Grok's Tip #8:Retire Worry-Free with TIPs as a foundation

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Grok's Tip #8:Retire Worry-Free with TIPs as a foundation

Postby grok87 » Fri Apr 01, 2011 11:13 pm

Grok's Tip #8/10:Retire Worry-Free with TIPs as a foundation

As Abraham Lincoln once said, “A goal properly set is halfway reached.”

Many people find the goal of saving for retirement to be challenging. Conventional wisdom (or perhaps more accurately fund company marketing) says to use target retirement date funds as the foundation for your retirement. The trouble is these funds didn’t exactly cover themselves in glory during the recent ‘08-‘09 market sell-off. Many pre-retirees (i.e. those close to retirement) who were invested in these funds were surprised at what heavy allocations to equities they had. Congress even held hearings on the issue:

http://aging.senate.gov/events/hr217cr.pdf

Executive Summary wrote:Although target date funds have proved popular with participants and have won the approval of many investment professionals, the losses suffered by target date funds during the economic downturn raised concerns about the design and transparency of these funds. For example, an Aging Committee investigation found that the allocation of assets among stocks, bonds, cash-equivalents varied greatly among target date funds with the same target retirement date, with select firms’ 2010 target date funds’ equity holdings ranging anywhere from 24 to 68 percent. It was also unclear to what extent plan sponsors educate their participants on these funds, as well as how fiduciary standards would be enforced.


The rude shock of the ‘08-‘09 market market sell-off caused many pre-retirees to lose confidence in their ability to retire comfortably. See for example this 2009 EBRI study

http://www.oecd.org/dataoecd/36/20/42595096.pdf

2009 EBRI study wrote:RECORD LOW CONFIDENCE LEVELS: Workers who say they are very confident about having enough money for a comfortable retirement this year hit the lowest level in 2009 (13 percent) since the Retirement Confidence Survey started asking the question in 1993, continuing a two-year decline. Retirees also posted a new low in confidence about having a financially secure retirement, with only 20 percent now saying they are very confident (down from 41 percent in 2007).



There must be a better way…

In this paper Zvi Bodie argues that TIPs are the natural financial instrument to use in laying a proper foundation for one’s retirement.

http://papers.ssrn.com/sol3/papers.cfm? ... _id=260628

Bodie wrote:This paper proposes a new approach to investing for retirement that takes advantage of recent market innovations and advances in finance theory to improve the risk/reward opportunities available to individual investors before and after retirement. The approach introduces three new elements:

- It uses inflation-protected bonds to hedge a minimum standard of living after retirement.

- It takes account of a person's willingness to postpone retirement.

- It uses option "ladders" to lever growth in retirement income.


With a series or ladder of long dated (e.g. 30 year) individual TIPs, younger workers can lock in a future real income stream today for their future retirement years. Since TIPs are real return instruments, their value is guaranteed to keep up with inflation if held to maturity. TIPS are best held in tax advantaged accounts and so one constraint to this approach is whether you actually have enough space in IRAs and 401ks (brokerage option) to buy them.

Let’s look at an example to see how the mechanics of Bodie’s strategy might work (it may be slightly trickier than you might think but it’s not rocket science).

Let’s say you plan to retire at age 2029 at age 62 (i.e. you are currently 44) and you want to guarantee an annual “real” income of $50,000 a year- i.e. $50,000 in today’s dollars that will increase with inflation. Based on this social security calculator
http://www.socialsecurity.gov/OACT/quickcalc/index.html
you estimate that your social security benefit at 62, in today’s dollars, will be $20,000. So will need $30,000 a year of other “real” income- i.e. 30,000 in today’s dollars.

To fund 2029, the first year of your retirement, you could buy $30k of face value of the 2.5% coupon TIP maturing at 1/2029. The cost works out to $35.28 k = $30k*1.026*1.146 = face*(inflation factor)*(price)

To fund the 2032 year, you would buy a smaller face amount of the 3.375% TIP maturing at 1/2032. This is because this bond has a substantial inflation factor of 1.24. So to lock in $30,000 in todays dollars you would buy 24k worth of face value (24 k*1.24 = face*inflation factor = $29.76 k) which would cost $38.78k = face*(inflation factor)*(price) = 24k *(1.24)*(1.302).

What about the 2030 and 2031 years? Well unfortunately there are no TIPs maturing in those years yet. So instead just buy the 2029 TIP for the 2030 year and the 2032 TIP for the 2031 year- i.e. it’s not a big deal to be a year or so off in your TIPs ladder.

Now after 2032 things get a little trickier because there is a long gap (8 years) till the next available TIP maturity of 2040. To handle this, I would advocate a “roll your own TIPs” approach for some of these years. Take the 2036 year for example. The “roll your own TIPs” approach involves first buying the 2026 TIP and then when that matures “rolling” it into a newly auctioned 10 year TIP that would take you up to 2036. So, factoring in the various inflation factors, here’s the ladder or series of TIPs you would buy:

2029: Buy 30 bonds of the 2029 TIP: cost = $35.28 k
2030: Buy 30 bonds of the 2029 TIP: cost = $35.28 k
2031: Buy 24 bonds of the 2032 TIP: cost = $38.78 k
2032: Buy 24 bonds of the 2032 TIP: cost = $38.78 k
2033: Buy 24 bonds of the 2032 TIP: cost = $38.78 k
2034: Buy 30 bonds of the 2029 TIP and then on maturity roll into a newly auctioned 5 year TIP: cost = $35.28 k
2035: Buy the 26 bonds of the 2025 TIP and then at maturity roll into new 10 yr TIP: cost = $34.43 k
2036: Buy 27 bonds of the 2026 TIP and then at maturity roll into a new 10 yr TIP: cost = $32.34k
2037: Buy 27 bonds of the 2027 TIP and then at maturity roll into a new 10 yr TIP: cost = $33.18 k
2038: Buy 29 bonds of the 2028 TIP and then at maturity roll into a new 10 yr TIP: cost = $31.51
2039: Buy 30 bonds of the 2040 TIP: cost = $32.93 k
2040: Buy 30 bonds of the 2040 TIP: cost = $32.93 k
2041: Buy 30 bonds of the 2041 TIP: cost =$32.49 k

The total works out to $450.89 k and guarantees you a maturing amount of $30k (in todays dollars) for each year from 2029 to 2041 (i.e. age 62 to 74) This $30 k a year is from maturing principal only- we haven’t even factored in the $7.21 k real income generated by the TIPs ladder each year (more on that later).

