|
Withdrawing from TIPS Ladder
(Updated 8/25/08)
Introduction The traditional approach to structure a portfolio for retirement is to accumulate a balanced mix of stocks and bonds. This is usually done using mutual funds. However, a portfolio containing stocks will experience volatility. This article will explore an alternative approach to structuring a retirement portfolio designed to address the problem of volatility. This alternative approach uses a TIPS ladder. “TIPS” is shorthand for Treasury Inflation Protected Securities. The Traditional Approach Historical studies have examined withdrawal rates using data from stocks, bonds and inflation. (See note 1). The results can be summarized with the following chart:
This chart was created using my Maximum Withdrawal Rate Spreadsheet (xls) The inflation-adjusted initial withdrawal rate that survived all 30-year periods using a balanced 50% stocks and 50% bond portfolio was 4%. Unless otherwise noted, stocks are S&P 500 and bonds are 5-year Treasuries One issue that may concern retired investors living off their portfolio is the volatile nature of annual returns. The following chart shows the inflation-adjusted annual returns that resulted from a balanced 50% stocks and 50% bond portfolio:
Data obtained from my Allocation Spreadsheet (xls) To reduce annual volatility, one possible solution would be lower the allocation to stocks. The following chart shows the inflation-adjusted annual returns that resulted from a 100% bond portfolio:
Data obtained from my Allocation Spreadsheet (xls) So while an all-bond portfolio reduced annual volatility, it also produced lower average annual returns. Generally speaking, the lower average annual returns from bonds have led to a lower surviving inflation-adjusted initial withdrawal rate.
This chart was created using my Maximum Withdrawal Rate Spreadsheet (xls)
If it were possible to eliminate annual portfolio volatility, it may be possible to produce an inflation-adjusted initial withdrawal rate of 4% with a high degree of certainty. The following table is a theoretical example of how such a result could be achieved.
This table was created using my TIPS Ladder Withdrawal Spreadsheet (xls) The above table assumes a retiree will have accumulated $1,000,000 in the year before retirement (Year -1). At the end of the year, the portfolio earned a real rate of interest of 1.3%. The amount earned was $13,000 ($1,000,000 * 1.3%). Also at the end of the year, a withdrawal of $40,000 was made (4% * $1,000,000). This amount will be used for the retiree's first year’s living expenses in Year 1. This procedure repeats for the remaining 29 years. At the end of the 29th year, the last withdrawal of $40,000 is made. This last withdrawal of $40,000 will be used for the living expenses in Year 30. (Note that all numbers have been expressed in real terms.) From this example, we see it is theoretically possible to achieve a sustainable inflation-adjusted 4% withdrawal rate, covering a period of 30 years, from a portfolio that generates a stable real rate of return of 1.3% or more. The challenge, then, is to identify an investment vehicle that can virtually guarantee a safe, stable and sustainable, inflation-adjusted rate of return of 1.3% or more for a period of 30 years. A TIPS ladder meet those requirements: Safe: TIPS are bonds backed by the full faith and credit of the United States Treasury. How TIPS Work At this point, I would like to discuss how an individual TIPS bond works. The following is a basic description:
This table was created using my TIPS Ladder Withdrawal Spreadsheet (xls) I should hasten to add that the preceding example is a simplification in order to show year-by-year numbers. As mentioned previously, TIPS’ principal is adjusted semi-annually with interest paid semi-annually. See note 2 for an example. Constructing a TIPS Ladder Constructing a bond ladder with TIPS is a rather complicated affair. The goal is to have one individual bond, or “step”, mature each year. For maximum income, one should start the ladder with 20-year TIPS, as you will be able to lock in the highest coupon rate. (TIPS are offered with 5-year, 10-year and 20-year maturities.) Thus, you will have 20 individual TIPS to fill the first 20 steps. And each 20-year TIPS will need to be purchased 20 years prior to when you want them to mature. (Alternatively, if you set up the ladder all at once, you would be purchasing most or all the steps on the secondary market.) At this point, I'm going to leave out a lot of detail done in building a ladder in the accumulation phase in order to skip ahead to the withdrawal phase. If the investor obtains a coupon rate of 1.3%, the value of the portfolio needs to be 25 times the amount withdrawn in the first year of retirement. However, with coupon rates currently around 2%, the value of the portfolio needed might be 23 times the initial withdrawal amount. See note 3 for details. Using the links below, I will present a detailed procedure for withdrawing from a TIPS ladder. It will use the same parameters as the table shown earlier. (Start value of $1,000,000, real rate of 1.3% and an inflation-adjusted initial withdrawal rate of 4% for 30 years.)
