TIPS cannot balance a non-COLA pension, correct?

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Archean
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TIPS cannot balance a non-COLA pension, correct?

Post by Archean » Thu Mar 26, 2020 2:04 pm

Dear Bogleheads:

First, thank you for creating such a great community - it is quite remarkable. I have been reading the wiki+forum for several years (as well as a number of books I found on this site, including those of the Bogleheads) and this is my first post.

We have assembled a Boglehead three-fund portfolio (40:60 equities:bonds, where 20% of the equities are international) of about $2.3M (40% taxable, 40% IRA, 20% Roth), with equities in taxable and Roth; this AA reflects our "sleep well at night" level.

I retired last week (in early 60's; one could question such timing...) and have a non-COLA pension ($90K/yr; no lump sum option, just annuity). We are putting off SS as long as possible, and doing IRA-to-Roth conversions up to Medicare thresholds before SS.

Question: Although TIPS are commonly proposed as an inflation hedge, TIPS only protects the principal amount invested in TIPS, correct? Specific to "making up" for a non-COLA pension, some calculations show one would need roughly five times the annual pension amount in TIPS to provide the "missing" inflation protection of the pension (depending on inflation rate, time). Alternatively, the "classic" approach to dealing with inflation would be through the equity portion (with increased risk). It is not clear to me which path I should take.

I would be interested to hear from anyone with a non-COLA pension and how they are dealing with the long-term effects of inflation.

Thank you!
"Archean - an early geologic eon before index funds"

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David Jay
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Re: TIPS cannot balance a non-COLA pension, correct?

Post by David Jay » Thu Mar 26, 2020 2:51 pm

Welcome to the forum!

You are correct, TIPs are appropriate for preservation of "real" capital, i.e. preservation of buying power, with a very small component of growth.

I have no formal pension, so I have no experience complementing a pension with decreasing buying power. I know those here who use non-escalating SPIA annuities purchase multiple annuities over time - one in their 60s, one in their 70s, one in their 80s, etc. In that way they bump up their dollar amount to maintain their purchasing power.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

dbr
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Re: TIPS cannot balance a non-COLA pension, correct?

Post by dbr » Thu Mar 26, 2020 3:06 pm

Archean wrote:
Thu Mar 26, 2020 2:04 pm

Question: Although TIPS are commonly proposed as an inflation hedge, TIPS only protects the principal amount invested in TIPS, correct? Specific to "making up" for a non-COLA pension, some calculations show one would need roughly five times the annual pension amount in TIPS to provide the "missing" inflation protection of the pension (depending on inflation rate, time). Alternatively, the "classic" approach to dealing with inflation would be through the equity portion (with increased risk). It is not clear to me which path I should take.

If you do that the TIPS investment itself is no longer compensated. But also see below.

I would be interested to hear from anyone with a non-COLA pension and how they are dealing with the long-term effects of inflation.

When you plan your retirement income you estimate your expenses and you estimate what resources you have to meet those expenses. The resources would be the pension, would be Social Security (unless your job was a non-qualifying job), would be withdrawing from your portfolio, and might include other sources of income, such as rental real estate or whatever. So the plan will see the inflation adjusted income from the pension going down and therefore will see something else going up, such as withdrawals from the portfolio. You can throw the whole thing into a planner and see what comes out in the wash. You don't need the investments to "compensate" for the pension; you only need the investments to survive with a withdrawal rate increasing faster than inflation. This is one of the ways the 4% rule is not a plan.

If you want to see this in action try some of the planners. An old and simple one like FireCalc already has provision for entering both fixed and inflation adjusted pensions as well as extra spending or extra additions to the portolio, selling a house, for example. The whole idea is pretty routine.


Thank you!

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Archean
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Re: TIPS cannot balance a non-COLA pension, correct?