Going forward you would buy 30k worth of the newly auctioned 30 year TIP each year. Of course you would have to adjust the amount for inflation. For example if CPI is 3% in 2012 then you would actually buy $31k (=$30k *1.03). You would keep buying each year until you hit 62 in 2029 (when you would buy a TIP maturing in 2059, the year you turn 92).

Now the point of this strategy is to lay a floor or a foundation for your retirement by guaranteeing a certain minimum income in retirement- in this example $50 k of real –(i.e. inflation adjusted) income. Since you have this in place, any other funds you have available could be invested very aggressively, for example 100% in equities, perhaps in small cap value stocks, etc. These investments will hopefully provide excess funds in retirement to enhance your standard of living beyond the minimum provided by Social Security and your TIPs ladder.

Bodie actually mentions at-the-money 3 year LEAPs or long term equity index options (on for example the S&P 500) as one alternative to consider. These are risky because if, for example, the stock market drops and stays down for 3 years, then these LEAPs could expire worthless (i.e. go to zero). One approach here might be to invest only the coupons from your TIPs ladder in these LEAPs. That way if the LEAPS go to zero, the combination of the TIPs ladder and the LEAPS will still have produced a minimum real return of zero.

Going back to our TIPs ladder, it generates $7.21k of real TIPs coupons per year. The S&P 500 is currently at 1332 and SPY (S&P 500 etf) is at 131. Options on SPY expiring in December 2013 with a strike of 135 are currently priced at $15. So you could buy 480 of these options each year or around 5 option contracts (an option contract is for 100 shares). These options would pay off if the S&P 500 rises above 1500 by the end of 2013. That works out to a 12.7% rise or 4.4% annualized, which doesn’t seem that much of a stretch.

Let’s say the LEAPs and heavy equity allocation really pay off as you approach retirement. You end up with say an extra $160k (in todays dollars). The nice thing now is that you can cash in those bets and use the money to replace the Social Security part of your retirement income for the first 8 years. By delaying Social Security from 62 to 70 you will make your later retirement even more secure.
Again going back to the example we’ve been considering, by taking Social Security at age 62 you are actually getting only 70% of your full retirement benefit (which is at age 67 in this example). If you delay retirement till age 70 you would actually get 124% of your full retirement benefit. That works out to a 77% increase over your age 62 SS benefit. In this example that would increase your SS benefit from $20 k per year to $35.4 k per year, and your total income from the SS/TIPs ladder combo would increase from $50 k per year to $65.4 k per year (again all in today’s dollars).
But again if disaster strikes and the heavy equity/LEAPs approach fails, you still can fall back on that $50 k per year to retire on.

This is the 8th in a series of 10 investment tips. Here are the previous tips:

Tip #1: Take your risk on the equity side
viewtopic.php?t=66322&highlight=

Tip #2: Use Cash to dampen portfolio risk
viewtopic.php?t=66328&highlight=

Tip #3: Index, Index, Index! But...
viewtopic.php?t=66408&highlight=

Tip #4: Rebalance early and often
viewtopic.php?t=66636&highlight=

Tip #5: To keep real wealth skip Gold, buy TIPs
viewtopic.php?t=66790&highlight=

Tip #6: Be aligned: Buy this, not that!
viewtopic.php?t=67727&highlight=

Tip #7: Skip foreign bonds
viewtopic.php?t=69087&highlight=

cheers,
Last edited by grok87 on Sun May 01, 2011 12:37 am, edited 2 times in total.
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Postby #Cruncher » Sat Apr 02, 2011 10:24 am

I've downloaded the Bodie paper Grok refers to and posted it on a web site so others won't to have download it themselves: Bodie Paper PDF. It's an interesting and easy read and is only about 10 pages long.
Regarding the TIPS ladder, on page 3 he wrote:The inflation-indexed bonds issued by the US Treasury can be “stripped” by qualified financial institutions to provide a complete array of CPI denominated pure discount bonds with maturities up to 30 years.

The paper was written in 2001. Too bad "stripping" hasn't come to pass. It would make constructing a TIPS ladder to cover the missing maturity years much easier. By the way here is a list of the current TIPS maturities along with the index ratios Grok is using. And here is a post by nisiprius that shows the missing years graphically. (Note: 2021 and 2041 have since
been filled in.)

Bodie's paper has a couple of interesting graphs on page 5 showing the relationship between portfolio risk and the age at which one can retire.

But the most interesting part of the paper in my opinion are the two graphs on page 7 and 8 where Bodie compares the returns of a 90:10 bond:LEAPS portfolio against more conventional investment allocations.

Edit 12/26/2013: fix domain on 2 links to eyebonds.info and fix link to nisiprius post in another thread
Last edited by #Cruncher on Thu Dec 26, 2013 1:38 am, edited 1 time in total.
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Is LTPZ (Pimco ETF) almost as good?

Postby jefmafnl » Sat Apr 02, 2011 11:00 am

Great strategy.

Don't mean to hijack this thread ... but for investors who are within 10 to 15 years of retiring, the ladder would have to be shorter and perhaps not worth the trouble.

For such investors, would it make sense to invest in the PIMCO 15+ Year US TIPS Index ETF (LTPZ)(average maturity 18+ years), and gradually add one of the "quasi 10-year TIPS" ETF's or funds, such as PIMCO's TENZ, Barclay's TIPS (both ETF's), or Vanguard's VIPSX (mutual fund)? This would allow the investor to enjoy the higher yields of the longer TIPS (at least as long as the current sloping real yield curve persists) while gradually reducing the average maturity and duration as one approaches and begins retirement.

Thanks.

J
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Postby elgob.bogle » Sat Apr 02, 2011 11:17 am

Grok - Excellent TIP again :P - pun intended

How would one set this up when within 2 months of retirement & nest egg of about $1m.

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Postby grok87 » Sat Apr 02, 2011 12:56 pm

#Cruncher wrote:I've downloaded the Bodie paper Grok refers to and posted it on a web site so others won't to have download it themselves: Bodie Paper PDF. It's an interesting and easy read and is only about 10 pages long.
Regarding the TIPS ladder, on page 3 he wrote:The inflation-indexed bonds issued by the US Treasury can be “stripped” by qualified financial institutions to provide a complete array of CPI denominated pure discount bonds with maturities up to 30 years.

