No Hype Investing for Income with the Income Strategy ...No Hype Investing for Income WITH THE ......

A common-sense approach to managing investments for steady, dependable, and long-term income

NNoo HHyyppee

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WITH THE

IInnccoommee SSttrraatteeggyy GGeenneerraattoorr™ By Roger & Kevin Katzenmaier

Income Strategy GeneratorIncome Strategy GeneratorIncome Strategy GeneratorIncome Strategy Generator™™™™

Copyright © 1996-2011, Brentmark Software, Inc.

All Rights Reserved.

February 5, 2011

Brentmark Software 3505 Lake Lynda Dr., Ste. 119

Orlando, FL 32817-8333

Technical Support: (407) 306-6160 FAX: (407) 306-6107 Sales: 1-800-879-6665

Internet: http://www.brentmark.com

E-mail: [email protected]

[email protected]

NNoo HHyyppee

IInnvveessttiinngg ffoorr IInnccoommee

WITH THE

IInnccoommee SSttrraatteeggyy

GGeenneerraattoorr™ By Roger & Kevin Katzenmaier

Table of ContentsTable of ContentsTable of ContentsTable of Contents

Copyright © 1996-2011, Brentmark Software, Inc.

All Rights Reserved.

Printed and bound in the United States of America

No part of this book may be used or reproduced in any manner whatsoever without written permission from the publisher except in the case of brief quotations embodied in critical articles and reviews. For information, write to Brentmark Software.

Fourth Edition

ISBN: 1-888390-06-9

i

Acknowledgments The creation of the Income Strategy Generator™ has been a dynamic and evolutionary process. It all began when Roger Katzenmaier asked his son Kevin for some help programming some basic financial concepts for him to help clients with their retirement planning. Kevin had a long history of programming computers to help his father solve specific finance problems beginning when he was thirteen years old using an Apple II+ computer. However this time their discussions expanded from some basic concepts to a complex mathematical model for optimizing investment allocations to provide income. The evolution continued over many months as Roger and Kevin considered, debated, and argued in a spirit of fun the multitude of challenges surrounding retirement income planning. Upon completion of the software, they knew they had created an important tool.

Roger and Kevin then had a mission for the Income Strategy Generator to be understood by as many people as possible. With the same collaborative spirit that created the software, they wrote this book, so that the unique Defined Withdrawals strategy would be meaningfully understood by its users. The team expanded when Brentmark Software, Inc. contracted to further develop and market the software. Gregory Kolojeski, President of Brentmark Software, directed the development effort at Brentmark. Thanks to Jane Schuck, Vice President of Brentmark Software, for her review of the software and this book. With this fourth edition Brentmark has once again added some fantastic new features. As a result the authors decided that it was time for a significant update to this book. This is by far our biggest and best upgrade!

The entire team is proud to present an even better Income Strategy Generator!

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Table of Contents ACKNOWLEDGMENTS.................................... ...............................................................I

TABLE OF CONTENTS .................................. ...............................................................III

PREFACE....................................................................................................................... V

INVESTMENT INCOME STRATEGIES...........................................................................1 SYSTEMATIC WITHDRAWALS ............................................................................................................................................... 1

Market Variability .......................................................................................................................................2 Dollar-Price Erosion...................................................................................................................................7

YIELD-BASED WITHDRAWALS............................................................................................................................................. 8 DEFINED WITHDRAWALS ..................................................................................................................................................... 8

Income Ladders ...........................................................................................................................................9 Bonds vs. Bond Funds ...............................................................................................................................10 Holding Periods.........................................................................................................................................10 Navigating .................................................................................................................................................11 Diversification ...........................................................................................................................................12 Tax Deferment ...........................................................................................................................................13 Onward......................................................................................................................................................13

GETTING STARTED.....................................................................................................15 INSTALLING THE INCOME STRATEGY GENERATOR ............................................................................................................. 15 SCREEN LAYOUT ............................................................................................................................................................... 16

BASIC INVESTMENT INCOME PLAN....................... ...................................................19 ENTERING SCENARIO AND INVESTMENT PARAMETERS....................................................................................................... 19 OPTIMIZING THE INVESTMENT ALLOCATION ...................................................................................................................... 22 SCENARIO DETAIL ............................................................................................................................................................. 26 THE INCOME LADDER........................................................................................................................................................ 28 TESTING MINIMUM STOCK HOLDING PERIODS................................................................................................................... 31 NAVIGATING ..................................................................................................................................................................... 32 SUMMARY ......................................................................................................................................................................... 36