Post by Archean » Thu Mar 26, 2020 3:26 pm

Ah, that makes sense, including the comment that the TIPS would no longer be compensated. I was looking at this in too much isolation from a full budget (which we have yet to fully work out). I will look into FireCalc. Thank you.
"Archean - an early geologic eon before index funds"

alex_686
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Re: TIPS cannot balance a non-COLA pension, correct?

Post by alex_686 » Thu Mar 26, 2020 3:26 pm

Archean wrote:
Thu Mar 26, 2020 2:04 pm
Question: Although TIPS are commonly proposed as an inflation hedge, TIPS only protects the principal amount invested in TIPS, correct?
Welcome!

No. Maybe? What are you trying to do.

The par amount of a TIPS bond is adjusted for CPI. The coupon is based on par. As the par increases so does your coupon payment. The being said, almost nobody tries to live off their TIPS coupons. One would have to be massively risk adverse.

KEotSK66
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Re: TIPS cannot balance a non-COLA pension, correct?

Post by KEotSK66 » Thu Mar 26, 2020 5:22 pm

say you take a single withdrawal at the beginning of the year to live off

by the end of the year you want the reduced portfolio value to grow to a value such that the next year's withdrawal is adjusted for inflation, and so on

it doesn't matter which asset classes you use

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Last edited by KEotSK66 on Thu Mar 26, 2020 9:24 pm, edited 1 time in total.

tibbitts
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Re: TIPS cannot balance a non-COLA pension, correct?

Post by tibbitts » Thu Mar 26, 2020 5:47 pm

Archean wrote:
Thu Mar 26, 2020 2:04 pm
Dear Bogleheads:

First, thank you for creating such a great community - it is quite remarkable. I have been reading the wiki+forum for several years (as well as a number of books I found on this site, including those of the Bogleheads) and this is my first post.

We have assembled a Boglehead three-fund portfolio (40:60 equities:bonds, where 20% of the equities are international) of about $2.3M (40% taxable, 40% IRA, 20% Roth), with equities in taxable and Roth; this AA reflects our "sleep well at night" level.

I retired last week (in early 60's; one could question such timing...) and have a non-COLA pension ($90K/yr; no lump sum option, just annuity). We are putting off SS as long as possible, and doing IRA-to-Roth conversions up to Medicare thresholds before SS.

Question: Although TIPS are commonly proposed as an inflation hedge, TIPS only protects the principal amount invested in TIPS, correct? Specific to "making up" for a non-COLA pension, some calculations show one would need roughly five times the annual pension amount in TIPS to provide the "missing" inflation protection of the pension (depending on inflation rate, time). Alternatively, the "classic" approach to dealing with inflation would be through the equity portion (with increased risk). It is not clear to me which path I should take.

I would be interested to hear from anyone with a non-COLA pension and how they are dealing with the long-term effects of inflation.

Thank you!
I'm not worried about inflation adjustments, even though my non-COLA'd pension is one-fourth the amount of yours. I would say the classic way to deal with inflation would be to save/invest a portion of the $90k, not dial up risk somewhere else. In other words, operate as if you really have a $75k (or whatever number your math leads you to) COLA'd pension.

You can't mimic some COLA'd pensions with TIPS because they use inflation adjustments not available through public investments. I would consider carefully whether TIPs would mimic your personal inflation profile.

dbr
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Re: TIPS cannot balance a non-COLA pension, correct?

Post by dbr » Thu Mar 26, 2020 6:32 pm

tibbitts wrote:
Thu Mar 26, 2020 5:47 pm


I'm not worried about inflation adjustments, even though my non-COLA'd pension is one-fourth the amount of yours. I would say the classic way to deal with inflation would be to save/invest a portion of the $90k, not dial up risk somewhere else. In other words, operate as if you really have a $75k (or whatever number your math leads you to) COLA'd pension.

You can't mimic some COLA'd pensions with TIPS because they use inflation adjustments not available through public investments. I would consider carefully whether TIPs would mimic your personal inflation profile.
If you've run a retirement withdrawal model considering all inputs what you describe above effectively comes out in the wash, money being fungible and all. But it isn't bad to notice that point of view.

