A TIPS Ladder Example

This should help you take advantage of a TIPS ladder in your retirement planning. I have extracted several elements of Peteyperson’s concept. I have added a few of my own. I have not come close to matching Peteyperson’s level of detail.

A TIPS Ladder allows you to avoid selling stocks at distressed prices, which is what causes retirement portfolios to fail. You can avoid selling any shares for an entire decade, if necessary. When stocks are doing well, you treat your TIPS Ladder as the normal bond allocation in your portfolio. You continue to sell shares of stock when needed and when prices are especially attractive. You replenish the TIPS Ladder when necessary. When stocks are doing poorly, you draw principal from your TIPS Ladder.

Initial Steps

For purposes of discussion, I am setting the required lifetime of your retirement portfolio at 40 years. I am setting the withdrawal rate at 4.0% plus inflation. (That is, you withdraw 4.0% of your portfolio's initial balance each year plus an adjustment to match inflation.)

First, we determine the withdrawal rate of an all-TIPS portfolio that lasts exactly 40 years. If the interest rate is 1.0%, the 40-year withdrawal rate is 3.05% (plus inflation). If the interest rate is 1.5%, the 40-year withdrawal rate is 3.34% (plus inflation). If the interest rate is 2.0%, the 40-year withdrawal rate is 3.66% (plus inflation). These rates are high because they include 2.50% (plus inflation) from principal.

For purposes of this discussion, I will assume that we can get an interest rate of 1.5% with 10-year TIPS. This corresponds to a 40-year withdrawal rate of 3.34% (plus inflation).

Next, we set a target allocation for the TIPS ladder. For purposes of illustration, I will set this allocation equal to 20%.

Under normal circumstances, the TIPS portion of the portfolio would contribute 20%*(the normal withdrawal rate for the TIPS) = 0.20*(3.34%) = 0.668% of the 4.0% that we are seeking.

This means that the equity portion of our portfolio must provide the remaining 3.332% (since 4.000% - 0.668% = 3.332%). Since we have allocated 80% of our portfolio to stocks, we are seeking a (real, annualized, total) return from stocks of 4.165% (since 3.332 % / 0.80 = 4.165%).

John Bogle’s modified version of the Gordon Equation (or the Dividend Discount Model) is that the total return from stocks equals the investment return plus the speculative return, where
Investment Return = Dividend Yield + Earnings Growth Rate
and
Speculative Return = the change in the price to earnings ratio over the period examined.

Historically, real earnings (i.e., after adjusting for inflation) have consistently grown 1.5% to 2.0% per year when taken over a decade. [Year-to-year earnings are vary wildly. But the cumulative earnings over a decade are remarkably consistent.]

To get an investment return of 4.165% (real, annualized, total return), we need a dividend yield of 2.165% to 2.665% (assuming that the real, annualized earnings growth remains between 1.5% and 2.0%).

We conclude that withdrawing 4% (plus inflation) is doable just so long as we can avoid being hurt by an unfavorable speculative return.

About the Speculative Return

It is highly likely that the stock market’s multiples will contract over the next decade. They are likely to contract by a factor between 2 and 4.

The TIPS Ladder to the Rescue

This is the beauty of the TIPS Ladder.

When prices fall, you use the principal of the TIPS that mature in that year in your withdrawal. Since your TIPS allocation is 20% and since your ladder is 10 years long, you receive 2% (plus inflation) of your desired 4% (plus inflation) withdrawal amount. That is, one-half of your withdrawal amount will come from cashing in TIPS as they mature at par. The rest comes from stock dividends.

Stock dividends generally keep up with inflation although not from one year to the next. Since dividends only have to supply 2.0% (plus inflation) of your portfolio’s initial balance, any dividend yield above 2.0% and any interest payment from TIPS gives you extra time before dividends have to catch up.

When stocks do well, you replenish your TIPS Ladder.

Higher TIPS Ladder Allocations

It makes sense to allocate more to your TIPS Ladder if you expect stocks to do poorly for more than a decade. Outside of the United States, there have been bad periods that have lasted for twice that long. If you were to make a 20-year TIPS Ladder, your TIPS allocation could still be as small as 40%.

In the example, doubling the TIPS allocation would result in their providing 1.336% (= 2*0.668%) of the 4.0% that we are seeking. Stocks would have to provide 2.664% (since 4.000% - 1.336% = 2.664%). The stock allocation would now be reduced to 60% (instead of 80%). Stocks would have to deliver a 4.44% (real, annualized, total) return. Subtracting 1.5% to 2.0%, the required dividend yield would be between 2.44% and 2.94%.

Once again, this is doable.

Have fun.

John Walter Russell
I wrote this on 4-28-05.