SOPHISTICATED RETIREMENT INCOME PLAN ............... ........................................38 CUSTOM INCOME NEEDS................................................................................................................................................... 39 OTHER SOURCES OF INCOME ............................................................................................................................................. 42 ANNUITIES ........................................................................................................................................................................ 45 MULTIPLE ALLOCATIONS FEATURE ................................................................................................................................... 46 NAVIGATING REVISITED.................................................................................................................................................... 49 SUMMARY ......................................................................................................................................................................... 49

MAXIMUM INCOME PLAN ................................ ...........................................................51

BUY-HOLD-TRANSFER PLAN ............................. .......................................................61

YIELD-BASED WITHDRAWALS PLAN ....................... ................................................65

CASE STUDIES ............................................................................................................69

RETIREMENT AT AGE 62 ............................... .............................................................71 EXECUTING THE PLAN ....................................................................................................................................................... 74 NAVIGATING ..................................................................................................................................................................... 78

RETIREMENT AT AGE 65 ............................... .............................................................81 CURRENT SITUATION .........................................................................................................................................................81 EXPLORING REALLOCATION OPTIONS................................................................................................................................ 84 MANDATORY IRA DISTRIBUTIONS AFTER AGE 70½.......................................................................................................... 86

EARLY RETIREMENT AT AGE 53......................... ......................................................89 SUMMARY OF ASSETS........................................................................................................................................................ 89

Income Strategy Generator™Income Strategy Generator™Income Strategy Generator™Income Strategy Generator™

SUMMARY OF INCOME NEEDS............................................................................................................................................90 INVESTMENT ASSUMPTIONS...............................................................................................................................................91 OTHER SOURCES OF INCOME..............................................................................................................................................93 ALLOCATING CAPITAL .......................................................................................................................................................95 EARLY FEDERAL WITHDRAWAL RULES..............................................................................................................................97 SUMMARY .......................................................................................................................................................................107

INCOME LADDERS..................................... ............................................................... 109 YIELD VS. INTEREST RATE ...............................................................................................................................................109 INCOME LADDER CALCULATIONS.....................................................................................................................................111 QUALITY .........................................................................................................................................................................113

STOCK TREND-LINES.................................. ............................................................. 115 EXAMPLES.......................................................................................................................................................................115 GUIDELINES.....................................................................................................................................................................122 COMPOUND-TREND ANALYSIS .........................................................................................................................................123

REFERENCE .............................................................................................................. 125 SYSTEM REQUIREMENTS..................................................................................................................................................125 INSTALLING THE INCOME STRATEGY GENERATOR............................................................................................................125 MAIN SCREEN LAYOUT ....................................................................................................................................................126

Section 1 – Scenario Parameters ............................................................................................................ 126 Section 2 – Investment Parameters ......................................................................................................... 127 Section 3 – Schedules.............................................................................................................................. 131 Section 4 – Initial Allocation and Scenario Results................................................................................ 131

MENUS............................................................................................................................................................................132 The File Menu ......................................................................................................................................... 132 The Edit Menu......................................................................................................................................... 134 The Calculate Menu ................................................................................................................................ 135 The View Menu........................................................................................................................................ 137 The Help Menu........................................................................................................................................ 137

FUNCTION KEYS...............................................................................................................................................................138

SUMMARY.................................................................................................................. 139

UPDATE POLICY ...................................... ................................................................. 141

TECHNICAL ASSISTANCE ............................... ........................................................ 141

INDEX ......................................................................................................................... 143

LICENSE AGREEMENT.................................. ........................................................... 145

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Preface It was back in the year 1990 that we developed the first ISG prototype software, now known as the Income Strategy Generator™. In the early days it ran on a state-of-the-art IBM compatible PC sporting the DOS 3.3 operating system. The Intel 286 chip clocked in at 12 MHz and made it possible to optimize basic investment allocations in a matter of minutes. A lot has changed!

Retirement planning has changed too. During the early ’90s, few people had significant capital accumulated in qualified retirement plans. Most retirees lived on a combination of Social Security, pensions, and sometimes interest from fixed-rate investments. Stocks were too risky for the vast majority of retirees. Who would have believed that some of them would later become day traders using something called an Internet?

Suddenly everyone was in the stock market. CSCO wasn’t just a stock, it was a status symbol for savvy living. A 20% annual return was about as exciting as day-old bread. Virtually no one worried about how to manage investments for dependable income. Why would they? Every day brought a better selling opportunity. The new economy had solved all the problems.