A different issue you mention that is important is that how one's personal need for money increases or decreases is, well, personal, and not necessarily tracked by CPI. That is especially true if things that happen involve big changes in spending. The other side of that is whether or not spending might not go down rather than up. But people have to have their eyes open and use common sense.

petulant
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Re: TIPS cannot balance a non-COLA pension, correct?

Post by petulant » Thu Mar 26, 2020 7:06 pm

Here's an unorthodox approach. Keep the TIPS allocation on the shorter duration side so there's less interest rate risk and then leverage up the position. Double the TIPS with low margin rates. For every dollar of inflation, the real cost of the margin loan goes down, but the real value of TIPS stays the same.

Thus, if the pension is $100 per year with a notional annuity payout ratio of 6%, the principal value is around $1666. $1666 would be invested in TIPS with another $1666 in TIPS financed with margin. Assume the TIPS coupon is 0% (bear with me) and the margin rate is 1.62% (actually possible at IBKR).

If CPI registers 2%, then the real value of the pension income would drop to $98, and the real value of the notional principal would be $1633, a real loss of $33. $3332 in TIPS would keep the same real value, going up by $66 in nominal terms. Further, the real value of the margin debt would decline by $33, but interest would have accrued in the amount of $27 (assuming away any issue on inflation on the interest). Overall, across all positions, there is a net loss of $27. Without the margined TIPS, the net loss would have been $33.

Let's see how it moves with higher surprise inflation. If CPI registers 5%, then the real value of the pension income would drop to $95, and the real value of the notional principal would be $1587, a real loss of around $79. $3332 in TIPS would keep the same real value, going up $167 in nominal terms. Further, the real value of the margin debt would decline by about $79, but interest would have accrued in the amount of $27. Overall, across all positions, there is a net loss once again of $27. Without the margined TIPS, the net loss would have been $79.

I think what this means is that as long as inflation is positive, you can use margin'd TIPS as a hedge on the pension. I suppose one doesn't even really need to use TIPS in the core portfolio or TIPS at all; what's really going on is that the portfolio assets aren't hammered by inflation, but margin debt is. A similar effect could be had by taking out a mortgage in retirement.

Probably not something I would do, but it's a fun idea.

rgs92
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Re: TIPS cannot balance a non-COLA pension, correct?

Post by rgs92 » Thu Mar 26, 2020 7:14 pm

My formula:
$90,000 /year = $7500/month.

To get $500/month from an immediate annuity you would need a lump sum of $100,000.
So, since you get $7500 a month, which is 15 times $500, this would cost you 15 times $100,000, or $1.5 million.

So your pension is worth a lump sum equal to $1.5 million.
Using the 4% rule, 4% of $1.5 million is $60,000/year.

So use $60,000 a year for expenses (as gross income including taxes) and invest the rest in, say, a 60/40 (stock/bond) portfolio, adding the inflation adjustment each year to the $60,000 income by withdrawing that adjustment amount from the portfolio.

KEotSK66
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Re: TIPS cannot balance a non-COLA pension, correct?

Post by KEotSK66 » Thu Mar 26, 2020 10:37 pm

you need to figure out what you need your investments to provide, initially after just the pension then after the pension and ss, once you have a target for your investments you can select an appropriate level of risk, although you'll have to do this twice

i'll have ss and my iras, after accounting for ss i figure out what i need my investments to provide

i want my investment portfolio to support real withdrawals by growing the portfolio with inflation sufficiently after i withdraw my money

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Archean
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Re: TIPS cannot balance a non-COLA pension, correct?

Post by Archean » Fri Mar 27, 2020 9:39 am

Thank you everyone for the wide variety of thoughts. This input has been very helpful!

Clark
"Archean - an early geologic eon before index funds"

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