The paper was written in 2001. Too bad "stripping" hasn't come to pass. It would make constructing a TIPS ladder to cover the missing maturity years much easier. By the way here is a list of the current TIPS maturities along with the index ratios Grok is using. And here is a post by nisiprius that shows the missing years graphically. (Note: 2021 and 2041 have since been filled in.)

Bodie's paper has a couple of interesting graphs on page 5 showing the relationship between portfolio risk and the age at which one can retire.

But the most interesting part of the paper in my opinion are the two graphs on page 7 and 8 where Bodie compares the returns of a 90:10 bond:LEAPS portfolio against more conventional investment allocations.

Thanks #Cruncher-

I agree those graphs on page 7&8 are very interesting. With the TIPs/LEAPs approach you get a capped downside but keep much of the upside of being fully invested in equities. In my opinion this sort of strategy is exactly what investors need. Note its interesting to me how many investors choose to do exactly the opposite- buy an equity index and write calls against it. This has never made any sense to me. You keep all of the risk/downside of equities but give away all or most of the upside in exchange for a little income! Crazy!

Note I'm still thinking about the 90/10 TIPs/LEAPS strategy. Losing 10% of your portfolio seems like a lot to me. As per my post, I think putting the TIPs coupons into LEAPs is easier to swallow. That works out to less than 10%. In my example the TIPs portfolio is $450 k and the 3 year LEAPs are 7 k a year. I guess if you did a 3 year ladder of the 3 year LEAPs you would have 21k at stake at any one time which would work out to 5% of your portfolio- i.e. I suggest considering a 95/5 TIPs/LEAPs approach.

cheers,
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Re: Is LTPZ (Pimco ETF) almost as good?

Postby grok87 » Sat Apr 02, 2011 12:58 pm

jefmafnl wrote:Great strategy.

Don't mean to hijack this thread ... but for investors who are within 10 to 15 years of retiring, the ladder would have to be shorter and perhaps not worth the trouble.

For such investors, would it make sense to invest in the PIMCO 15+ Year US TIPS Index ETF (LTPZ)(average maturity 18+ years), and gradually add one of the "quasi 10-year TIPS" ETF's or funds, such as PIMCO's TENZ, Barclay's TIPS (both ETF's), or Vanguard's VIPSX (mutual fund)? This would allow the investor to enjoy the higher yields of the longer TIPS (at least as long as the current sloping real yield curve persists) while gradually reducing the average maturity and duration as one approaches and begins retirement.

Thanks.

J

Thanks J.
Well I can see that perhaps not wanting to buy very short TIPs. But starting with 10 year TIPs and longer would be worth it I think. And remember I'm suggesting you keep buying 30 year TIPs each year until you retire. Effectively I'm saying one needs to plan for a 30 year retirement. I.e. if your retire at 62 you should fund out to age 92.
cheers,
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Postby grok87 » Sat Apr 02, 2011 1:28 pm

elgob.bogle wrote:Grok - Excellent TIP again :P - pun intended

How would one set this up when within 2 months of retirement & nest egg of about $1m.

elgob

Thanks elgob,
Hmm...well you would need to set up a 30 year ladder of TIPs. For the 13 years from 2029 to 2041 you would follow the blueprint I gave- again the cost is $450 k. But then you would also need to cover the 18 years from 2011 to 2028. Here's what I'd recommend:

2011-2018: Ladder of CDs. Say from PenFed or other institution that has easy early withdrawal penalties. See this thread for example
viewtopic.php?t=44081&highlight=
Cost = $210k
My reasoning here is that 1)unexpected inflation is not that big of a deal in the near term 2) the real rates on TIPs for these maturities are low (<0.5%) and 3) the early withdrawal feature (can withdraw early and just lose a few months interest) is valuable.


2019-2028: Buy TIPs. There are a few years missing (2022-2024) where you'd have to use the "roll your own TIPs" strategy. I'm not exactly sure what his would cost. At least $300k- probably more like $350 k.

So if you add up all these amounts you would nicely get back to just about your $1M.

cheers,
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Postby abuss368 » Sat Apr 02, 2011 1:28 pm

Why has Mr. Bogle removed TIPS and focused simply on Total Bond Market in the tax advantaged accounts and muni's in taxable?
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Postby chaz » Sat Apr 02, 2011 1:37 pm

I have a TIPS fund - is that bad?
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Postby grok87 » Sat Apr 02, 2011 1:54 pm

chaz wrote:I have a TIPS fund - is that bad?

Hi chaz,
I wouldn't say that it is bad. But it may be less than optimal. For example the Vanguard TIPs fund has an average maturity of 9 years. In theory you would want to compare that to the average maturity of the "liabilities" (i.e. retirement income needs) you are trying to fund with this asset. If your average life expectancy is 9 years then the two would match up. If your average life expectancy is 15 years or so, then you might want some longer TIPs. In his post above, Jefmanfl points to a Pimco TIPS ETF (LTPZ) that owns longer TIPs. I haven't investigated it yet though so I can't recommend it one way or the other.
cheers,
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Postby chaz » Sat Apr 02, 2011 2:00 pm

grok87 wrote:
chaz wrote:I have a TIPS fund - is that bad?

Hi chaz,
I wouldn't say that it is bad. But it may be less than optimal. For example the Vanguard TIPs fund has an average maturity of 9 years. In theory you would want to compare that to the average maturity of the "liabilities" (i.e. retirement income needs) you are trying to fund with this asset. If your average life expectancy is 9 years then the two would match up. If your average life expectancy is 15 years or so, then you might want some longer TIPs. In his post above, Jefmanfl points to a Pimco TIPS ETF (LTPZ) that owns longer TIPs. I haven't investigated it yet though so I can't recommend it one way or the other.
cheers,


Thanks grok. 9 years seems right for me.
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Postby grok87 » Sat Apr 02, 2011 2:14 pm

abuss368 wrote:Why has Mr. Bogle removed TIPS and focused simply on Total Bond Market in the tax advantaged accounts and muni's in taxable?

