Always Insist on a Baseline

Always insist on a baseline.

I cannot stress enough how important it is for you to have a baseline. Without one, you are likely to end up with an inferior retirement portfolio.

These days, you can buy TIPS and I-Bonds. They are guaranteed to match inflation. You even get interest.

You can always do better than owning an inflation-match cash equivalent. You never need to accept an inferior strategy. If you are planning to withdraw equal amounts each year in terms of real dollars (that is, after adjusting for inflation, maintaining constant buying power), you can always withdraw 1/N times your initial balance for N years.

You never need to do anything inferior to withdrawing 3.33% (plus inflation) over 30 years or 2.50% (plus inflation) over 40 years or 2.00% (plus inflation) over 50 years. Not only can you always do better than this, you can do so with complete safety. Just put together a portfolio consisting entirely of TIPS and I-Bonds. This is your baseline.

You can use the mortgage formula (or mortgage tables) for actual interest rates. Here are some numbers. They are in terms of real dollars:

1) With an interest rate of 1.0%, you can withdraw 3.87% for 30 years or 3.40% for 35 years or 3.05% for 40 years with total safety.

2) With an interest rate of 1.5%, you can withdraw 4.16% for 30 years or 3.69% for 35 years or 3.34% for 40 years with total safety.

3) With an interest rate of 2.0%, you can withdraw 4.467% for 30 years or 4.00% for 35 years or 3.66% for 40 years with total safety.

These percentages are large because you are withdrawing principal as well as interest.

We are just beginning to look at such portfolios in more practical terms, not simply as a theoretical exercise. Ten-year TIPS (and/or I-Bonds) ladders held to maturity make a lot of sense in an actual portfolio these days. But you must own TIPS, not a mutual fund that invests in TIPS.

There are a host of other considerations, especially the effect of taxes and whether to diversify into the international equivalents to US TIPS.

There is a vital piece of information in these numbers. They show that you can come close to withdrawing 4% (plus inflation) of your portfolio¹s initial balance every year during your retirement. Stated differently, plan on saving 25 times the amount of each income stream that you will need during retirement.

This is only a rough guideline, but it is a great starting point. It works in many circumstances, but not all. It works for some allocations, but not others. It works for some types of investors, but not others. Use it as a rule of thumb. It is reasonable to presume that you will need assets of 25 times the amount that you plan to live on each year.

Have fun.

John Walter Russell
I posted this first on May 25, 2005.