I have been considering a "self directed" method to provide COLAs (Cost of Living Adjustments) to a fix annuity that I own (that has no Inflation adjustment built into it). Some retirement income such as (SSI) have COLA as a component of of its payment, but many fixed annuities do not.
Looking back over the last 7 years it appears that SSI COLAs have been as follows:
COLA Year
3.6% 2012
1.5% 2013
1.5% 2014
1.7% 2015
0.0% 2016
0.3% 2017
2.0% 2018
The last seven years the COLA average has been 1.51%.
So COLA is a moving target year to year. Historically the SSA provides COLAs as far back as 1975:
https://ssa.gov/OACT/COLA/colaseries.htmlUsing this data, the average COLA over the last 44 years has been 3.71%.
So to be safe, an annuitized income (without a COLA) needs an average additional 3.71% added to its payout to keep up with inflation. For every $1000 received as an annuitized income one would need to source an additional $37 (from other investments) just to keep up with inflation. Also, these COLAs are additive each year, so in year two the "Annuity + COLA" is valued at $1037 and needs to source (2) COLAs: $1037 *3.71% or ($39) plus year one's amount ($37) therefore year two payout equates to $1076...and so on.
By Year 20 these "additive" COLAs will nearly equal the annuity payment (see chart below), by year 30 it is nearly twice the original annuity payment (again, see chart below). Here's the math going out 31 years:
My long winded question is...What type of an investment would be appropriate to fund this "self directed COLA" over the next 31 years?
My first year's Annuity Payout will be $27,000 therefore the first COLA (@3.71%) will need to be close to $1,000 and it will need to grow (3.71%) as displayed in the chart above (X27).
Comments
https://money.usnews.com/investing/investing-101/articles/2017-09-12/inflation-proof-your-retirement
I received a lump sum plus an monthly annuity when I retired from my last employer. That annuity does not adjust for inflation, and although it's nice now I know in 20 years it will likely just pay for going out to dinner once in a while. I'm curious what you are thinking and how this differs from just withdrawing from your nest egg.
Thanks for chiming in. Yes, I see your point...just supplement from other retirement resources. And yes this would be an "Annuity COLA bucket". I too am finding that my retirement components (Pension + Annuity) are meeting my present needs, but I am also noticing the importance of the COLA my pension has paid out over the last 7 years. My annuity (without COLA) has been stuck in the mud.
In a different thread (Bond questions Again...linked here) you mentioned a risk free approach using CD ladders, especially if rate raise to the 4% range for these CD's. This would be a very safe approach, but were not quite there yet with CD rates. Also, a 2% CD that would generate a $1k would require a $50K CD just for year one. That would required a number of $?K CDs for each rung on the ladder. This could tied up a lot of available resources.
Here's another approach (using a conservative allocation fund...you can use your favorite)
I ran VWINX into the Portfolio Visualizer's simulator using a $25K investment (100% in VWINX with a 4% yearly withdrawal...I rounded 3.71% up to 4%). I stressed the portfolio timing risk by starting the simulation at the very worse moment (the recent downturn of 2008). Even with that, VWINX provided close to 90% of the needed cash ($900 of the $1,000) in year one and then met 100% of the needed cash in all subsequent years. It also, ended with a larger balance then when it started ($25K distributing with a 4% distribution every year and ended with a balance of $32K). Not bad. Obviously there is a lot more risk with this approach verses a CD ladder.
Here's the link to Portfolio Visualizer:
https://portfoliovisualizer.com/backtest-portfolio#analysisResults
The table you provided really shows the effects of inflation and how it eats into a fixed payout. Very helpful.
When setting up a CD Ladder do I have my math correct
-use going rates for each rung (5 CD, durations 1- 5 years)
- Fund the CD with appropriate cash to distribute cash needed yearly (in my case $1K growing at 4%)
Using Bankrate CD rates I am noticing 2% for a 1 year CD.
https://bankrate.com/cd.aspx
To generate $1k "risk free" distribution I would need to invest:
Year 1 ladder looks like this:
$50k for a 1 year CD (paying 2%) = $1,000
$24K for a 2 year CD (paying 2.2%) = $1056...growing at over 4% from previous year
$16K for a 3 year CD (paying 2.3%) = $1104...growing at over 4% from previous year
$13K for 4 year CD (paying 2.3%) = $1196...growing at over 4% from previous year
$10k for 5 years CD (paying 2.65%) = $1325...growing at over 4% from previous year
- this requires $113K to set up...ouch!
Year two:
-Roll about $10k of the $50K (1 year CD expiring) into a new 5 year CD at the going rate
-Ladder Cost is now $73K ($40K freed up)
Year three:
-Roll about $11k of the $24K (2 year CD expiring) into a new 5 year CD at the going rate
-Ladder Cost is now $60K ($13k freed up)
Year Four:
-Roll about $12k of the $16K (3 year CD expiring) into a new 5 year CD at the going rate
-Ladder Cost is now $56K ($13k freed up)
Year Five and beyond:
-Roll all $13k of the (3 year CD expiring) into a new 5 year CD at the going rate
-Ladder Cost is remains $56K ($13k freed up)
How does this look?
I am presently spending the annuity as it comes in. As you mention, all of this is before taxes and all will be potentially taxable.
My distribution approach will be to spend down (starting at 59.5) taxable IRAs in combination with taxable account dividends trying to stay below the 15% tax bracket, then Roth IRAs or HSA distributions depending on the best choice (Roth vs HSA).
The answer, using 3.71% as the assumed rate of return, is $12,750. (Use the COLA figures above, put -12,750 in year 0, and use Excel's IRR function on that column to see that the rate of return is 3.71%.)