I think Mr. Bogle and Professor Bodie have different perspectives. Mr. Bogle is taking an "own the market approach"- that is infinitely superior to what most actively managed investors do. Professor Bodie is taking an ALM (asset liability matching) perspective to investment. In that approach you first figure out what your liabilities are and then buy assets to match those liabilities. For retirement investors the "liabilities" are a series of future income needs that are inflation-sensitive- i.e. they are not nominal or fixed dollar liabilities but depend on the future rate of inflation. So TIPs are the best match.
cheers,
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Postby elgob.bogle » Sat Apr 02, 2011 2:27 pm

Thanks Chaz -

Some parts of your solution will work for us and some won't. We have about 10% of portfolio in taxable, 15% in ROTH IRA, and 75% in 4xxx accounts. Spouse has 40% at Fido, and no access to TIPS, so only my 25% could be allocated once I retire & transfer my 457 account to a Vanguard TIRA. This works out to $.6m for FI and $.4m for Fido's Spartan Mutual Funds until she retires in about 7 years, and would not be not optimal for taxes. Alternatively, I could take a $275k lump sum settlement instead of a modest pension, transfer that to a Vanguard TIRA after 90 days, and then get closer to your proposal.

I don't want to hijack your thread, so I can move this discussion elsewhere if you would like..

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Postby tarnation » Sat Apr 02, 2011 2:46 pm

Another idea I had toyed with for the missing rung in ladders is to use I bonds. Basically, one would use coupon payments to buy I bonds every year. The nice thing about this is they are tax advantaged and flexible regarding maturity, but with low yield and limited ability to purchase. This thread shows a worked out example.
http://www.bogleheads.org/forum/viewtopic.php?p=880408#880408

The other obvious consideration for TIPS is taxes, phantom income and cash flows.
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Postby market timer » Sat Apr 02, 2011 2:58 pm

tarnation wrote:Another idea I had toyed with for the missing rung in ladders is to use I bonds.


I'm thinking of using I bonds and EE bonds to provide a mini-annuity between ages 50-67, with a goal of early retirement at age 50. Contributing $20K/year to savings bonds between ages 30-47 should result in about $25K/year withdrawals in today's dollars after-tax between ages 50-67, with the ability to redeem early if rates rise dramatically in the interim. Not spectacular returns, but enough to pay the bills, and relatively tax efficient. Then Social Security can provide the funds for necessities.
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Postby grok87 » Sat Apr 02, 2011 3:15 pm

elgob.bogle wrote:Thanks Chaz -

Some parts of your solution will work for us and some won't. We have about 10% of portfolio in taxable, 15% in ROTH IRA, and 75% in 4xxx accounts. Spouse has 40% at Fido, and no access to TIPS, so only my 25% could be allocated once I retire & transfer my 457 account to a Vanguard TIRA. This works out to $.6m for FI and $.4m for Fido's Spartan Mutual Funds until she retires in about 7 years, and would not be not optimal for taxes. Alternatively, I could take a $275k lump sum settlement instead of a modest pension, transfer that to a Vanguard TIRA after 90 days, and then get closer to your proposal.

I don't want to hijack your thread, so I can move this discussion elsewhere if you would like..

elgob

elgob,
Not hijacking at all. This is exactly the sort of discussion I had hoped this thread would generate.
The key thing is to try and match the duration of you and your wife's future retirement income needs with the duration of the tips (and ibonds) you are buying.
As others have pointed out, you could buy Ibonds with the taxable money. I think you can only buy 20 k a year, so get started!
Since I bonds have zero duration you then might want to buy even longer dated tips with your roth and roll over ira money.
Does your wife have a tips fund in her 401k? Sometimes they are called rea return funds. Does she have a brokerage link option available?
Cheers,
grok, CFA
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Postby grok87 » Sat Apr 02, 2011 3:19 pm

market timer wrote:
tarnation wrote:Another idea I had toyed with for the missing rung in ladders is to use I bonds.


I'm thinking of using I bonds and EE bonds to provide a mini-annuity between ages 50-67, with a goal of early retirement at age 50. Contributing $20K/year to savings bonds between ages 30-47 should result in about $25K/year withdrawals in today's dollars after-tax between ages 50-67, with the ability to redeem early if rates rise dramatically in the interim. Not spectacular returns, but enough to pay the bills, and relatively tax efficient. Then Social Security can provide the funds for necessities.

Markettimer,
I like the ibonds idea. Even at zero yield they look better than short tips with their negative real yields. Plus as you point out you get a cheap put option.
I'm not convinced about the EE bonds though. Last time I looked they seemed like a bad deal to me. Can you make the case as to why you like them?
Cheers,
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Postby bobcat2 » Sat Apr 02, 2011 3:25 pm

Hi grok,

The Bodie paper you reference was written in 2001. At that time inflation-indexed (real) life annuities were not available in the US. So Bodie's considering a strategy that included an inflation-indexed life annuity at that time would have been purely hypothetical.

I suspect Bodie's primary advice today would be to purchase a real life annuity at retirement that covers at least the gap between the retirement investor's minimum retirement income target and SS and DB pension benefits.

During pre-retirement the investor would invest in TIPS that mature at roughly the investor's retirement target year for at least the estimated amount that such a life annuity purchased at retirement would cost.

The investor now has a safe (ALM) investing strategy for at least minimal acceptable retirement income both before retirement and during retirement. This strategy is also easier to implement than a TIPS ladder.

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The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
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Postby grok87 » Sat Apr 02, 2011 3:40 pm

bobcat2 wrote:Hi grok,

The Bodie paper you reference was written in 2001. At that time inflation-indexed (real) life annuities were not available in the US. So Bodie's considering a strategy that included an inflation-indexed life annuity at that time would have been purely hypothetical.

I suspect Bodie's primary advice today would be to purchase a real life annuity at retirement that covers at least the gap between the retirement investor's minimum retirement income target and SS and DB pension benefits.

During pre-retirement the investor would invest in TIPS that mature at roughly the investor's retirement target year for at least the estimated amount that such a life annuity purchased at retirement would cost.

The investor now has a safe (ALM) investing strategy for at least minimal acceptable retirement income both before retirement and during retirement. This strategy is also easier to implement than a TIPS ladder.

