October 20, 2007 Letters to the Editor

Updated: November 3, 2007.

A Story for Accumulators

I received this letter from Rob Bennett.

It's an illuminating article.

You're identifying two factors to be considered in deciding on a stock allocation -- the valuation level that applies and the amount of assets held by the investor at the time. Are you able to give examples of when you would have one factor nix the other? Are there some valuations that are so extreme that valuations should control the allocation decision regardless of the amount of assets held? Are there some holding levels so high that the holding level would nix the allocation decision that one would be led to through consideration of the valuation level alone?

I agree that both factors should be considered. I have a good understanding of how valuations affect things. I am not so clear on the extent to which the amount held should be permitted to nix the valuations factor. You say: "This is why you should vary allocations in accordance with valuations as soon as you have a big enough nest egg to protect."

There is a suggestion in these words that it is not so important to vary allocations in accord with valuations when the nest egg is tiny. Perhaps that's so, but I'm not so sure.

Say that an investor has only $10,000 at risk. You could argue that his potential downside is less because he cannot see his entire retirement portfolio wiped out. I of course get that. But is that the right standard by which to measure things? This fellow only has $10,000 to his name. $10,000 is a lot of money to this fellow; it is his entire life savings.

Say that the fellow is 25. Say that he is going to live to 85. That's 60 years of compounding available to him on that $10,000. That translates into an awful lot of money. If he puts it in stocks and loses 50 percent of it, he hasn't lost $5,000. He's lost $5,000 plus 60 years of compounding on $5,000. That's a big deal.

The older investor has more assets and less future compounding. The younger investor has a smaller pile of assets and more compounding available to him. I neither case is it a good idea to take on big downside risks with little upside potential attached to them.

I am not suggesting that the idea that the investor who has accumulated more does not need to be more careful about not losing it. That idea makes sense to me. I am questioning the EXTENT to which it is so. I think that analysis has some complexities to it that have not been adequately explored in the conventional investing literature.

HERE IS MY RESPONSE

Thank you, Rob.

My research is at an early stage in terms of answering your questions.

When P/E10=8, the best decision was always 100% stocks. Dividends were good enough by themselves. There was also the likelihood of capital appreciation.

At the other extreme are the very wealthy who want absolute security. Even a 1% chance of failure would be too great. For them, investing part of their income into TIPS without drawing down principal would meet this need. Or, perhaps, they might want to buy a Single Premium Immediate Annuity SPIA to provide a guaranteed income floor throughout their lifetimes.

[The very wealthy often own businesses with substantial risk. They want to diversify into zero risk and/or very low risk products.]

Today’s valuations are high enough to cause concern. However, a person who is starting out will also see favorable valuations within 10 to 20 years. The key is to keep such a person engaged. A severe loss early can create a lifetime aversion to stocks.

The best decision is a matter of probabilities and tradeoffs. I do not have a good handle on that. In your examples, I believe that the best tradeoffs are in terms of TIME. A younger investor may be willing to work longer in the hope of gaining a more favorable result. How many years does it take to replace his nest egg? How big is his account balance in terms of annual living expenses?

A Story for Accumulators

TIPS Table

I received this letter from Erwin.

Firstly, thank you so very much for the excellent article "How much can you safely withdraw from your retirement portfolio?" I found it to be the most comprehensive treaty on the subject. Your effort is worth a million, not $5!

I was particle interested on the issue of TIPS. As you know, Larry Swedroe now feels that 100% of the fixed income portion of a retired investor should be in TIPS. I wonder if you share this view with him.

Reviewing your TIP tables, I have difficulties understanding the "Zero Balance Rate at the different years. What does "Zero Balance Rate at Year 20 = 5.54%" mean? Also, does "Balance at Year 10 = 79%" mean that you have 79% of your original money invested in TIPS if you withdraw the stated rate, say 4%? Lastly, don't those calculations depend on the inflation rate? If I am correct, which one did you use to develop the TIPS tables?

I would appreciate your reply.

HERE IS MY RESPONSE

Thank you kindly, Erwin.

About the referenced article: I did not write it. John Greaney did. He hosts the Retire Early Home Page, through which you found this site. The article certainly was outstanding at its time.

Fortunately, we have advanced the state of the art. You can safely withdraw more than 5% of the original balance each year (plus adjustments that match inflation) on a continuing basis. There are several ways to do this. The best is using a Dividend Blend. I have written numerous articles. For a comprehensive study, search using “Income Allocator” and “Dividend Blend.” Or, to save time, go to the Guidelines section. There is a button on the left.