But in the late ‘90s the party fizzled, and many who thought they were set for life had to recalibrate expectations. The lucky ones just kept going back to work. A less fortunate group had already retired and was now depending upon income from investments. Many had not adequately considered the consequences of selling stocks on a regular basis in a declining market. The realities are beginning to sink in, and professional advisors are recommending lower and lower withdrawal rates to compensate. But all too often the investment strategy is a carryover from the wealth accumulation phase. Modern Portfolio Theory and classic interpretations of risk tolerance are helpful asset allocation tools prior to retirement. But when the goal becomes long-term dependable income, we need a new way of thinking. The popular Systematic Withdrawals approach, where one simply sells investments as needed from a diversified portfolio, is tactically easy to implement, but it is not an investment income strategy. It is simply the default situation that occurs when no deliberate strategy has been employed. The Defined Withdrawals strategy is as it soundsa highly deliberate and defined approach to withdrawing investment income. It has proven the test of time. We are pleased to report that retirees who have adopted it during the past 15 years are some of the happiest people you will find! Visit www.ISGplanning.com for a real-life account that was featured in the St. Paul Pioneer Press newspaper. There are many fad strategies that give excellent advice for investing in the recent past. But Defined Withdrawals was developed based on a broad look at historic risks and market cycles. We studied the very worst periods in history to understand how a retiree could have survived. See the authors’ 1998 article titled, Navigating an Investment Storm, also available at www.ISGplanning.com.


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In the pages that follow, we will discuss the pitfalls associated with Systematic Withdrawals and explain the Defined Withdrawals strategy in detail. We will show how to create a basic investment income plan and then expand the example into a sophisticated overall retirement income plan that includes other sources of income and variable annual income needs. Defined Withdrawals is the basis for the Income Strategy Generator software, and we are pleased to say that the software is now more powerful and flexible than ever before. Thanks to the speed of modern computers, we can now offer advanced calculations that would have been impractical back when the first version was released. The examples presented are just the tip of the iceberg. With a little creativity you will find that the software is useful for a range of financial situations well beyond those covered in this book.

Finally it may be interesting to know that in the early days of developing this software, we never intended to sell a product. We built it for ourselves. In time we came to realize the power of the methodology and felt that it was worthwhile and important to make the software available to others. We hope that it helps to guide your financial decisions as well as it has for us!

1

Chapter 1

Investment Income Strategies Managing investments for steady, dependable, and long-term income is more challenging than most people realize. It is tempting to believe that spending down a portfolio is the easy part of the retirement planning journey. But there is more to it than meets the eye. Selling one’s hard-earned investments for income at bargain prices during a bear market can quickly devastate a portfolio to the point where it is no longer possible to catch upeven after the market does. We need to think beyond simply selling investments from a diversified portfolio, and realize that the strategies that worked well during the wealth accumulation phase are not necessarily ideal during the investment income phase. Modern Portfolio Theory is a great model for optimizing risk and reward to build wealth, but it is not an Investment Income Strategy. To reliably succeed, and achieve the confidence and peace-of-mind that everyone strives for, we need a more thoughtful, strategic, and deliberate approach to investment income planning. In this chapter we will discuss some of the common investment income strategiesalong with their shortcomings. We will then describe the Defined Withdrawals strategy and the complementary topic of Navigating. Defined Withdrawals is a simple, but powerful, investment income strategy that is the basis for the Income Strategy Generator software.

Systematic Withdrawals With a Systematic Withdrawals Strategy, an investor simply sells investments as needed for income from a diversified portfolio, and then periodically rebalances the portfolio to match a target allocation. The portfolio typically consists of a combination of stocks and bonds. These investments may be purchased individually or held in funds. But Systematic Withdrawals isn’t so much a strategy as it is a lack of strategy. It is essentially the default situation that occurs when no deliberate investment income strategy has been employed. It’s popular, because it’s easy. Selling investments as needed for income is probably the easiest approach that one can imagine, and it may seem like the natural thing to do. But there are hidden dangers. Selling investments on a regular basis tends to magnify the effects of market variability, and this makes it difficult to predict or control the rate that capital is depleted.


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Market Variability Market variability affects nearly all investors, but not to the same extent. When accumulating capital, most people experience some ups and downs and develop an appreciation for the variable nature of financial markets. During some years the value of a 401(k) or similar plan increases by leaps and bounds. During other years it can be depressing to review the annual statement. But what is not obvious is that market variability can play an even larger role when managing investments for income. This is best demonstrated with an example. Consider three investors with different financial situations:

Our first investor is Sally. Sally has inherited $114,618. She invests this amount at the beginning of a 30-year period. She holds the investment for the duration. Our second investor is Mike. Mike is saving for retirement. He starts by investing $9320 at the beginning of the first year. He increases this amount 3% each year for 30 years.