BobK

Thanks Bob- good point. I think inflation adjusted annuities sound like a good idea as long as you stay within state guarantee fund limits. Those are kind of low sometimes. The problem is that if you die early your heirs get nothing. Probably a combination of an inflation adjusted annuity and a tips ladder makes some sense
Who do you think are the best carriers? Do any have caps on the inflation adjustment?
Cheers
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Postby market timer » Sat Apr 02, 2011 3:53 pm

grok87 wrote:Markettimer,
I like the ibonds idea. Even at zero yield they look better than short tips with their negative real yields. Plus as you point out you get a cheap put option.
I'm not convinced about the EE bonds though. Last time I looked they seemed like a bad deal to me. Can you make the case as to why you like them?
Cheers,


The attractive feature of EE bonds is the call option on a 20-year zero coupon yielding 3.53% with tax deferral, and potentially tax free growth if used for education. Tax deferral is extremely valuable to me, as I expect to be in a low tax bracket in retirement. Depending on your financial situation, this 3.53% may be comparable to 5% or more fully taxable, which is more than long term Treasuries.

Now suppose you only care about the option value, and maybe only value the tax deferred 3.53% as, say, 4.30% on taxable long term Treasuries -- below the current market rate of 4.48% on the 30-year. I'm going to use TLT as a proxy for long term Treasuries to get a sense of what is the option value of the "free" call. When the 30-year is at 4.30%, TLT should be worth around 95 (currently, it's at 92.19). A Jan 2012 95 call is worth about $2.30. Therefore, the free EE call -- if it were only valid until Jan 2012 -- would be worth around 2.5% of the bond's value. Clearly, the option value is increasing in time, with the Jan 2013 95 call implying an option value of around 4%. On a short term basis, 1-3 years, the 0.6% nominal return is comparable to Treasuries, but you pick up a free option that I think is worth at least 5% of the bond's value. Plus, like I said earlier, I look at the 3.53% as comparable to 5% taxable, so the relevant calls would imply even higher option value.
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Postby bobcat2 » Sat Apr 02, 2011 4:20 pm

Hi grok,

You wrote.
I think inflation adjusted annuities sound like a good idea as long as you stay within state guarantee fund limits. Those are kind of low sometimes. The problem is that if you die early your heirs get nothing. ... Who do you think are the best carriers?


Assuming you annuitize 50% or less of your portfolio, your heirs always do well if you die early. :lol: If you die late your heirs rarely do well, whether you annuitize or not, once the time value of money is accounted for. :wink:

I believe the Income Solutions portal thru Vanguard offers inflation-indexed life annuities from three companies. If you are really worried about insurance companies not being able to meet their annuity obligations then split your purchased annuities among the three companies. Personally I think that risk is way overblown. I wish mutual fund companies peddling equity funds had a guaranteed 2% real return backing them up. Then we could all worry about what would happen if the equity return guarantee would fail. :lol:

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Postby conundrum » Sat Apr 02, 2011 4:38 pm

Thanks Grok for another great tip. We are roughly using your recommended approach. Our tax deferred accounts (only 15% of of total portfolio) are all in 20-30 year individual TIPS. At this point we have a bit of a haphazard ladder with a number of missing rungs but overall have been satisfied with this plan.

Thanks again for all your great tips.

Drum :lol:
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Postby Beagler » Sat Apr 02, 2011 4:39 pm

bobcat2 wrote:
I believe the Income Solutions portal thru Vanguard offers inflation-indexed life annuities from three companies. If you are really worried about insurance companies not being able to meet their annuity obligations then split your purchased annuities among the three companies. Personally I think that risk is way overblown. I wish mutual fund companies peddling equity funds had a guaranteed 2% real return backing them up. Then we could all worry about what would happen if the equity return guarantee would fail. :lol:

BobK


Bob, isn't there a cumulative guarantee? That is, even if you divide a $1M amount over a number of insurers, the State guarantees only a maximum amount per insured! (open to correction)
Last edited by Beagler on Sat Apr 02, 2011 6:39 pm, edited 1 time in total.
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Postby elgob.bogle » Sat Apr 02, 2011 6:35 pm

Grok:

Spouse has neither TIPS nor bokerage link. FI choices are PTRAX (PIMCO Total Return) & FBIDX (Fido Total Bond Market). I don't like the composition of FBIDX right now with about 27% of holdings below an A rating, only 23% treasuries, and about 9% foreign. I'm not an expert, but this doesn't seem to me to be a "total US bond index". I also am unsure of Bill Gross's fund as a current proxy for US Bond Market since he dumped his Treasuries.

We were loading up on Spartan funds (US large FUSEX, Completion (FSEMX) and International Large (FSIIX) in spouse's account, and adding International Small (VSS) and Emerging Markets (VWO) in our ROTH accounts in an attempt to track international markets.

Your (& Bodie's) TIPS plan makes a lot of sense. Laeery Swedroe also is a proponent of a heavy TIPs portfolio for the average person in retirement. So I am looking at it, but our assets are somewhat out of alignment for such a portfolio. Recently, I have been thinking that if our great Florida Governor does not convince our Legislative folks to remove the annual 3% COLA on pensions, that I would it. Now it looks like I need to rethink it. I won;t know the status of the COLA until the end of the FLorida Legislative Session this month - two weeks before I retire with about enough time to process my paperwork! :roll:

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Postby #Cruncher » Sun Apr 03, 2011 2:21 am

I've constructed a little Excel spreadsheet to help in building a 30 year TIPS ladder. The example below shows a ladder delivering approximately 30,000 real dollars every year from 2012 - 2041 for a cost of about $700,000. The desired annual amount, of course, can be changed.

It starts with the most distant year and then takes interest into account in determining how many bonds are needed for each preceding year. This has the effect of reducing the number of shorter term bonds required.

It handles the missing maturity years differently than does Grok's approach in the initial post of this thread. He buys a shorter term bond and then rolls it over into a new bond that matures in the missing year. My approach uses only the currently available maturities. It buys extra bonds in the year after and / or before the missing years. I've made default assumptions on which bonds to do this with, but it can easily be changed.

The sheet can be easily modified to build a ladder for a different time period. For example to build a ladder from 2029 - 2041 as Grok does, just blank out the cells below 2029 in the "Years to Cover" column.

If anyone wants to play around with the spreadsheet, there is a link at the bottom of this post to download it. I haven't done much testing or writing of instructions. I wanted to wait to see if anyone is interested. To make the picture below less complicated, I've hidden some of the columns.

