A Bright Future

I wrote this originally written on 6-12-04. Interest rates for TIPS are now below 2.0%. But these ideas remain helpful. They focus our attention on using TIPS as a baseline when evaluating alternative investments.

Stocks are at record valuations. Interest rates have been held artificially low and they are poised to jump. How do things look for a new retiree?

Bright. Very bright indeed.

Waiting it out

I draw your attention to two of my earlier posts:
Interim Withdrawal Rates and
3% SWR for 56 Years

We can wait out any bad times until the markets become attractive once again. We can buy TIPS bonds on the secondary market in the mean time.

How long can we wait? Thirty or forty years or even longer if the need arises.

I have purchased TIPS with a 2.5% yield to maturity since I wrote about Interim Withdrawal Rates. Back in October 2003, TIPS bonds yielded 2.6% to maturity. They were down to 2.2% in February 2004 and drifted just below 2.0% before rebounding. I made my purchases at 2.5% at that time. To keep up with the latest rates, visit the Bloomberg web site. Bloomberg Interest Rates

April 20, 2005 update: They are currently below 2.0%.

I have made some more calculations using the formulas from last October. If you withdraw 3.5% from 30-year TIPS, then at the end of 30 years you would have 39.1% of your initial balance (in real dollars) if the yield to maturity is 2.0%. You would have 49.0% of your initial balance if the yield to maturity is 2.3%. You would have 56.1% of your initial balance if the yield to maturity is 2.5%.

If you were to remain out of stocks and if you could get a real interest rate of 0% (i.e., match inflation exactly), you could continue to withdraw the same amount (in real dollars) for an additional 11.2 years if the yield to maturity of your TIPS were 2.0%. You could continue to withdraw the same amount (in real dollars) for an additional 14.0 years if the yield to maturity of your TIPS were 2.3%. You could continue to withdraw the same amount (in real dollars) for an additional 16.0 years if the yield to maturity of your TIPS were 2.5%.

That is, you would have a truly safe withdrawal rate of 3.5% that lasts for 41.2 years if your TIPS had a 2.0% yield to maturity. You would have a truly safe withdrawal rate of 3.5% that lasts for 44.0 years if your TIPS yielded 2.3% to maturity. You would have a truly safe withdrawal rate of 3.5% that lasts for 46.0 years if your TIPS yielded 2.5% to maturity.

If you are able to invest in anything with a real interest rate above zero percent, the number of years increases.

Here are similar calculations using a 4% safe withdrawal rate. If you withdraw 4.0% from 30-year TIPS, then at the end of 30 years you would have 18.9% of your initial balance (in real dollars) if the yield to maturity were 2.0%. You would have 27.7% of your initial balance if the yield to maturity were 2.3%. You would have 34.1% of your initial balance if the yield to maturity were 2.5%.

If you were to remain out of stocks and if you could get a real interest rate of 0% (i.e., match inflation exactly), you could continue to withdraw the same amount (in real dollars) for an additional 4.7 years if the yield to maturity of your TIPS were 2.0%. You could continue to withdraw the same amount (in real dollars) for an additional 6.9 years if the yield to maturity of your TIPS were 2.3%. You could continue to withdraw the same amount (in real dollars) for an additional 8.5 years if the yield to maturity of your TIPS were 2.5%.

That is, you would have a truly safe withdrawal rate of 4.0% that lasts for 34.7 years if your TIPS had a 2.0% yield to maturity. You would have a truly safe withdrawal rate of 4.0% that lasts for 36.9 years if your TIPS yielded 2.3% to maturity. You would have a truly safe withdrawal rate of 4.0% that lasts for 38.5 years if your TIPS yielded 2.5% to maturity.

As before, if you are able to invest at a real interest rate above zero percent, the number of years increases.

A 100% TIPS portfolio at currently available rates are truly safe at a withdrawal rate of 4.0% longer than thirty years.

This finding is highly significant considering the hazards in today’s stock market. We are well outside of the ranges of dividend yields and valuations that supported 4.0% withdrawals in the past.

I am confident that stocks will become attractive once again. We need not concern ourselves as to whether we will have some really good buying opportunities by 2010 or 2015 or even 2020. We can wait as long as necessary. When stocks become attractive once again, retirees can expect to enjoy a high level of safety at withdrawal rates of at least 5% to 6%.

The future is bright, very bright for the new retiree who invests wisely.

Have fun.

John Russell