Our third investor is Steve. Steve is retired and partially funding his income from investments. He has $608,704 invested at the beginning of the 30-year period. He withdraws $36,522 at the beginning of the first year for income. Each year he increases the amount withdrawn by 3% to compensate for inflation.

The values in this example have been carefully chosen. If our three investors were able to achieve a 10% rate of return each and every year, they would all finish with $2,000,000 at the end of 30 years. Sally’s one-time investment would grow to $2,000,000. Mike’s annual investments would grow to $2,000,000, and Steve would be able to withdraw his desired income while still having the balance of his portfolio grow to $2,000,000.

Chapter 1: Investment Income StrategiesChapter 1: Investment Income StrategiesChapter 1: Investment Income StrategiesChapter 1: Investment Income Strategies

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Now is where it gets interesting. Let’s add in some real-life market variability. Consider the following two market scenarios:

Year Scenario 1 Year Scenario 2 1953 -1.0 1965 12.5 1954 52.6 1966 -10.1 1955 31.6 1967 24.0 1956 6.6 1968 11.1 1957 -10.8 1969 -8.1 1958 43.4 1970 4.0 1959 12.0 1971 14.3 1960 0.5 1972 19.0 1961 26.9 1973 -14.7 1962 -8.7 1974 -26.5 1963 22.8 1975 37.2 1964 16.5 1976 23.8 1965 12.5 1977 -7.2 1966 -10.1 1978 6.6 1967 24.0 1979 18.4 1968 11.1 1980 32.4 1969 -8.1 1981 -4.9 1970 4.0 1982 21.4 1971 14.3 1983 22.5 1972 19.0 1984 6.3 1973 -14.7 1985 32.2 1974 -26.5 1986 18.5 1975 37.2 1987 5.2 1976 23.8 1988 16.8 1977 -7.2 1989 31.5 1978 6.6 1990 -3.2 1979 18.4 1991 30.6 1980 32.4 1992 7.7 1981 -4.9 1993 10.0 1982 21.4 1994 1.3

CAARR 10% CAARR 10%

Scenario 1 shows the annual total rates of return for large company stocks from 1953 through 1982. Scenario 2 shows the annual total rates of return for large company stocks from 1965 through 1994. Notice that the rates of return are the same for the overlapping years from 1965 through 1982. These two time periods were chosen because they just happen to have the same Compound Average Annual Rate of Return (CAARR) at the end of the 30-year period10% in both cases. How would our three investors have faired with these rates of return?

Source: Ibbotson Associates, 2003 Yearbook, Stocks, Bonds, Bills, and Inflation.


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The smooth black curve on the graph below shows how Sally’s investment would grow with a constant 10% rate of return each year. The orange line shows how her investment would grow if she obtained the rates of return from Scenario 1. The blue line shows how her investment would grow if she obtained the rates of return from Scenario 2.

Sally

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

0 5 10 15 20 25 30

Year

Scenario 1Scenario 2

Constant 10%

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

0 5 10 15 20 25 30

Year


Constant 10%Scenario 1Scenario 2

Constant 10%

Sally’s final outcome is $2,000,000 for each scenario. During the intermediated years, there are times when Scenario 1 is more favorable and times when Scenario 2 is more favorable. But they both achieve the same result after 30 years. This is because the 30-year compound average annual rates of return are the same, and Sally does not buy or sell investments during the intermediate years. Market variability has no effect on Sally’s final outcome.


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The next graph shows Mike’s results. Here again the smooth black curve shows how his annual investments would grow if he were able to obtain a 10% rate of return each year. He does not do as well with Scenario 1, and he does better with Scenario 2. Scenario 2 is preferable for Mike because the rates of return are initially lower, and he is able to purchase investments at bargain prices during the early years.

Mike

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

0 5 10 15 20 25 30

Year


Constant 10%

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

0 5 10 15 20 25 30

Year



Constant 10%

The effect of market variability on Mike is not trivial. Scenario 2 results in over a million dollars more than Scenario 1. We should again emphasize that this difference is completely due to market variability since the 30-year compound average annual rates of return are the same for both scenarios. But believe it or not, Mike’s results are relatively consistent and predictable compared to Steve’s.


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The next graph shows Steve’s results for the same two market scenarios. Here again the smooth black curve shows how his portfolio would grow if he were able to achieve a 10% rate of return each year. This is in addition to the annual income payments that he withdraws. Steve does fantastically well with Scenario 1, but amazingly he actually runs out of money during the 23rd year with Scenario 2.

