TIPS Ladders for Today

Today’s TIPS are yielding 1.8% to maturity. That is, 10-year, 20-year and 30-year TIPS are yielding 1.76%, 1.89% and 1.80%. The coupons are 1.625%, 2.375% and 3.375%, respectively.

We could reasonably plan to withdraw 3.53% annually for 40 years from a TIPS-only portfolio. We would need to be able to buy TIPS at 1.8% interest in the future. We would not to sell any TIPS on the secondary market if we were to construct a TIPS ladder.

We can do better.

Planning for Today

Let us start with a 100% TIPS allocation and build from there.

We can expect to do much better if we allow ourselves to vary allocations with P/E10. Switching with 2% TIPS brings today’s 30-year Safe Withdrawal Rate [i.e., 95% chance of success] up to 4.4%. Switching brings today’s 30-year Calculated Rate [i.e., 50% chance of success] up to 5.12%.

It is reasonable to plan to withdraw 4.0% for 40 years. Switching is likely to bring success. It is not too much to hope that TIPS ladders will average 2% interest. Even if the rates remain lower, we have enough of a pad. A withdrawal rate of 4.0% is low enough when compared to 4.4% and 5.12%. Extending withdrawals from 30 to 40 years does not require much of a reduction in withdrawal rates. Doing both, that is, extending withdrawals to 40 years starting with TIPS at an interest rate of 1.8%, requires a little bit more luck, but it is still reasonable.

We have a good fall back position. Interest rates do not need to increase much to extend our portfolio’s lifetime. Even the worst-case is not horribly bad. A 100% TIPS portfolio allows you to withdraw 4.0% for 33 years if the interest rate is 1.8%, 35 years if the interest rate is 2.0% and 40 years if the interest rate is 2.5%.

Four Segments

One of the things that we wish to do is to reduce the need for selling TIPS on the secondary market. We can do this by paying a premium for longer-term TIPS. The difference between the coupon payment and the yield-to-maturity is a draw down of principal (from the premium price to par). This draw down is equivalent to selling TIPS at par.

The optimized switching stock allocations of the past were 100%-50%-30%-20%-0%. The 50% stock (and 50% TIPS) allocation corresponds to P/E10 values between 9 and 12 or 13. The 100% stock (and 0% TIPS) allocation corresponds to P/E10 levels below 9. We would retain a high TIPS allocation, close to 75%, unless stock prices were to fall to bargain levels. It is reasonable to devote 50% of the portfolio to TIPS with longer maturities. In fact, it is reasonable for us to devote 25% to TIPS with the very longest maturities.

We break the portfolio into four segments.

We allocate 25% of the portfolio to 30-year TIPS.

We allocate the next 25% of the portfolio to 20-year TIPS.

Depending upon our outlook, we allocate the next 25% of the portfolio either to 10-year TIPS or 20-year TIPS. In addition, we consider allocating this 25% to high dividend paying stocks.

We allocate the final 25% of the portfolio to 10-year TIPS.

We cannot build a ladder using 30-year TIPS because there are no replacements. We can build a ladder with 20-year TIPS. We definitely plan to build a ladder with the 10-year TIPS.

At least 2.5% of the portfolio matures each year from the 10-year TIPS ladder. This turns out to be sufficient.

Faster Responses

If we allocate 50% of our portfolio to 10-year TIPS, 5% of our holdings mature each year. This allows us to redeploy funds rapidly without having to sell into the secondary market.

Based on an initial balance of $1.0 million, the coupons from the 25% allocation of 30-year TIPS supply $8437.50 annually. The coupons from the 25% allocation of 20-year TIPS supply $5937.50 annually. The coupons from the 50% allocation of 10-year TIPS supply $8125.00 annually. The total coupon payments add up to $22500.00. The annual withdrawal of $40000 requires $17500 from principal.

The 10-year TIPS that mature each year return $50000 of principal. The annual withdrawal requires $17500. You have the remaining $32500 available for reinvesting. You can reinvest it into 10-year TIPS, extending the ladder, or you can redeploy part of it into stocks.

Bigger Coupons

If we allocate 25% of our portfolio to 10-year TIPS, 2.5% of our holdings mature each year. This reduces our ability avoid selling in the secondary market.

Based on an initial balance of $1.0 million, the coupons from the 25% allocation of 30-year TIPS supply $8437.50 annually. The coupons from the 50% allocation of 20-year TIPS supply $11875.00 annually. The coupons from the 25% allocation of 10-year TIPS supply $4062.50 annually. The total coupon payments add up to $24375.00. The annual withdrawal of $40000 requires $15625 from principal.

