TIPS versus Dividends

Today’s stock valuations are sky high. They are lower than they were in 2000. But they are higher than they were in most of 1929.

I expect stock prices to fall substantially, but I don’t know when. Most likely, they will fall within the next ten to fifteen years.

What should a new retiree do?

How about some TIPS and dividend-based strategies?

Here are some examples. They may help you in your own planning.

The Examples

I compare sitting on the sidelines drawing down 10-year TIPS with investing in good companies with higher than normal yields, in this case 3.0%. (You can get 3.0% from iShares DVY as well as from individual stocks.)

In my first example, I look at withdrawals of 3.0%. I simply live off the dividends. I assume that dividend amounts will keep up with inflation, which has usually been true in the past, but not always. I compare this with drawing down a TIPS portfolio, waiting for stock prices to fall and then buying stocks at more attractive yields.

I have added another example in which I withdraw 4.0% total. I draw down a TIPS portfolio, while waiting to buy stocks later at more attractive yields. I split my holdings 80%-20% between stocks that pay 3.0% dividends and a TIPS-only portfolio that I draw almost all of the way down to zero. Then I look at this same situation splitting my holdings 20%-80%.

Finally, I look at withdrawing 3.5% from a 50%-50% combination of stocks and TIPS.

I have not included taxes in this analysis.

There are many other details. They are not likely to be a problem with an actual portfolio. For example, you will need to reinvest some money to cover dividend cuts and/or companies that go out of business. Typically, dividend amounts grow faster than inflation and they are enough to supply these funds.

The First Example

One option is to live off the dividends of quality companies. The alternative is to draw 3.0% from a TIPS-only portfolio. Ten-year TIPS are currently yielding 1.6% to maturity. I take advantage of any expected drop in stock prices when it occurs. I sell TIPS (at par) to buy dividend paying stocks.

For purposes of calculation, I assume that I have to wait ten years. The TIPS-only portfolio’s remaining principal after ten years is 85% of the original balance. If I were to buy stocks with this money, I would need them to yield 3.53% (= 3.0% / 0.85) for me maintain my income. That is, stock prices would have to fall 15%, the same amount that my principal has decreased. If stock prices were to fall farther, I would have done well. I would increase my income.

The Second Example

If I were to withdraw 4.0% from a TIPS-only portfolio for ten years, I would end up with 74% of my original balance. I would need to be able to buy stocks that yield 5.41% (= 4.0% / 0.74) to maintain my level of income.

The S&P500 index currently yields 1.84%. For this yield to increase to 5.41%, stock prices would have to drop by a factor of 2.94 (= 5.41 / 1.84), assuming that the dividend amount remains steady (after adjusting for inflation). This would require that valuations overshoot as they come down. P/E10 would have to drop from today’s level around 28 to 9 to 10, which is in bargain territory but not uncommon.

Getting income from the market as a whole (the S&P500 index) is difficult. There are many good companies that pay higher dividends.

We could be looking for today’s higher yielding stocks to increase from 3.0% to 5.41%. This would be a factor of 1.8. In terms of P/E10, this would be similar to a drop from 28 to 15 or 16, which is quite reasonable. The S&P500 is at fair value when P/E10 is between 14 and 15.

This approach has risk. But it has a good chance for success.

The Third Example

Now, consider the alternative withdrawal strategy. The stocks yield 3.0% and they occupy 80% of the initial portfolio. They provide an income stream equal to 2.4% of the portfolio’s initial balance (3.0%*0.80).

The TIPS-only portion occupies 20% of the initial portfolio and it must bring the total withdrawal amount up to 4.0%. That is, it must provide an income stream equal to 1.6% of the portfolio’s initial balance (4.0% - 2.4% = 1.6%).

Since the TIPS-only allocation is only 20%, it must allow withdrawals of 8.0% (= 1.6% / 0.20) for ten years.

This is too much. You would have to replace the 8.0% income stream from TIPS with what remains in your TIPS account with stocks that produce a very high level of income.

The principal remaining after ten years of withdrawals would be 31% of the original TIPS balance assuming a 1.6% interest rate. We would need to buy stocks with dividend yields of 25.8% (= 8% / 0.31). This is far too much.

The Fourth Example

This time stocks occupy 20% of my portfolio. With a dividend yield of 3.0%, they provide an income stream equal to 0.6% (= 3%*0.20) of the portfolio’s initial balance.

The TIPS-only portion occupies 80% of the initial portfolio and it must bring the total withdrawal amount up to 4.0%. That is, it must provide an income stream equal to 3.4% of the portfolio’s initial balance (4.0% - 0.6% = 3.4%).

Since the TIPS-only allocation is 80%, it must allow withdrawals of 4.25% (= 3.4% / 0.80) for ten years.

The principal remaining after ten years of withdrawals would be 71.5% of the original TIPS balance assuming a 1.6% interest rate. We would need to buy stocks with dividend yields of 5.94% (= 4.25% / 0.715).

To get the S&P500 dividend yield up to 5.94% would require a price collapse of 3.22 (=5.94/1.84). This would bring P/E10 down from 28 to between 8 and 9, which is in bargain territory but still within recent experience. To get the dividend yield of 3.0% stocks to 5.94% would require a price decrease of 1.98 (=5.94/3.0). This is reasonable, bringing P/E10 down from 28 to a fair value around 14.

The Fifth Example

This time, we withdraw 3.5% of the portfolio’s initial value from a portfolio that is split 50%-50% between stocks and TIPS.

With a dividend yield of 3.0%, stocks provide an income stream equal to 1.75% (= 3.5%*0.50) of the portfolio’s initial balance.

TIPS must provide an income stream equal to 2.25% of the portfolio’s initial balance (4.0% - 1.75% = 2.25%).

Since the TIPS-only allocation is 50%, it must allow withdrawals of 4.50% (= 2.25% / 0.50) for ten years.

The principal remaining after ten years of withdrawals would be 68.8% of the original TIPS balance assuming a 1.6% interest rate. You would need to buy stocks with dividend yields of 6.54% (= 4.50% / 0.688).

To get the S&P500 dividend yield up to 6.54% would require a price collapse of 3.55 (=6.54/1.84). This would bring P/E10 down from 28 to between 7 and 8, which comes close to recent lows. To get the dividend yield of 3.0% stocks to 6.54% would require a price decrease of 2.18 (=6.54/3.0). This is reasonable, bringing P/E10 down from 28 to 12 or 13, a little bit below the fair value around 14.

Formulas

Here are my formulas:

The withdrawal rate that you get from TIPS at an interest rate of r when you draw down all of its principal over N years is what I call the TIPS Equivalent Safe Withdrawal Rate TESWR.

TESWR = r / [1 – (1 / [(1+r)^N ) ].

This is what you get from a mortgage calculator.

The Remaining Fraction is RF when you withdraw at a rate WR, which is less than the TIPS Equivalent Safe Withdrawal Rate TESWR with a TIPS interest rate of r.

RF = [TESWR-WR] / [TESWR-r]

The number of years N influences the remaining fraction indirectly since it affects the TESWR.

Summary

I have provided a series of examples close up for people who would like to blend a baseline strategy of waiting on the sidelines for better stock prices with a dividend-based strategy.

Waiting on the sidelines with a TIPS-only portfolio produces the most attractive numbers, but they carry risk. Stock prices must fall within a decade or so for it to work. Retirees who are much more comfortable starting out with a dividend-based strategy might consider putting a speculative portion of their holdings into TIPS to take advantage of opportunities as they appears.

Have fun.

John Walter Russell
I wrote this on May 5, 2005.