Gentle Failure Mechanisms

Our TIPS baselines and dividend strategies share one thing in common. They have gentle failure mechanisms. At worst, they could result in your cutting back to 70% of your original buying power.

TIPS Baselines

You can withdraw 4% of your original balance (plus inflation) for 35 years if you construct a TIPS ladder with a (real) interest rate of 2%.

This makes a powerful baseline.

Now suppose that conditions change. Suppose that you can no longer buy TIPS at a 2% (real) interest rate.

If the (real) TIPS interest rate were to fall to 1%, you could continue to withdraw 4.00% for 29 years. Or, you could cut back and withdraw 3.40% for 35 years. Your choice would range from 83% to 85% of the number of years or the amount of income, respectively. Or, you could choose a combination such as withdrawing 3.67% for 32 years.

Historically, commercial paper and, today, money market funds have been able to provide a consistent real return of 1%.

Even if the (real) interest rate of TIPS and other cash equivalents were to fall to zero percent, you could still withdraw 2.86% for 35 years (since 100%/35 = 2.86%) or 4.00% for 25 years. You might prefer a combination such as withdrawing 3.33% (plus inflation) for 30 years.

Your choice would be to cut your number of years or real income to 71.0% to 71.5% of the original amount.

Regardless, the worst case failure mechanism is gentle. You will not be blindsided.

Dividend Reductions

The S&P500 experience since the 1950s gives us insight as to how well dividend income holds up during times of stress. The worst case reduction in the dividend buying power was from (January) 1967 to 1976. The (real) dividend amount bottomed at 75.7% of its previous peak. It did not recover fully until 1990.

There were more severe cuts prior to the 1950s. But those were at much higher payout ratios than we have experienced for decades.

A dividend investor can expect to maintain 75% of his buying power under worst case conditions. He does need to pay attention to the quality of his earnings. He does this by looking at the payout ratio, especially in terms of several years of smoothed earnings, the sustainability of earnings and other factors such as a company's credit rating.

Summary

Both our TIPS baselines and dividend strategies have gentle failure mechanisms. Retirees can expect to maintain 70% to 75% of their buying power under the worst case conditions.

Have fun.

John Walter Russell
March 30, 2007