The 10-year TIPS that mature each year return $25000 of principal. The annual withdrawal requires $15625. You have $9375 available for reinvesting. You can reinvest it into 10-year TIPS, extending the ladder, or you can redeploy part of it into stocks. This can be attractive when your preference is for the security offered by bonds and when 20-year TIPS provide substantially more interest than 10-year TIPS.

Dividend Approach

This time, we allocate 25% of our portfolio to high dividend paying stocks. We can still get a dividend yield of 4.0% in today’s market from carefully selected stocks.

Based on an initial balance of $1.0 million, the stock allocation is $250000 and the total TIPS allocation is $750000. The coupons from the 25% allocation of 30-year TIPS supply $8437.50 annually. The coupons from the 25% allocation of 20-year TIPS supply $5937.50 annually. The coupons from the 25% allocation of 10-year TIPS supply $4062.50 annually. The dividends from the 25% stock allocation supply $10000.00 annually. The total payments add up to $28437.50. The annual withdrawal of $40000 requires $11562.50 from principal.

The 10-year TIPS that mature each year return $25000 of principal. The annual withdrawal requires $11562.50. You have $13437.50 available to reinvest.

We need to take the risks associated with stocks into consideration. A reasonable provision for loss would be for the dividend amounts to fall and/or to fail to grow. Worst case, this might cut the yield in half, to 2% of the initial purchase price (plus adjustments for inflation) after ten years. We would expect the remaining dividend payments to grow (erratically) enough to keep up with inflation.

This leaves us with $5000 per year from dividends (plus inflation) after ten years.

At the same time, we will assume that TIPS continue to yield 1.8% to maturity throughout the entire 40 years. Since we have been drawing down principal at a 4% rate during the first 10 years, our principal has fallen from $750000 to $570000.

[At an interest rate of 1.8%, the 10-year TIPS Equivalent Safe Withdrawal Rate is 11.0%. Withdrawing 4.0% for 10 years reduces the principal to 76% of its initial amount (since [11.0-4.0] / [11.0-1.8] = 0.76). In this case, it reduces $750000 to $570000.]

At this point, the Safe Withdrawal Rate for the remaining 30 years is 4.34%. Taking 4.34% of $570000 equals $24738.

Adding back the $5000 per year of dividend income gives us $29738 annually.

Making these highly pessimistic assumptions, we would end up with a withdrawal rate of 4.0% for the first ten years followed by a withdrawal rate of 2.97% for the remaining 30 years.

An alternative approach would be to continue withdrawing 4.0% annually in spite of bad luck. The $570000 would have to provide $35000 each year after the first decade. This is 6.1%. TIPS at 1.8% interest would provide this between 19 and 20 years. The total time frame for withdrawals would be between 29 and 30 years under such worst case assumptions.

The upside potential is for dividends start at 4% and to grow. This would mitigate any shortfall in the event of unfavorable TIPS interest rates. Dividends supply a separate income stream that should last well into the far off future.

Recap

By breaking our portfolio into four segments, we can adjust how much principal becomes available to redeploy each year. In all cases, we had enough TIPS maturing each year so that we did not need to sell any bonds on the secondary market as a matter of routine. Of course, we can always choose to sell some TIPS in order to redeploy funds.

Because today’s yields-to-maturity are all close to 1.8%, it is a good idea to emphasize shorter maturities with the hope of obtaining higher interest rates in the future.

Since all maturities have approximately the same yield, the taxable portion does not vary by much. In a taxable account, 1.8% of the initial balance in the first year would be interest and 2.2% would be a return of capital. Unfortunately, increases in principal are taxed even though they are caused by inflation. The increases are taxable when they occur.

Keep in mind that bonds are much more volatile than most people imagine. With traditional bonds, it is highly likely that the interest rate at some maturity will change by 0.5% or more every six months. It is likely that TIPS will show similar volatility. They did last year.

It may be a good idea to set aside 25% of the portfolio to stocks that pay high dividends. The upside potential is an income stream that would match inflation and last into the far off future or even better. The downside under worst case circumstances is likely to be a reduction of half of the hoped for dividend income after ten years.

Summary

We have been able to reach a 4.0% Safe Withdrawal Rate over 40 years in today’s marketplace. The odds of success are around 95%.

The odds are 50%-50% that you will be able to increase your withdrawals safely to 5.0% or better.

In the unlikely event that we end up in the danger zone, we could choose to cut withdrawals to 2.97% of the initial balance (plus inflation) after the first decade. We would still make it to year 40. If we were to choose to continue withdrawing 4.0% in spite of bad fortune, would make it beyond year 29 if we encounter a dividend disaster or to 33 to 35 years by staying entirely in TIPS. In fact, all that has to happen is for the yield-to-maturity of TIPS to rise to 2.5% for us to reach year 40.

We have eliminated the need to redeem TIPS on the secondary market.

Have fun.

John Walter Russell
I wrote this on June 15, 2005.