Steve

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

0 5 10 15 20 25 30

Year


Constant 10%

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

0 5 10 15 20 25 30

Year



Constant 10%

It may be hard to believe that market variability can affect Steve’s outcome that much given that all three scenarios have the same 10% compound average annual rate of return after 30 years. But Steve is highly vulnerable to low and especially negative rates of return during the early years. With a Systematic Withdrawals approach, he is forced to sell investments to maintain income regardless of how the investments perform. Holding out for a better selling opportunity is not an option. As a result the portfolio can be quickly depleted to a level where it is no longer possible to recover from the loss while continuing to maintain his desired income. In practice Steve probably would not have invested all of his capital in large company stocks. We simplified the example to demonstrate how selling investments on a regular basis magnifies the effects of market variability. We will say more about the importance of diversification and the new role that it plays when managing investments for income later in this chapter. The important takeaway from this example is that…

Market Variability affects retirees more than it affects those who are saving for retirement.


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Sound investment income planning must account for market variability, and employ techniques to minimize its impact, to a degree that is not required when simply investing for growth. Otherwise the outcome is just too unpredictable. Of course year-to-year market variability is not the only source of uncertainty. In the previous example our investors achieved an overall 10% compound average annual rate of return with all scenarios. In practice the compound average annual rates of return will also vary. Inflation and changing tax laws are additional sources of uncertainty. A popular approach is to combine the various uncertainties into a statistical Monte Carlo Analysis and then choose a withdrawal rate that offers a high probability of success. This is appropriate if one is resigned to Systematic Withdrawals. But this approach does not provide a strategy to manage market variability. It simply reduces income to a level that is more likely to tolerate market variability. It would be far better to employ a deliberate strategy to manage market variability and reduce its impact. We will get to this later in the chapter, but first we have to explain the other problem with Systematic WithdrawalsDollar-Price Erosion. Dollar-Price Erosion Many people have heard about Dollar-Cost Averaging, whereby one purchases a constant dollar amount of stock, or other variable investment, on a regular basis to take advantage of the ups and downs of the market. With this technique more shares are automatically purchased when stock prices are low, and fewer shares are purchased when stock prices are high. It is no different than taking advantage of a sale to load up on groceries. But not as many people realize that an opposite phenomenon occurs when variable investments, such as stocks, are sold on a regular basis. Let’s look at another example. Assume that the price of XYZ stock fluctuates from one quarter to the next as shown below:

Quarter XYZ Stock

Price Amount Shares 1 $100 $5400 54 2 $60 $5400 90 3 $150 $5400 36 4 $120 $5400 45

Let’s assume this time that Steve needs $5400 of investment income each quarter. His best time to sell is during the third quarter when the price is highest at $150. But he ends up selling the fewest number of shares at this time, only 36. He has to sell 90 shares during the second quarter to maintain his income, which is his worst time to sell. He automatically sells the most shares at the worst time and the least shares at the best time. It is not just bad luck. It is an automatic consequence of the Systematic Withdrawals approach. We could look at the situation in reverse and pretend that Steve is selling shares of the stock to Mike. Mike would buy the most shares at the lowest price and the fewest shares at the highest


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price. We all know that the goal is to buy low and sell high. On average Mike accomplishes half of the goal. But on average Steve does not. He is a victim of Dollar-Price Erosion. We call it Dollar-Price Erosion because the average price per share is eroded when selling a constant dollar amount on a regular basis. Of course one could sell a constant number of shares regardless of the price. But this leads to variable income, which is typically not acceptable.

Dollar-Price Erosion reverses the benefits gained earlier from Dollar-Cost Averaging.

To summarize, Systematic Withdrawals has two serious problems. First it is highly unpredictable. Second it is subject to automatically selling more investments when prices are low. Both are a result of market variability and a lack of sound strategy to mitigate its effects.

Yield-Based Withdrawals Another common strategy is Yield-Based Withdrawals. With this strategy an investor withdraws income strictly from the yield of the investments. For stock investments, only dividends are used for income, and for fixed-rate investments, only the interest is used for income. A typical approach is to allocate 50-60% of capital to dividend-paying stocks and 40-50% of capital to fixed-rate investments. Over time the stocks are likely to appreciate in value enough such that the overall portfolio is able to keep pace with inflation. If the portfolio is periodically rebalanced to maintain the original allocation of stocks and fixed-rate investments, there will be an automatic tendency to sell stocks when they are priced high and likewise to sell fixed-rate investments when they have outperformed. Yield-Based Withdrawals is a good strategy for those who can afford it. The only downside is that it can be difficult to find quality investments that offer high yields on an ongoing basis. Many people will have difficulty meeting their income needs from interest and dividends alone. For those who can, the Income Strategy Generator can readily develop this type of plan (see Chapter 7 for an example).

