poker chip sized meat patties in a big mac lately?), Bill found the reported CPI suffered from about a 1% understatement. He also found the "hedonic adjustments" worthless and irrelevant. That the CPI also suffers from "basket substitutions" whereby if steak becomes too expensive, hamburger is substituted just adds insult to injury.

Thats not measuring inflation...I know exactly what that is because I used to do it for a living. Its called fiddling with the numbers until you get the answer you want.

Its not shocking...the guys who are measured by keeping inflation low and who have to pay higher sums of money out of the treasury when the rate is high also get to measure it?

On Nord's allocations, its a funny two way street. When I was paying my own way out of my portfolio 100%, I was very conservative. Felt like I had to be...no safety net. Now that I have the income stream from my wife that can pay most of the regular bills, I could go one of two ways...stay conservative because I dont need the money every month, or become very aggressive because...I dont need the money every month! On one hand, you can sleep good if putting your money at risk worries you. On the other hand, you can put it all at high risk because its not completely relevant to your short to medium term financial needs.

I'm staying conservative right now simply because I hate the value levels of broad stock indexes. If and when things settle down or drop, I'll probably shift from the 50/50 I'm at now to an 80/20.

 

[cute fuzzy bunny]

Whoops...Nords stepped in front of me while I was off changing the baby...

I've read the "cpi is ok" articles, but it comes down to this:

What they're saying in essence is "yes things are getting more expensive but you're getting more for your dollar, so thats ok".

Uh...I must be missing the whole idea of inflation then, where you're trying to measure the increased cost of a good or service.

Is that my beef is better, my car having airbags or my computer being faster going to make me feel better about my "inflation adjusted" security not buying me the same goods and services 10 years from now as they do today?

Nope.

As far as Bill G goes, there are exactly 3 guys I listen to without hesitation when it comes to money. Gross, Bogle and Buffett.

As far as these columnists and other experts go...how much money have they made and what level of financial assets have they been trusted with? Mmm hmm...

My favorite bit comes at the end of the first columnists article where he notes that Greenspan has already acknowledged that he thinks CPI is wrong, but that it overstates rather than understates by a percent.

Ok, so we have an acknowledgement from the top of the Fed food chain that they're not doing it right - that the calc is favorable to people needing inflation adjustments isnt relevant. And we can probably guess that something will get "fixed" to drop the current calculation by one percent. This is what we used to call "softening up for the blow".

Oh well...I suppose we'll all know for sure 5 years from now...

 

[charlie]

Thanks Nords. Two out of three of your links
support the notion that the official CPI is an
honest, if imperfect, attempt to measure inflation.

I stand pat.

Cheers,

Charlie

 

[haha]

Thanks Nords.  Two out of three of your links
support the notion that the official CPI is an
honest, if imperfect, attempt to measure inflation.

I stand pat.  

Cheers,

Charlie

I may be wrong, but I read Nords post as being ironic. How could anything that references the credibility of the federal government be anything other than ironic?

My working hypothesis is to look favorably on the opposite of whatever the government says, especially if they have a horse in the race

Remember the WMD in Iraq?

Mikey

 

[unclemick]

Call me gullible.

I generally give government the benefit of the doubt.

Except perhaps for spies(they supposed to lie) and sex.

Otherwise they make the same 'honest'? mistakes as the rest of us.

 

[Nords]

I may be wrong, but I read Nords post as being ironic.

You got it, Mikey. A Google search on <hedonic CPI> turns up thousands of hits, all of which can be mined to "prove" either side of this reciprocated diatribe.

My personal cynicism is that there's too much self-interest at stake for the government to NOT manipulate a statistic that they have a monopoly on measuring. With our best interests at heart, of course.

Sorry, Charlie, enjoy your moral victory while contemplating the hedonic value of your new car hybrid golf-cart vehicle and your steak high-nutrition protein patty. And we didn't even get started on the subject of medical care's contribution to the CPI. Oh, wait, life extension at any cost must be another hedonic benefit, right?