Many Alternatives

I have developed many alternatives. A retiree can pick and choose among them to suit his personality and to satisfy his needs.

Alternatives

A TIPS-only approach assumes only that TIPS will continue to be available. By building a TIPS ladder, a retiree can avoid the problem of losses through sales.

You build a ladder over several years. You purchase TIPS of all maturities up to a maximum length, perhaps 10 years, possibly 20 years. Each year, as older TIPS mature, you remove any principal that you wish to withdraw and reinvest the rest at the longest maturity of the ladder. This way, you almost always get the best interest rate available. [The exception is when there is an inverted yield curve.]

With a dividend based strategy, you never sell any shares. You live off stock dividends and any interest that you are receiving from other investments. A dividend growth strategy starts at a lower initial withdrawal rate, but it grows much faster than inflation. A high yield approach starts with a much higher yield, but which grows slowly, if at all, possibly falling behind inflation. A blended dividend strategy combines these two and adds a cash equivalent account (such as TIPS, CDs or money market funds) on the side to steady the income stream (after adjusting for inflation).

It is easy to identify the initial dividend yield of a stock or an Exchange Traded Fund (ETF). It can be difficult to estimate the dividend growth rate accurately.

Traditional safe withdrawal rate studies focused on liquidation strategies. They sold shares as needed to maintain a steady income stream (in terms of buying power). Most included annual rebalancing to maintain a fixed stock allocation. Most studies used a portfolio lifetime of 30 years.

Switching is a liquidation strategy that varies stock allocations in accordance with stock valuations. It increases income dramatically. Satisfactory measures of valuation include P/E10, P/D10 and Tobin’s q.

NOTE: You can use the Stock Return Predictor to convert P/E10 into current S&P500 prices.

A delayed purchase strategy starts with one approach, often TIPS-only, and switches to an alternative, often a dividend strategy, when valuations become favorable.

Doing Better

The traditional studies (incorrectly) claimed a 30-year safe withdrawal rate of 4% of a portfolio’s initial balance (plus inflation). The optimal portfolio had a very high stock allocation. Yet, a (2% interest) TIPS-only portfolio has a 30-year safe withdrawal rate of 4.46% and a 35-year safe withdrawal rate of 4.0%. In this sense, you are doing better already.

My TIPS Income Stream Allocator B will open your eyes to the potential of dividend based strategies. The outlook is incredibly bright.

The difficulty is in identifying realistic inputs.

The S&P500 has a dividend yield just below 2%. It has had a remarkably stable NOMINAL dividend growth rate of 5% per year since the 1950s (actually, since the 1940s). The oldest dividend focused ETF DVY has a dividend yield of 3%. Many high quality, high dividend stocks pay as much as 4%. I believe that a careful investor can easily get a combination of 3% to 4% initial dividend yield and 5% per year NOMINAL dividend growth. [Inflation averages about 3% per year.]

[Remember that many S&P500 companies pay no dividends at all. You can increase its dividend yield by buying the dividend paying companies of the S&P500.]

For planning purposes, assume that the sum of the initial dividend yield and the annual NOMINAL dividend growth rate equals a constant. In today’s market, this sum equals 8% to 9%. It takes above average stocks to deliver higher returns.

Price discipline is always important. It is the single, critical factor absent from most studies. Don’t buy a stock unless it has a favorable price. With a dividend focused strategy, you would set a limit order with an initial dividend yield in mind. Always be willing to let a particular company get away from you. There will always be another opportunity.

Although I have developed optimized switching algorithms and looked at a Latch and Hold approach, I have found that you can do even better by practicing on my Simplified Retirement Trainer with Dividends A. Simple mechanically implemented algorithms make obvious mistakes such as buying and selling repeatedly as valuations vary slightly around a P/E10 threshold.

The key to success is not a matter of controlling your emotions, although that is important. They key to success is having an indicator that you can rely on. Studying the effects of indicator errors and knowing that they are limited will help steady your nerves. Knowing the limitations of an indicator will help prevent overconfidence.

We can estimate how far stock prices are likely to fall. Valuations are twice normal and four times as high as at a bottom. We can estimate roughly when prices will fall. Demographic research argues for a bottom before 2020. History suggests earlier.

You do not need great precision. If you withdraw 4% (plus inflation) from a 2% (real interest rate) TIPS ladder, you still have 78% of your principal (plus inflation) remaining after 10 years and 51% (plus inflation) after 20 years.

If stock valuations simply fall in half at least once within 20 years AND if you withdraw 4% of your original balance (plus inflation) in the interim, you should be able to break even. Stocks should be yielding twice as much as today and, with care, you should be able to pick up high quality stocks that pay twice as much as similar stocks yield today. You will be ahead if stock valuations fall faster or if the bottom is deeper. Historically, the market has always overreacted.

A delayed purchase strategy fails only in comparison to a dividend strategy which grows faster. A reasonable compromise is to set aside a portion of one’s retirement portfolio into TIPS in the hope of being able to exploit bargains later. This fits well with a blended dividend strategy.

Spreadsheets

I have many spreadsheet calculators, retirement trainers, income stream allocators and other tools in my Yahoo Briefcase. Super SVTVR L and Year 15 Calculator A allow you to design conventional and switching liquidation portfolios in 15 year increments. You can choose the final balance percentage. You are not stuck with total liquidation. Both take valuations into account.

Look at a variety of them. They will help you do better.

Have fun.

John Walter Russell
February 10, 2007

Yahoo Briefcase