Risky Alternatives

We have developed several intermediate-term timing strategies recently. Retirees invest in TIPS at 2% (real) interest up to a decade waiting for valuations to improve. Later, they switch to high stock allocations to extend the portfolio lifetimes and to increase income. The worst-case outcome would occur if valuations never became attractive. If so, the investor could still withdraw 4.0% (plus inflation) for 35 years before running out of money.

But what about alternatives? What if we hold stocks and 2% TIPS for the first decade?

Procedure

I have calculated the balances at year 10 of portfolios HSWR80T2 and HSWR50T2 for historical sequences beginning in 1923-1980. I have compared these results with TIPS-only portfolios at withdrawal rates of 3.0% (plus inflation), 4.0% (plus inflation) and 5.0% (plus inflation).

HSWR80T2 consists of 80% stocks (i.e., S&P500) and 20% TIPS at a 2% interest rate. It is rebalanced annually. Expenses are 0.20% of the portfolio’s current balance.

HSWR50T2 is the same as HSWR80T2 except that it has 50% stocks and 50% TIPS.

I used my Deluxe Calculator V1.1A08a. I used Excel plots to determine regression equations (i.e., linear curve fits) of balances versus the percentage earnings yield 100E10/P. I have solved the equations at today’s earnings yield (of 3.5%, roughly). I have estimated confidence limits (visually) from the graphs.

Equations

y = the (real) balance at year 10 starting from $100000.
x = the percentage earnings yield 100E10/P (i.e., 100/[P/E10]).

HSWR80T2, Withdrawal Rate = 3.0%, y = 15561x+25195 plus 100000 minus 70000. R-squared = 0.3614.

HSWR80T2, Withdrawal Rate = 4.0%, y = 15090x+15235 plus 100000 minus 70000. R-squared = 0.3682.

HSWR80T2, Withdrawal Rate = 5.0%, y = 14620x+5273.9 plus 100000 minus 70000. R-squared = 0.3749.

HSWR50T2, Withdrawal Rate = 3.0%, y = 8917.1x+52924 plus 60000 minus 40000. R-squared = 0.3973.

HSWR50T2, Withdrawal Rate = 4.0%, y = 8661.5x+42379 plus 60000 minus 40000. R-squared = 0.4065.

HSWR50T2, Withdrawal Rate = 5.0%, y = 8405.9x+31834 plus 50000 minus 40000. R-squared = 0.4158.

TIPS at 2% interest, Withdrawal Rate = 3.0%: the balance at year 10 equals 89.0% of the initial balance.

TIPS at 2% interest, Withdrawal Rate = 4.0%: the balance at year 10 equals 78.1% of the initial balance.

TIPS at 2% interest, Withdrawal Rate = 5.0%: the balance at year 10 equals 67.1% of the initial balance.

Comparisons at Year 10

Today’s earnings yield is 3.5%.

HSWR80T2, Withdrawal Rate = 3.0%, y = 79.7% of the initial balance (from 9.7% to 179.7%).

HSWR50T2, Withdrawal Rate = 3.0%, y = 84.1% of the initial balance (from 44.1% to 144.1%).

TIPS at 2% interest, Withdrawal Rate = 3.0%: the balance at year 10 equals 89.0% of the initial balance.

HSWR80T2, Withdrawal Rate = 4.0%, y = 68.1% of the initial balance (from -1.9% to 168.1%).

HSWR50T2, Withdrawal Rate = 4.0%, y = 72.7% of the initial balance (from 32.7% to 132.7%).

TIPS at 2% interest, Withdrawal Rate = 4.0%: the balance at year 10 equals 78.1% of the initial balance.

HSWR80T2, Withdrawal Rate = 5.0%, y = 56.4% of the initial balance (from -13.6% to 156.4%).

HSWR50T2, Withdrawal Rate = 5.0%, y = 61.3% of the initial balance (from 21.3% to 111.3%).

TIPS at 2% interest, Withdrawal Rate = 5.0%: the balance at year 10 equals 67.1% of the initial balance.

Conclusions

Starting from today’s valuations, the most likely outcomes at year 10 favor lower stocks holdings. The best is to own no stocks at all.

There is quite a bit of spread in the outcomes with stocks. At the highest stock allocation, there is a chance of losing almost all of your nest egg by year 10 even at a withdrawal rate of 3.0% (plus inflation). There is also a chance of adding 80% to your money by year 10.

Context

Our latest dividend-based strategies bring the safe withdrawal rate up to 4.8% (plus inflation) lasting into the indefinite future. It starts from a TIPS-only portfolio.

Compare this with owning stocks during the first decade. Owning stocks, you assume considerable risk when you withdraw 4.0% or 5.0%. Owning lots of stocks, you assume considerable risk even when withdrawing 3.0%.

Have fun.

John Walter Russell
January 29, 2006