It's not likely that you can find a CD-like investment yielding 3.7%, no matter how long you make the maturity. If I try using a yield of 2.5% (more realistic for today's CDs), I find that an initial investment of $16,225 should suffice to generate the targeted cash stream.
Your problem is difficult because you're not growing your cash demand at a constant rate. The first year you're drawing $37, the next year more than double that ($76), the next year 50% more ($115), and so on. So any investment with a constant rate of return is going to pay out too much in the early years; after that your money will earn less than you need to draw out.
With the 2.50% rate of return, that transition happens after 11 years. It's not a big problem. The total excess income over those first 11 years is about $2,080. You could keep that extra cash in a more liquid account earning a little less, and use it to make up the shortfalls through year 19. At that point, this spare cash is exhausted.
That leaves 13 years (years 20-32) in which you need to be able to tap principal. It's in those years that you'll need CDs maturing on a yearly basis, or some other way to tap the principal.
Obviously there are other investments you could use If you used anything other than CDs or individual bonds (e.g. treasuries), you'd likely get a better rate of return but also have to over-fund because the investment returns would be more volatile.
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On the question of Roth vs. HSA, I can't see any reason to draw on the Roth first, assuming that you've got medical expenses you can claim. (One can use medical expenses incurred any time after opening the HSA, even ones many years old.)
Since the HSA has strings attached (needing to find medical expenses) and the Roth doesn't, it seems better to be done with the HSA first. Also, an HSA cannot be inherited by anyone other than a spouse. A Roth can be inherited by anyone, and a non-spouse can (at least until tax laws are changed) stretch it for years. Even if the tax laws are changed, it will still be possible to hold it for five years.
It's important to tax effect all of this and there are certainly simpler and more complicated ways. You can tax effect each piece on its own or you can try to do it overall and what's easier probably depends more on the specifics of your situation than anything else, but based on the nature of many of your posts I doubt you'd have a difficult time making the necessary adjustments.
The IRR function in excel that msf mentioned is a helpful function but I've also read that it can give you answers that aren't completely reliable because of its iterative nature. An alternative that I use in cases like these, at least to validate the IRR calculation, is excel's 'Goal Seek', which is included in the Data tab under 'What-if Analysis'. That would allow you to "find" the rate of return that takes into account all the above factors and has the assets you want for your heirs at the end of the plan.
In my case, I've done this based on how I currently live, how I might like to live if I wasn't concerned about money and the minimum I think I could live on so I get a range of "necessary" returns to achieve my goals.
With that you can consider asset allocation options and investment options that help you achieve those goals from an overall perspective rather than just related to the annuity, and you could also use Portfolio Visualizer's Monte Carlo analysis to get an idea of the range of outcomes you'd be most likely to experience based on different investment decisions. It would also allow you to see the impact of the sequence of returns if, for instance, the next 7 or 10 years are a flat line as GMO predicts, followed by larger returns after that.
Good luck!!
Having a "cash reserve" for those years (7-10 years of a flat line) is addressed by Wade Pfau which I threaded recently... re-linked here:
How to Use Reverse Mortgage to Secure Your Retirement
In his talk this "big picture" retirement road map is discussed:
His suggests to set up a reverse mortgage (obviously there are costs to set this up) as early as possible in retirement (age 62) and provide access to your home's equity as a buffer asset to draw cash (to meet income or spending shocks) during lean years when your investments are experiencing sequence of returns risks. During the stress of the 2007-2009 recession HELOCs were being called in by banks, a reverse mortgage can not.
Thanks.
Well, sort of. Pragmatically speaking, for this specific set of cash flows (first one puts money into an investment like CDs; after that one periodically draw out amounts until the investment is depleted), there is no reliability issue.
Below is a basic explanation of why.
The object is to find a single discount rate that makes the net present value of all the cash flows together equal to zero.
That is, 0 = flow0 + flow1/(1 + r) + flow2/(1 + r)^2 + ... + flowN/(1+r)^N
After multiplying by (1+r) ^ N to clear fractions, we're left with an Nth degree polynomial.
As we may recall from algebra, polynomial equations have multiple solutions - the quantity (including duplicates and complex values) equals the degree of the polynomial.
For example, x^2 - 2x - 3 = 0 = (x+1) (x-3) has two solutions, -1 and 3.
If we try to solve that equation iteratively, e.g. using Newton's method, we may converge on the solution x=-1 or the solution x=3, depending on where we start the iteration.
The method works by starting with a guess, and seeing where the tangent to the curve at that point hits zero. That's used as the next guess. If we start with a guess less than 1, we're on the left side of the parabola, and we converge to -1. If we start with a guess greater than 1, we're on the right side, and we converge to 3. But if we start with a guess of 2, the tangent is a horizontal line, it never hits y=0, and the method fails. The key is starting with a guess close enough to the particular solution we want to find.
Getting back to the polynomial for internal rate of return, there's another bit of algebra we can apply. Descartes rule of sign.
First you look at the signs of the coefficients of the polynomial. Our cash flow polynomial starts with a negative coefficient (the initial amount invested), and then the subsequent cash flows (the cash drawn out) are positive. So there's exactly one sign change in the coefficients.
Descartes rule says that the number of positive roots of the polynomial is either the number of sign changes, or an even number less than that. So the number of positive roots must be one (we can't have a negative number of solutions). This in turn means that there's no ambiguity about the positive internal rate of return. We just need a positive starting guess reasonably close and the method becomes both reliable and useful (it finds the correct root).