TIPS (Treasury Inflation Protected Securities) are always an excellent choice. There are times when I prefer alternatives because of special circumstances. For example, Jim wrote a recent letter asking about Preferred Stocks. They look attractive in a Dividend Blend retirement portfolio.

August 29, 2007 Letters to the Editor

The TIPS Table lets you know what a continuing TIPS ladder would allow you to do. All of the numbers match inflation because the TIPS principal always matches inflation. [There is a subtle distinction, however. The TIPS inflation numbers are never adjusted after payment. The official inflation statistics are revised from time to time.]

A bond ladder, or in this case, a TIPS ladder consists of bonds that mature each year. You reinvest any amount not withdrawn at the longest maturity of the ladder. That way, you almost always get the highest possible interest rate.

A "Zero Balance Rate at Year 20 = 5.54%" means that you withdraw equal inflation adjusted amounts each year for 20 years from your TIPS ladder. In this case, you withdraw 5.54% of your original balance plus inflation each year. [This is for an interest rate of only 1%, similar to an I bond.] You adjust withdrawals simply by scaling from the coupon that the Government pays you per bond. That is, you start with the dollar amount of your first withdrawal, which is 5.54% of your original amount. Each year, you observe how much the Government increases the amount paid per bond and divide it by the Government’s original (first year) payment per bond. Then you multiply the original payment amount by this ratio.

This will last 20 years. After that, the principal will be depleted. Your balance will be zero dollars.

Again, looking at the 1% interest rate conditions, the "Balance at Year 10 = 79%" means that you have 79% of your original money invested in TIPS if you withdraw the stated rate--after adjusting for inflation. In this instance, the withdrawal rate in the table is 3%.

Mathematically, these are the same calculations that you would use if you were to sell a mortgage to a home buyer. The difference is that the calculations are all in terms of inflation adjusted dollars. It is the Government that determines the inflation adjustment, both to adjust the TIPS principal and for to report to the public. It is not necessary for me to assume an inflation rate. I simply use the Government’s official adjustments.

TIPS Table

The Rule of 25 Article

I received this letter from a confused reader.

Quoting from my article, he wrote:

"Of course, you end up depleting your principal if you withdraw the full 4.0% (plus inflation) from 1.2% TIPS for 30 years. But you do make it through year 30, something that the traditional, high stock portfolio only has about a 50%-50% chance of accomplishing."

Then he stated:

From 1927 a 100% S&P500 portfolio only failed 4 out of 50 30 year periods. That would be 8% chance of failure not 50%.

From 1927 a 75% S&P500 25% % year treasury notes portfolio only failed 1 out of 50 30 year periods. That would be 2% chance of failure not 50%.

I just started to read your page and [it] is full of errors...

HERE IS MY RESPONSE

I thank the writer for his concern. He is hopelessly confused about putting things into a proper statistical context.

What he fails to recognize is that only two or three comparable conditions exist in the historical record. He does not have a sample of 50. Today’s valuations exceed ALL of the completed sequences of the past. The closest relevant sequences began in 1929, 1965 and 1966. The track record of those sequences was not good.

You can check the probabilities for yourself. Use the Year 30 SWR button on your left. Enter a P/E10 value around 28 or 29 with a 1.25% TIPS interest rate. Sure enough, the odds of success are close to 50%-50% at a 4% (plus inflation) withdrawal rate.

I can calculate Year 30 Safe Withdrawal Rates because I have identified the linear relationship between the market’s percentage earnings yield 100E10/P and Year 30 surviving withdrawal rates. The relationship makes sense. It is consistent with theory.

This allows me to use the entire dataset. The number of degrees of freedom is adequate. I can place confidence intervals about this regression line. The lower confidence limit (5% chance of failure) is the Safe Withdrawal Rate.

The sequence of returns is what causes the randomness in outcomes. Careful examination of past results reveals that the 1929, 1965 and 1966 sequences were only slightly unfavorable. This came out during the investigations that led to the SWR Translator. If the returns sequences had been less fortunate, the conventionally quoted Year 30 surviving withdrawal rates would have been close to 3%.

The Rule of 25

Letters to the Editor in 2007

Letters to the Editor in 2006

Letters to the Editor in 2005