Defined Withdrawals The third strategy that we will describe is Defined Withdrawals. This strategy is the basis for the Income Strategy Generator software. Defined Withdrawals is a simple but powerful strategy that helps to mitigate the problems associated with market variability. The foundation of the strategy is an Income Ladderan investment, or series of investments, that provide defined and certain income for a predetermined number of years. The income ladder replaces salary, while the remainder of the portfolio is invested in stocks for growth. Eventually stocks are sold to


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extend the income ladder. But with a long-term income ladder, an investor has time to choose favorable stock selling opportunities. If the market suddenly crashes, the investor isn’t forced to sell stocks at bargain prices. He or she can hold out for a better time to sell. This strategy provides greater peace-of-mind to both clients and their advisors, and it often allows for a higher level of investment income compared to other strategies. There are several important concepts associated with Defined Withdrawals that we will explain next. They include:

• Income Ladders • Bonds vs. Bond Funds • Holding Periods • Navigating • Diversification

Income Ladders An Income Ladder is an investment, or series of investments, that provide dependable income for a predetermined number of years. One way to create an income ladder is to purchase a series of high quality bonds with staggered maturity dates such that the combination of interest and matured principal exactly provide the desired income. The concept is similar to a traditional bond ladder except that interest and matured principal are used to support income rather than to purchase more bonds. The following table is an example of a ladder of bank certificates of deposit (CDs) that will provide a dependable stream of income for 10 years.

Years to Maturity

Interest Rate (Yield Rate)

Principal Value (Maturity Value)

0 (cash) - $30,000 1 2.5% $21,868 2 2.8% $23,342 3 2.9% $24,951 4 3.1% $26,658 5 3.5% $28,497 6 3.7% $30,538 7 3.8% $32,742 8 4.0% $35,093 9 4.0% $37,638

During the first year income is met with cash. During the second year income is partially met with the principal from the 1-year CD ($21,868) and partially met with interest earned from all CDs. It can be shown that this ladder will provide $30,000 of income during the first year and that this amount will increases 3% each year thereafter. Notice that a 10-year income ladder


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only requires 9 CDs because the tenth year of income is met with the interest and principal from the CD that matures after 9 years. The Income Strategy Generator can construct basic income ladders like the one in the previous example, and this will be demonstrated in later chapters. A bank or investment firm can help to construct more complex income ladders. For those who are mathematically inclined and want to create their own income ladder, we will explain how to do this in Chapter 11. Income ladders can be created with various types of fixed-rate investments. Some annuities can also serve the same purpose. The key is to create a period of time when income is fully defined and certain. Bonds vs. Bond Funds When creating income ladders it is important to realize that there are two types of investmentsthose that come with a promise to pay a known amount of principal and interest on a known date, and those that don’t. Individual high-quality bonds (or other fixed-rate investments) held to maturity offer this promise to pay. Bond funds do not. A bond fund fluctuates in value and never matures. There is no promise to pay a known amount on a known date. Therefore bond funds are not suitable substitutes for an income ladder when managing investments for dependable income. Bonds and fixed-rate investment are often used to add diversification to a portfolio, but with a Defined Withdrawal strategy, we’re looking for more than just diversificationwe’re looking for certainty. The near-term income-generating portion of the portfolio should not be left to chance. This is part of the key to overcoming the hazards of market variability.

Individual bonds can be used to create income ladders, bond funds cannot.

Holding Periods With a Defined Withdrawals strategy, part of the portfolio is invested in an income ladder and part of the portfolio is invested in stocks. The income ladder creates a period of time when stocks can be held if necessary to avoid selling stocks during a down market. A stock Holding Period is the maximum number of years that a stock or mutual fund can be held before it must be sold. Holding periods are defined upfront when creating a Defined Withdrawals planthe longer the holding periods, the more conservative the plan. In the context of a Defined Withdrawals strategy, this does not necessarily mean that the stocks or mutual funds will be held the full duration of their holding periods. It simply means that they can be held that long if necessary. We often emphasize that Defined Withdrawals is not a Buy


11

and Hold strategy, it is a Buy and Hold Out strategy. There is a big difference. Holding stocks for say 10 years will tend to reduce risk and produce a more predictable return. But there is no guarantee that the tenth year will offer a favorable selling opportunity. The tenth year could easily land in the middle of a bear market. To really enjoy the benefits of Defined Withdrawals, it is essential to take advantage of favorable stock selling opportunities when they arise. We call this Navigating.

