Income for Life - Part 1 - Bonds

I talk a lot on this site about the process of accumulating wealth, but today I will expand that focus to include a realistic picture of how much wealth is actually needed to create a steady income for life. There are a few commonly accepted ways to draw income from one's wealth and over the next few posts I will try to I will explain the most common methods. I will also try to address the most important risk factors to your nest egg. These risks turn a seemingly simple process into a mine field of problems that can snag even a well prepared retiree.

Bonds:
It is simple to look up the historical rate of return for bonds and say, "I will put all of money into bonds that pay X% interest and spend the interest each year." Based on data from the Federal Reserve from 1955 to 2007 government bonds averaged 5.735% return. Bonds are suppose to be a safe and stable source of income right? In fact if you look at the data the returns of bonds are actually are fairly choppy. The standard deviation (measure of volatility or predictability of returns) for the government bond data is 3.214. What this means is that in most years the returns from bonds will end up between 5.735% minus 3.214% (or 2.521%) and 5.735% plus 3.214% (or 8.949%). Around 1/3 of the time the returns will even fall outside this broad range (2.521-8.949%) to be very large (like 16.39% in 1981) or very small (like 1.13% in 2003). In other words, from year to year the returns of bonds can still be unpredictable, so you can not count on drawing the same amount year after year without significant risk of dipping into the balance and potentially running out of money.

Another important risk factor for drawing income from your wealth is inflation. Each year prices for all types of goods and services increase, which will cause income needs to increase over time to maintain the same purchasing power ($1.00 in 1987 would require $1.83 in 2007). That means in order to keep up with inflation, the size of your nest egg still must grow in retirement to keep up. Using the same time period as above from 1955 to 2007, inflation took away 1.8% per year of the average 5.725% return. That leaves us with at the most a 3.935% withdraw rate to generate income to account for inflation. There can be some years where the inflation rate even exceeds the return of government bonds. This would also require dipping into the balance to maintain a stable income.

To provide a truly guaranteed income from bonds that is protected from inflation there is a special product called a Treasury Inflation Protected Security (TIPS) that are issued by the Federal Government and pay interest at a rate that varies based on an index which tracks inflation called the Consumer Price Index. The bonds pay a fixed percentage of income historically from 2-3% above the CPI stated inflation rate. This approach will guarantee an income that keeps up with inflation and is fairly stable, but at a price of creating an income stream that is fairly small. A TIPS portfolio that pays a 2.5% premium over CPI the initial principle required for an annual income of $50,000 would be $2,000,000.

If you a person is able to accumulate $2,000,000 today and will need $50,000 income for life then they are all set. However, if you are like me and have decades until retirement (for me 38 years to be exact) then you have to also factor in the effect of inflation from now until then. I feel that the 1.8% average inflation presented before may be a little conservative, and I want a little wiggle room in my calculations, so instead I will use an inflation estimate of 3% for my calculations. This gives me an inflation factor of 3.07 (or a 307% increase in my income needs) at retirement as compared to now. Using these assumptions I calculate the following: ($50,000 * 3.07) / (2.5% TIPS premium) = $6.14 Million. That is a LOT of money to accumulate in my lifetime, but absolutely achievable! At an 8% annual return I would need to save about $1975 per month for 38 years which is roughly equal to taking maximum advantage of my 401(k) ($15,500 plus match) and Roth IRA ($5000).