Chart
Disadvantage to a TIPS Ladder As previously mentioned, one disadvantage to a TIPS ladder is that it is more complicated. Whereas a traditional retirement portfolio will have only a handful of mutual funds, a TIPS ladder will comprise twenty individual securities. At this point, you may be wondering if there might be a simpler solution to laddering. Perhaps, just buying a TIPS mutual fund? I looked at this option. But then you would be subject to annual volatility -- the same problem inherent in the traditional portfolio. Besides, even if a TIPS fund achieved an average annual real rate of return of 1.3%, it still might fail to provide an inflation-adjusted initial withdrawal rate of 4%. I base this observation by looking at the historical data for bonds:
Data obtained from my Allocation Spreadsheet (xls) and my Maximum Withdrawal Rate Spreadsheet (xls)
The lower chart takes the data from the upper chart and presents it as a scatter plot. This enables us to view the data more easily by sorting real returns from lowest to highest going from left to right. The red data points show that, in certain 30-year periods with real average annual returns above 1.3%, the inflation-adjusted withdrawal rate was below 4%. Even when the real average annual return was as high as 3%, there was a 30-year period where the withdrawal rate fell shy of 4%. This demonstrates the risk of relying on a TIPS fund if a withdrawal rate of 4% is required. Another disadvantage to withdrawing from a TIPS ladder involves taxes. For both the traditional portfolio and the TIPS ladder, tax treatment will be the same from tax-advantaged accounts. However, when using personal (taxable) accounts, tax treatment will favor the traditional portfolio. In personal accounts, a portfolio composed of stocks bought and held over a long period will likely have unrealized long-term capital gains. When these stocks are then sold, they will be taxed at the lower long-term capital gains rate. By contrast, TIPS throw off semi-annual interest income that is taxed at the higher marginal bracket. In addition, the investor of individual TIPS will be taxed on “phantom income” from principal adjustments. (See note 4). These features make TIPS very tax inefficient while the investor is building and accumulating his ladder. Unlike the inefficiencies of TIPS, stocks in a traditional portfolio can be accumulated with less tax burdens. Qualified dividends are taxed at a lower rate. And if the stock fund keeps annual turnover low, capital gains distributions may also be low. Conclusion When withdrawing from a traditional portfolio composed of stock and bond mutual funds, the investor will experience annual volatility. For the investor who wishes to eliminate annual volatility, a TIPS ladder may offer an alternative. However while a TIPS ladder offers the advantage of stability, there are certain disadvantages to consider. A TIPS ladder involves a greater number of securities than a traditional portfolio, which generally comprises only a handful of mutual funds. Also, a TIPS ladder will be exposed to higher tax rates than a traditional portfolio when held in a personal (taxable) account. |
| Note 1 | The following articles are historical studies that have examined “safe” withdrawal rates.
Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable The Retirement Calculator from Hell Determining Withdrawal Rates Using Historical Data (pdf) Asset Allocation for a Lifetime (pdf) Conserving Client Portfolios During Retirement, Part III (pdf)
The following calculators will demonstrate "safe" withdrawal rates using historical data. Max Rate Withdrawal Spreadsheet (xls)
|
| Note 2 | Suppose an individual invests $1,000 on January 15 in a new inflation-protected 10- year note with a 3% real rate of return.
If inflation was 1% during the first six months of that year, then by mid-year the inflation-adjusted principal amount of the security would be $1,010. In addition, at mid-year, on July 15, the investor would receive the first semiannual interest payment of $15.15 ($1,010 times 3% divided by 2). Suppose, then, that inflation accelerated during the second half of the year, so that it reached 3% for the full year. By the second semiannual interest payment date, January 15, the inflation-adjusted principal amount of the security would be $1,030. The second semiannual interest payment would be $15.45 ($1,030 times 3% divided by 2). Source: www.investinginbonds.com
|
| Note 3 | In its brief history, the real rate on 20-year TIPS has been around 2 percent.
Source: Federal Reserve Bank of St. Louis
So if we plug in 2.0% into my simple calculator, we see that we can take out an inflation-adjusted 4.4% initial withdrawal rate.
This table was created using my TIPS Ladder Withdrawal Spreadsheet (xls)
This means that the nest egg needs to be 23 times the first withdrawal.
|
| Note 4 |
Federal tax The semi-annual interest payments on TIPS are taxable to a holder of securities when received. This is consistent with the tax treatment of other Treasury securities. State tax Like all securities issued by the U.S. Treasury, TIPS are exempt from taxation by a state or a political subdivision of a state, except for state estate or inheritance taxes and other exceptions provided by law. Source: www.investinginbonds.com
|