Defined Withdrawals is not a buy and hold strategy. It is a buy and hold out strategy.

Navigating In time the income ladder will need to be extended. Navigating is the art of choosing reasonable times to sell stocks to purchase more fixed-rate investments. We know what you are thinkingit all hinges on market timing. But navigating is not market timing. We don’t need to game the market or predict the future. There are a series of logical questions that can be asked to decide whether or not it is a favorable time to sell stocks. They include: 1. Have the plan benchmarks been met or exceeded? 2. Are stocks at or above trend-line? (See Chapter 12) 3. Am I beyond the minimum planned stock holding period? 4. Am I nearing the maximum planned stock holding period? 5. Are interest rates at higher levels? The answer may not be yes to all questions, and each individual situation needs to be evaluated separately, but in general the more yes’s, the more likely it is time to sell some stocks to extend the income ladder. The purpose of the stock holding periods is to provide flexibility. Instead of being forced to sell stocks at a particular point in time, the holding period gives the investor some breathing room to choose opportune moments. We will say much more about navigating in later chapters. There is a free Excel-based tool called Practice Navigator available at www.ISGplanning.com that allows you to create a Defined Withdrawals plan and then test your navigating skills. You can also compare your results to the results that would have occurred using Systematic Withdrawals. With a little practice you may be surprised to see how much better a Defined Withdrawals plan performs compared to a Systematic Withdrawals plan.


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Diversification When managing investments for growth, diversification helps to reduce the risks associated with owning any one particular investment. One common way to achieve this is to invest in mutual funds. But diversification plays another role when investing for income. Proper diversification offers more choices to pick from when it is time to sell stocks to extend the income ladder. Since investments sometimes increase or decrease in value at different times, it is often the case that a particular stock or mutual fund may offer a favorable selling opportunity at the same time that another may not. So whereas owning a small number of mutual funds may provide adequate diversification during the wealth accumulation phase, it is generally more advantageous to own either a diversified portfolio of individual stocks or a wider variety of mutual funds when investing for income.

Stocks are like fruit; they are not all in season at the same time. The Income Strategy Generator has three default stock categories: • High Yield Stocks • Blue Chip Stocks • Growth Stocks High-Yield Stock companies pay investors dividends representing a substantial portion of the corporation’s income. The market for the company’s products and/or services is generally stable, and therefore there is less need for the company to reinvest income. These companies are often regulated, for example utility companies. High-yield stocks often play a key role when investing for income since they provide higher levels of divided income. Blue-Chip Stock companies derive their name from the poker card game where the blue chips have the greatest value. This category is often called large cap, short for large capitalization, which in common terms means that the companies are worth a lot. Examples include General Electric, Proctor & Gamble, and Coca-Cola. They are generally associated with mature industries, and their products are often name brands. Blue-chip companies usually pay some dividends, however they reinvest more of their income for growth than high-yield companies. Growth Stock companies are usually just the opposite of high-yield companies. They typically do not pay dividends, but rather reinvest all of their income in the growth of the company. These are typically smaller companies that serve rapidly growing markets. For this reason they often offer more potential for long-term appreciation, but they can also be highly volatile. We prefer this categorization for the purpose of investment income planning, because the stratification by growth potential and dividend income is highly relevant when investing for income. However there are many other ways to categorize stocks. If you prefer a different categorization, you will be able to rename the default categories and define arbitrary subcategory investments within the three main categoriesmore about this in Chapter 3.


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Tax Deferment A final topic before we get into the software is tax deferment. It is typically advantageous to hold investments within tax-deferred arrangements such as:

• Qualified Retirement Plans (e.g., 401(k), 403(b), Keogh, SEP) • Tax-Deferred Annuities • Individual Retirement Accounts (IRAs) • And some forms of life insurance contracts

This is especially important when managing investments for income. With a Defined Withdrawals strategy, capital is periodically transferred from stocks to fixed-rate investments, preferably without current taxation. In some cases this can be accomplished within a particular account, for example a self-directed IRA. In other cases there may need to be a transfer, or tax-free exchange, of one deferred arrangement for another. The rules that govern these arrangements are complex and well beyond the scope of this book. Professional assistance is recommended when participating in these arrangements. Onward That was a whirlwind tour of the Defined Withdrawals strategy! Don’t worry if all of the concepts are not clear yet. We will elaborate on them in the examples that follow. For now just know that Defined Withdrawals is about creating certain income for a period of time, and then waiting for favorable moments to sell uncertain investments like stocks. Now we can’t possibly expect to always sell stocks at the best possible times. That would require a crystal ball. But we can avoid selling stocks at the worst times. If stocks have not yet reached their target values, and the income ladder is able to provide certain income for many years to come, then wait for a more favorable selling opportunity. It’s that easy. We will leave this chapter with a profoundly simple thought…

If you can avoid selling stocks at the worst times, You will enjoy better results.