Image

I've used this file in Excel 2003 for Windows and Excel X for Macintosh so it should work with most Excel versions. It has no macros. Only the cells in bold blue are intended to be edited. Click on the link below to download the file:

Download Excel spreadsheet

Edit 3/25/2012: 1) updated ladder spreadsheet to 2013 - 2042 using today's prices, 2) set annual amount to $63,000 to compare to another ladder spreadsheet in this post by magellan, 3) made new image file respecting forum's new 600 max pixel height, 4) changed URL for both spreadsheet and the image to new domain.

Edit 3/30/2012: 1) I've corrected the calculation of interest that was causing the spreadsheet to understate the number of bonds needed to be purchased. For this reason as well as using current TIPS and prices, the image above differs from the $700,000 mentioned in the text. 2) I've started a new thread to discuss TIPS Ladder Spreadsheets in General & Two in Particular.
Last edited by #Cruncher on Fri Mar 30, 2012 11:27 pm, edited 2 times in total.
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Ladder vs. ETF

Postby jefmafnl » Sun Apr 03, 2011 7:14 am

A couple more points:

1. I understand the difference between duration and maturity, although I'm not convinced that duration calculations for TIPS are scientifically based, due to the relatively short history with TIPS.

Grok, do you advocate matching [/i]duration or maturity to life expectancy?

2. For those who are more than 30 years from expected retirement date, the ladder of long TIPS is simple. For those who are older: Without wanting to re-activate the whole "what counts as market timing" debate, isn't there an opportunity cost to constructing a whole ladder (or a substantial part of it) at one point in time, such as the present, with lower than historical-average real rates? Even if one DCAs over 6 months or a year? Vs. the "always adding new bonds at new interest rates" advantage of a fund or ETF such as LTPZ (Pimco's fund)?

J
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Postby jon-nyc » Sun Apr 03, 2011 7:39 am

I was building a nice TIP ladder for just such a strategy using auctions for the 20 year. Then the basterds discontinued them!

Anyway, I'll likely revisit the strategy, but I need to find a better place to buy TIPs on the 2ndary market. The retail spreads on Bonddesk (via etrade) are criminal.
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Spreads

Postby jefmafnl » Sun Apr 03, 2011 8:58 am

Are the spreads via VBS (on secondary market TIPS) normal and reasonable, compared to other brokerages?

J
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Postby larsm » Sun Apr 03, 2011 12:29 pm

Grok,

Thanks for your post, interesting.

How good a substitute do you think I-bonds are for TIPS? Plus, EE-bonds also have an aspect of inflation hedge in that they reset every six months based on 10 year.

Given there are not the current tax issues with I/EEs that you have with TIPS, I've convinced myself that I/EEs are a good inflation hedge without the tax headaches...

Thoughts?
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Postby elgob.bogle » Sun Apr 03, 2011 2:25 pm

#Cruncher - Thanks for the spreadsheet - I'm impressed :D , and the $700k cost for the bonds is likely within reach for me. :) The $30k would be a good supplement to spouses income (She's 56 & about 7 years from retirement, which is when I plan to start collecting SS).

Grok: How does one handle RMD's with individual TIPS mostly in tax-deferred accounts? In my case, I have about 7 years until I have to start taking money out. Which bonds from the ladder would be preferable in our ROTH accounts?

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Postby Chuck T » Sun Apr 03, 2011 5:23 pm

#cruncher
Thanks for posting your spreadsheet. I have downloaded it and will begin to tailor it to my personal situation. It looks very useful.

Grok
Thanks for another tip that stimulates thinking and planning for retirement. These are very helpful.

I get the impression that this approach is primarily for someone that hasn't yet retired. Would it make sense for someone like me at 65 that is already retired? What adjustments need to be made? (Other than not taking the ladder beyond life expectancy. Whatever that may be.) Thanks again. Chuck
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Postby grok87 » Sun Apr 03, 2011 9:57 pm

market timer wrote:
grok87 wrote:Markettimer,
I like the ibonds idea. Even at zero yield they look better than short tips with their negative real yields. Plus as you point out you get a cheap put option.
I'm not convinced about the EE bonds though. Last time I looked they seemed like a bad deal to me. Can you make the case as to why you like them?
Cheers,


The attractive feature of EE bonds is the call option on a 20-year zero coupon yielding 3.53% with tax deferral, and potentially tax free growth if used for education. Tax deferral is extremely valuable to me, as I expect to be in a low tax bracket in retirement. Depending on your financial situation, this 3.53% may be comparable to 5% or more fully taxable, which is more than long term Treasuries.

Now suppose you only care about the option value, and maybe only value the tax deferred 3.53% as, say, 4.30% on taxable long term Treasuries -- below the current market rate of 4.48% on the 30-year. I'm going to use TLT as a proxy for long term Treasuries to get a sense of what is the option value of the "free" call. When the 30-year is at 4.30%, TLT should be worth around 95 (currently, it's at 92.19). A Jan 2012 95 call is worth about $2.30. Therefore, the free EE call -- if it were only valid until Jan 2012 -- would be worth around 2.5% of the bond's value. Clearly, the option value is increasing in time, with the Jan 2013 95 call implying an option value of around 4%. On a short term basis, 1-3 years, the 0.6% nominal return is comparable to Treasuries, but you pick up a free option that I think is worth at least 5% of the bond's value. Plus, like I said earlier, I look at the 3.53% as comparable to 5% taxable, so the relevant calls would imply even higher option value.

Hmm..well I think you are 90% right in your analysis. But the problem is, as you actually point out, if you hold for anything less than 20 years you earn at a rate of 0.6%. So I don't think your analysis of the value of the call is quite correct. Also two facts you didn't mention is that you can't cash out for 1 year (at all) and if you cash out before 5 years you lose 3 months of interest. But let's ignore those two facts for now (for simplicity).

I think the simplest way to look at it, is to build on the way you have analyzed it, as a 20 year bond with a call option, but to realize that the call option is not in fact free, but quite expensive. Let' say you hold the $10,000 worth of the bond (i.e. your initial investment is $10,000) for 10 years and then want to cash in early. As a 20 year bond compounding continuously at 3.53% (actually compounds semi-annually but again for simplicity we'll assume continuous compounding) after 10 years it would be worth $14,140. Now you want to cash it in early. Surprise- you only get $10,616! That is a 25% reduction on the $14,140. Quite an expensive call option.
So I think the call option is really an illusion. It's really a non-marketable 20 year bond at 3.53%- i.e. if you want to think of it as earning that rate of interest you are locked in for the term.

