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Using Treasury Inflation Protected Securities (TIPS) to increase your safe withdrawal rate.

Using Treasury Inflation Protected Securities (TIPS) to increase your safe withdrawal rate.


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This article was first posted on July 1, 2000, revised August 1, 2000.

With all the focus on "Stocks for the Long Run", it is surprising to discover that adding bonds to your portfolio in country-sized helpings can dramatically increase your "100% safe" withdrawal rate. Eliminating inflation risk by adding inflation protected Treasury securities to a portfolio provides considerable advantages.

The first United States Treasury Inflation Protected Security (TIPS) was auctioned on January 29, 1997, so there is not much in the way of historical performance data for these securities. However, this does not prevent us from doing a safe withdrawal study similar to others published on the Retire Early site. By modifying the Retire Early Safe Withdrawal Calculator it is possible to simulate what would have happened if TIPS were available during the entire 1871-2000 Shiller data series. This is accomplished by assuming a coupon rate for TIPS and adding that to the annual inflation rate (CPI-U) to get the annual yield for the security. It's also possible to determine the minimum TIPS coupon rate that would make it attractive to replace the 4 – 6 month commercial paper in he Retire Early study with TIPS. These “minimum attractive TIPS coupon rates” appear in the table below.

Minimum Attractive TIPS Coupon Rate
Pay Out Period
(Years)
10 20 30 40 50 60
TIPS Coupon 0.00% 0.77% 1.90% 1.66% 1.82% 1.72%

Readers interested in running some safe withdrawal studies with TIPS can download a copy of the modified Excel spreadsheet used in this study from the Retire Early web site, click here.

TIPS are indexed for inflation using the CPI-U published by the Bureau of Labor Statistics. The current quote on the latest 30-year inflation bond maturing in April 2029 is 3.92%. This 3.92% real return on US Government bonds is historically very high. The compounded annual real return for long-term US Government bonds has averaged 2.80% over the past 125 years (1871-1997). If you have more than a 30-year pay out period, there is a good chance that when you rollover your 30-Year TIPS at maturity, you'll receive a lower inflation adjusted yield. Still, 3.92% is very attractive and will improve the maximum 100% safe inflation-adjusted withdrawal rate – though at some cost to the terminal value of the portfolio.

One important caveat applies to TIPS -- they are only appropriate for IRAs or other "tax-advantaged" accounts. Because of the unusual way they are taxed (i.e., you pay income tax each year on the annual interest payments you receive as well as the inflation adjustment. Even though you don't receive the inflation adjustement until maturity) if you held these securities in a taxable account you'd actually be paying income tax on money you wouldn't see for years in the future.

The following chart depicts the advantage of replacing the 4–6 month commercial paper used in the Retire Early study with TIPS at a 3.92% coupon rate. The “sweet spot” on the efficient frontier for a portfolio of stocks and cash (i.e., 4-6 month commercial paper) is 64% stock/ 36% cash. (Note: this differs slightly from the 74%/26% optimal stock allocation in the Retire Early study. The difference is due to the substitution of the CPI-U for the PPI as the inflation index.) A retiree would enjoy a 4.34% inflation adjusted withdrawal with this allocation. Substituting TIPS for the cash significantly improves the 100% safe withdrawal rate. The “sweet spot” in this scenario resides at 33% stock/ 67% TIPS and results in a 100% safe inflation-adjusted withdrawal of 5.21%. This increase in the safe withdrawal rate comes at some reduction in the terminal value of the portfolio. The median terminal value for the 64% stock/36% cash portfolio is $2,551for an initial portfolio value of $1,000. The median terminal value drops to $1,268 for the 33% stock/67% TIPS portfolio with a 5.21% withdrawal.

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A portfolio of 100% TIPS yields a lower 100% safe withdrawal rate (4.76% vs. 5.21%.) Retirees willing to limit their annual withdrawal to the 3.92% coupon are guaranteed the return of their $1,000 principal, plus an inflation adjustment. Looking at all the 30-year periods from 1871-2000 the median average inflation rate (as measured by the CPI-U) is 2.47%. That means that a $1,000 30-year inflation bond would grow to a value of $2,079 when it matures. The worst 30-year period of inflation since 1871 had a 5.41% per annum rate. Under these conditions, the 30-year inflation bond would be worth $4,858 at maturity. Of course, the US Treasury guarantees the return of your principal at maturity, even if there is deflation during the term of the bond. At a minimum, you'll receive your initial $1,000 investment.

A comparison of “safe withdrawal” alternatives
$1,000 initial portfolio balance, 30-Year pay out period,
Stock allocation: S&P500 index fund, Fixed Income (FI) = 4-6 mo. comm. paper
investment exp. = 0.20%, Inflation index: CPI-U, 30-Year TIPS coupon = 3.92%
. Inflation-Adjusted Withdrawal Terminal Value Minimum Terminal Value Median Terminal Value Maximum
100% Stock3.94%$0$4,596 $25,155
Stock Portfolio 64%/36% Stock/FI4.34%$0$2,551$7,056
Stock Portfolio 33%/67% Stock/TIPS 3.94%$1,186$3,351$6,986
Stock Portfolio 33%/67% Stock/TIPS 4.34%$921$2,821$6,305
Stock Portfolio 33%/67% Stock/TIPS 5.21%$0$1,268$4,258
100% 30-Year TIPS 4.76%$0 $946 $2,326
100% 30-Year TIPS 3.92%$1,000 $2,079 $4,858

This analysis gets very interesting if a retiree decides to withdraw less than the maximum "100% safe" withdrawal rate. For example, if a retiree taking the maximum 100% safe inflation adjusted withdrawal from a 64%/36% stock/FI portfolio (4.34%) decided to take the same 4.34% from a 33%/67% stock/TIPS portfolio, there is almost no chance of losing principal in the account. The minimum terminal value for a 4.34% withdrawal is $921. Indeed, the median terminal value for the stock/TIPS portfolo ($2,821) is higher than the terminal value for a stock/FI portfolio that contains double the allocation to equities ($2,551.)

Does this mean we should all buy TIPS?

It depends. For risk adverse retirees with pay out periods of 30 years or less, TIPS should allow you to increase your annual withdrawal while remaining "100% safe". For retirees with pay out periods in excess of 30 years, the reinvestment risk at maturity may give them pause. There is no guarantee that you'll be able to roll over your TIPS at maturity for the same 3.92% coupon.

For retirees able to survive on very low withdrawal rates (i.e, 3% or less), a portfolio with a large allocation to equities still gives you the most upside potential. Those fortunate enough to be in that position will likely see little merit in trading away their "upside" by shifting the bulk of their portfolio to TIPS.


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Copyright © 2000 John P. Greaney, All rights reserved.

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