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Tuesday, May 1, 2012

Spending the Nest Egg (Con't.)

Yesterday we took a slightly different way of looking at spending the nest egg.  We examined a $1.0 million nest egg and assumed a $40,000/year payout (4% rule of thumb), adjusted for inflation of 3% over the first 10 years.  We met the required payout by using zero coupon Treasury bonds.  This process is referred to as "immunizing a liability stream."  It is sometimes used to meet pension fund obligations.

We found that, with today's interest rates, this cost us $430,440.

We next looked at the required return to grow the remaining balance of $569,560 ($1,000,000 - $430,440) back to $1,000,000 at the end of the 10-year period.  It was 5.7%.

At this point, we are 75 years old and we have our original $1,000,000 back.  We now need to start with a payout of $52,191, adjusted for inflation, to maintain our standard of living.

Before we move to the next 10 years--ages 76 to 85--let's revisit the assumptions.  We calculated a return of 5.7% to get us back to $1.0 million.  Let's assume this was attempted with an allocation of 50% stocks/50% fixed income which was gradually adjusted to 40% stocks/60% fixed income. Obviously there is no guarantee on the return.  What would our starting value for the next 10 years be if the return averaged 4%/year, say?  This is easy to figure out - $569,560 * (1.04)^10 = $843,088.  In this way, you can carry out all of the sensitivity analysis you want.

In thinking about the asset allocation return, you want to recognize that, although you are retired, these assets are earmarked for somewhat longer-term expenditure requirements.

On the payment side, we assumed inflation of 3%.  If you are doing this in a spread sheet, you can easily adjust inflation.  For example, you can examine the impact if inflation jumps to 4% 5 years from now.

The bottom line of all of this is that retirees, in carefully monitoring their nest egg paydowns, need to revisit the schedule at least annually and put in actual market performance as well as inflation experience.

76 - 85

The table shows us that our costs of immunizing the required payments for ages 76 - 85 total $407,875.  This is what it costs to buy zero coupon Treasury bonds that will generate the payments.  We started with $1.0 million and now have $592,125 at the start of the period from which to get payments for years 76 on.

If we can achieve an average annualized return of 5.38% over the 10-year period, we will start our 86th year with $1.0 million.

Additional Points

What we've looked at is akin to a  poor man's offshoot of what is known as optimal control theory, which uses linear programming techniques to optimize a multi-period problem.  It goes to the end of the period - for example, our 95th birthday - and asks how much we would need, on an inflation-adjusted basis.  This would be $40,000 adjusted for inflation if our goal is to die broke on our death bed, assuming it occurs on our 95th birthday.  Then it works backwards, taking into account specified constraints.

In terms of data, quotes on zero coupon Treasury issues can be found at Barron's "Market Data" Center under "Bonds" and then "Treasury Strips."   For those who aren't clear on how zero coupon issues work, look at the table above.  If you buy $1,000 worth of the 2029 issue, it will cost you $598 today. In 2029, you will be paid $ 1,000.

As a point of information, U.S. Treasury zero coupon bonds are the most expensive (i.e., lowest yielding) because of their safety.  In fact, there are highly-rated zero coupon Corporate bonds that would greatly lower the cost of immunizing described above.

Disclaimer:  Data was obtained from sources deemed to be reliable.  Post is for educational purposes only.  Individuals should do their own research or consult with a professional before making investment decisions.



    I was definitely thinking about corporate when I read this as well. Sometimes I do wonder if people try to be too safe by always opting for Treasury. Alas, it depends on your risk tolerance.

  2. You make a really good point. In fact, you could throw in bonds and just distribute the coupon and principle payments etc. I kind of approached this from the "bucket approach" that many retirees are considering and asking what would it look like if we locked up payments at 10 year intervals using the 4% rule of thumb.