Another way to think about it, is that it is a short term, money market instrument that will always yield 0.6% and with tax deferral, and with an enormous kicker interest payment that you get if you actually hold for 20 years. Based on that, it may be ok but not really all that compelling. FDIC insured savings accounts are currently yielding 1%, which after tax is likely >= 0.6%. And remember you are eventually going to pay tax on the EE bonds 0.6%.
Plus the 1% FDIC insured savings accounts will eventually pay more as rates rise whereas the EE's 0.6% is locked in. So I guess it all comes down to how likely it is for one to get the kicker payment in 20 years. I think in general people overestimate their ability to hold long bonds to maturity. In life, stuff happens...
cheers,
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Postby grok87 » Sun Apr 03, 2011 10:33 pm

Beagler wrote:
bobcat2 wrote:
I believe the Income Solutions portal thru Vanguard offers inflation-indexed life annuities from three companies. If you are really worried about insurance companies not being able to meet their annuity obligations then split your purchased annuities among the three companies. Personally I think that risk is way overblown. I wish mutual fund companies peddling equity funds had a guaranteed 2% real return backing them up. Then we could all worry about what would happen if the equity return guarantee would fail. :lol:

BobK


Bob, isn't there a cumulative guarantee? That is, even if you divide a $1M amount over a number of insurers, the State guarantees only a maximum amount per insured! (open to correction)

I'd be interested if anyone knows the answer to this...
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Postby grok87 » Sun Apr 03, 2011 10:35 pm

bobcat2 wrote:Hi grok,

You wrote.
I think inflation adjusted annuities sound like a good idea as long as you stay within state guarantee fund limits. Those are kind of low sometimes. The problem is that if you die early your heirs get nothing. ... Who do you think are the best carriers?


Assuming you annuitize 50% or less of your portfolio, your heirs always do well if you die early. :lol: If you die late your heirs rarely do well, whether you annuitize or not, once the time value of money is accounted for. :wink:

I believe the Income Solutions portal thru Vanguard offers inflation-indexed life annuities from three companies. If you are really worried about insurance companies not being able to meet their annuity obligations then split your purchased annuities among the three companies. Personally I think that risk is way overblown. I wish mutual fund companies peddling equity funds had a guaranteed 2% real return backing them up. Then we could all worry about what would happen if the equity return guarantee would fail. :lol:

BobK

thanks- I'll check it out. Any thoughts on what the best of the 3 companies is?
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Postby grok87 » Sun Apr 03, 2011 10:36 pm

elgob.bogle wrote:Grok:

Spouse has neither TIPS nor bokerage link. FI choices are PTRAX (PIMCO Total Return) & FBIDX (Fido Total Bond Market). I don't like the composition of FBIDX right now with about 27% of holdings below an A rating, only 23% treasuries, and about 9% foreign. I'm not an expert, but this doesn't seem to me to be a "total US bond index". I also am unsure of Bill Gross's fund as a current proxy for US Bond Market since he dumped his Treasuries.

We were loading up on Spartan funds (US large FUSEX, Completion (FSEMX) and International Large (FSIIX) in spouse's account, and adding International Small (VSS) and Emerging Markets (VWO) in our ROTH accounts in an attempt to track international markets.

Your (& Bodie's) TIPS plan makes a lot of sense. Laeery Swedroe also is a proponent of a heavy TIPs portfolio for the average person in retirement. So I am looking at it, but our assets are somewhat out of alignment for such a portfolio. Recently, I have been thinking that if our great Florida Governor does not convince our Legislative folks to remove the annual 3% COLA on pensions, that I would it. Now it looks like I need to rethink it. I won;t know the status of the COLA until the end of the FLorida Legislative Session this month - two weeks before I retire with about enough time to process my paperwork! :roll:

elgob

Hmm. if you end up with a pension without a cola, I guess you don't really need this strategy but you somehow need a way to buyback the cola. Not sure how feasible that is...
cheers,
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Postby grok87 » Sun Apr 03, 2011 10:38 pm

#Cruncher wrote:I've constructed a little Excel spreadsheet to help in building a 30 year TIPS ladder. The example below shows a ladder delivering approximately 30,000 real dollars every year from 2012 - 2041 for a cost of about $700,000. The desired annual amount, of course, can be changed.

It starts with the most distant year and then takes interest into account in determining how many bonds are needed for each preceding year. This has the effect of reducing the number of shorter term bonds required.

It handles the missing maturity years differently than does Grok's approach in the initial post of this thread. He buys a shorter term bond and then rolls it over into a new bond that matures in the missing year. My approach uses only the currently available maturities. It buys extra bonds in the year after and / or before the missing years. I've made default assumptions on which bonds to do this with, but it can easily be changed.

The sheet can be easily modified to build a ladder for a different time period. For example to build a ladder from 2029 - 2041 as Grok does, just blank out the cells below 2029 in the "Years to Cover" column.

If anyone wants to play around with the spreadsheet, there is a link at the bottom of this post to download it. I haven't done much testing or writing of instructions. I wanted to wait to see if anyone is interested. To make the picture below less complicated, I've hidden some of the columns.

Image

I've used this file in Excel 2003 for Windows and Excel X for Macintosh so it should work with most Excel versions. It has no macros. Only the cells in bold blue are intended to be edited. Click on the link below to download the file:

Download Excel spreadsheet

Thanks #cruncher. Interesting approach to using the tips interest- I'll play around with the spreadsheet when I get a chance.
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Re: Ladder vs. ETF

Postby grok87 » Sun Apr 03, 2011 10:42 pm

jefmafnl wrote:A couple more points:

1. I understand the difference between duration and maturity, although I'm not convinced that duration calculations for TIPS are scientifically based, due to the relatively short history with TIPS.

Grok, do you advocate matching [/i]duration or maturity to life expectancy?

2. For those who are more than 30 years from expected retirement date, the ladder of long TIPS is simple. For those who are older: Without wanting to re-activate the whole "what counts as market timing" debate, isn't there an opportunity cost to constructing a whole ladder (or a substantial part of it) at one point in time, such as the present, with lower than historical-average real rates? Even if one DCAs over 6 months or a year? Vs. the "always adding new bonds at new interest rates" advantage of a fund or ETF such as LTPZ (Pimco's fund)?

J

Good question on the matching. I guess I think you should retire as late as you can and then plan on a 30 year retirement. This is meant to be conservative to minimize the chance of running out of money. If you retire at 65, I think you should plan to live to 95 even though the chance of that is probably only 10%.

As far as it being a bad time to buy TIPs, yeah I do worry about that. If you are younger you are sort of hedged (as you point out) since if real rates spike you get to buy your later tips at the higher real rates. The other thing is that if you do the "invest the TIPs coupons in LEAPS" part you may be hedged as well. It is less likely that TIPs and Equities are both overpriced at the same time (it's possible of course).
cheers,

cheers,
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Postby grok87 » Sun Apr 03, 2011 10:44 pm

elgob.bogle wrote:#Cruncher - Thanks for the spreadsheet - I'm impressed :D , and the $700k cost for the bonds is likely within reach for me. :) The $30k would be a good supplement to spouses income (She's 56 & about 7 years from retirement, which is when I plan to start collecting SS).

Grok: How does one handle RMD's with individual TIPS mostly in tax-deferred accounts? In my case, I have about 7 years until I have to start taking money out. Which bonds from the ladder would be preferable in our ROTH accounts?

elgob

It's a good question. You obviously want to avoid selling TIPs before maturity. Someone told me that you can withdraw TIPs in kind- i.e. you don't have to sell them to withdraw. not sure if that's true...
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Postby grok87 » Sun Apr 03, 2011 10:45 pm

conundrum wrote:Thanks Grok for another great tip. We are roughly using your recommended approach. Our tax deferred accounts (only 15% of of total portfolio) are all in 20-30 year individual TIPS. At this point we have a bit of a haphazard ladder with a number of missing rungs but overall have been satisfied with this plan.

Thanks again for all your great tips.

Drum :lol:

thanks Drum!
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Postby grok87 » Sun Apr 03, 2011 10:46 pm

jon-nyc wrote:I was building a nice TIP ladder for just such a strategy using auctions for the 20 year. Then the basterds discontinued them!

Anyway, I'll likely revisit the strategy, but I need to find a better place to buy TIPs on the 2ndary market. The retail spreads on Bonddesk (via etrade) are criminal.

yeah I wish they'd bring back the 20 year too. But I'd rather have the 30s than the 20s if I have to choose one. By concentrating the issues I think they are trying to improve liquidity.
cheers,
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Re: Spreads

Postby grok87 » Sun Apr 03, 2011 10:47 pm

jefmafnl wrote:Are the spreads via VBS (on secondary market TIPS) normal and reasonable, compared to other brokerages?

J

I think VBS looks reasonable to me. Fidelity used to have really wide spreads.
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Postby grok87 » Sun Apr 03, 2011 10:49 pm

Chuck T wrote:#cruncher
Thanks for posting your spreadsheet. I have downloaded it and will begin to tailor it to my personal situation. It looks very useful.

Grok
Thanks for another tip that stimulates thinking and planning for retirement. These are very helpful.

I get the impression that this approach is primarily for someone that hasn't yet retired. Would it make sense for someone like me at 65 that is already retired? What adjustments need to be made? (Other than not taking the ladder beyond life expectancy. Whatever that may be.) Thanks again. Chuck

Hi Chuck,
glad you find it helpful. I actually would take the ladder beyond one's life expectancy to avoid the risk of running out of money.
cheers,
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Postby grok87 » Sun Apr 03, 2011 10:50 pm

larsm wrote:Grok,

Thanks for your post, interesting.

How good a substitute do you think I-bonds are for TIPS? Plus, EE-bonds also have an aspect of inflation hedge in that they reset every six months based on 10 year.

Given there are not the current tax issues with I/EEs that you have with TIPS, I've convinced myself that I/EEs are a good inflation hedge without the tax headaches...

Thoughts?

the older ee bonds reset- I love those! the new ones do not. See my discussion with market-timer.
I'd still buy some ibonds i guess. But really more for emergency money etc. For long range retirement funding I'd rather have the higher real rates. 2% would be ideal.
cheers,
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Postby Leesbro63 » Sun Apr 03, 2011 10:56 pm

Tips DO NOT create a worry free retirement for large taxable accounts. Because you have a tax penalty that actually increases as the very thing TIPS are meant to hedge increases...inflation.
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Postby Scotttheking » Sun Apr 03, 2011 10:59 pm

grok87 wrote:
elgob.bogle wrote:#Cruncher - Thanks for the spreadsheet - I'm impressed :D , and the $700k cost for the bonds is likely within reach for me. :) The $30k would be a good supplement to spouses income (She's 56 & about 7 years from retirement, which is when I plan to start collecting SS).

Grok: How does one handle RMD's with individual TIPS mostly in tax-deferred accounts? In my case, I have about 7 years until I have to start taking money out. Which bonds from the ladder would be preferable in our ROTH accounts?

elgob

It's a good question. You obviously want to avoid selling TIPs before maturity. Someone told me that you can withdraw TIPs in kind- i.e. you don't have to sell them to withdraw. not sure if that's true...


That is correct; IRA distributions can be taken in kind.

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Postby Leesbro63 » Sun Apr 03, 2011 11:02 pm

Scotttheking wrote:
That is correct; IRA distributions can be taken in kind.

--Scott


Only if your brokerage allows it.
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Postby grok87 » Sun Apr 03, 2011 11:37 pm

Leesbro63 wrote:Tips DO NOT create a worry free retirement for large taxable accounts. Because you have a tax penalty that actually increases as the very thing TIPS are meant to hedge increases...inflation.

Agree
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Postby Leesbro63 » Mon Apr 04, 2011 7:32 am

So what to YOU advise in that situation?
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I am 53

Postby Marmot » Mon Apr 04, 2011 9:19 am

Can you help me understand how I might go about utilzing this concept? I can easily understand it for someone 30 years out. Trying to wrap my brain around the shorter time span idea.
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Re: I am 53

Postby grok87 » Mon Apr 04, 2011 2:31 pm

Marmot wrote:Can you help me understand how I might go about utilzing this concept? I can easily understand it for someone 30 years out. Trying to wrap my brain around the shorter time span idea.

Hi elgob,
See my reply to elgob above sat april 2nd at 12pm. If you give me more specifics I could help you more.
cheers,
grok, CFA
"You can only convince people who think they can benefit from being convinced."- Taleb
grok87
 
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