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Chapter 2

Getting Started This brief chapter includes the Income Strategy Generator™ installation instructions and a description of the screen layout. We will also provide some tips for following along with the examples in this book.

Installing the Income Strategy Generator 1. Insert the program disk into your CD drive. 2. If setup does not start automatically when you insert the CD into the drive, click Start on the

Windows taskbar. Then click Run and type D:\setup.exe (substituting your drive letter for D) and click OK.

3. Follow the on-screen instructions to finish the installation.


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Screen Layout The main screen is divided into four sections as shown below:

1. Scenario Parameters

2. Investment Parameters

3. Schedules

4. Initial Allocation and Scenario Results You can move from one input to another using the mouse, the up and down arrow keys, or the Tab key.

1→

3→→→→

←2

←4

Chapter 2: Getting StartedChapter 2: Getting StartedChapter 2: Getting StartedChapter 2: Getting Started

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Scenario Parameters that need to be entered in order to follow along with an example will be summarized in a table as follows:

Scenario Parameters Beginning Capital $500,000 Initial Investment Income $25,000 Payment Period Annual Years in Scenario 30 Anticipated Inflation 3%

And likewise Investment Parameters will be summarized in a similar table:

Investment Parameters Total Return Dividends Holding Period Fixed Rate 4.33% - - High Yield Stocks 8% 4% 10 Blue Chip Stocks 9% 2% 10 Growth Stocks 11% 0% 12

Section 3 includes four schedules. Clicking on any one of them will cause an Edit button to appear. Clicking the Edit button will then open the schedule. If a checkbox is checked and the Edit button is showing, then the schedule is active and included in the scenario calculations. To deactivate a schedule and remove it from scenario calculations, simply click it again to uncheck the checkbox.

Section 4 includes a summary of the initial allocation along with the ending capital results as shown next:

The plus sign in the lower right corner is a button. Clicking this button opens the Current Scenario window for a detailed look at the scenario results.


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The menu is located in the top left corner of the main screen. It includes the File, Edit, Calculate, View, and Help pull-down menus. See Chapter 13 for more information about the pull-down menus.

When beginning a new example, it is a good idea to start by first selecting File from the menu and then New from the pull-down menu. This will clear all screens and schedules and reset all default settings. Specific actions that need to be taken in order to follow along with the examples in this book will appear in blue italics.

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Chapter 3

Basic Investment Income Plan This chapter will demonstrate how to develop a basic investment income plan using the Defined Withdrawals strategy. We will start by making some assumptions about the Scenario and Investment Parameters. Then we will determine how much capital to allocate to an income ladder and how much capital to allocate to stocks. Various factors will be weighed before selecting the final investment allocation. We will explore the details of the plan and show how to determine the investments required for the income ladder. We will conclude this example by discussing how to manage, or navigate, the plan in the real world.

Entering Scenario and Investment Parameters Let’s assume that Steve is on the verge of retirement and has $500,000 of capital to invest. He would like to withdraw $25,000 of pre-tax income during the first year and increase this amount 3% each year thereafter to compensate for inflation. His investment income plan will span 30 years. These initial assumptions are summarized below:

Scenario Parameters Beginning Capital $500,000 Initial Investment Income $25,000 Payment Period Annual Years in Scenario 30 Anticipated Inflation 3%

Steve is comfortable with the assumption that high-yield stocks will return 8% annually over time, including dividends of 4%, as long as he can hold them for up to 10 years if necessary. He may decide to sell earlier, but this will depend upon how the stocks perform. He will use the dividends from high-yield stocks to support his income. Likewise he is comfortable with the assumption that blue-chip (large company) stocks will return 9% annually over time, including dividends of 2%, as long as he can hold them for up to 10 years if necessary. Finally Steve will also invest in some small-company growth stocks that do not pay dividends, but offer the potential for a higher return. He is comfortable with the assumption that growth stocks will return 11% annually over time, but he wants to be able to hold growth stocks for up to 12 years if necessary.


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These assumptions are summarized below:

Investment Parameters Total Return Dividends Holding Period High Yield Stocks 8% 4% 10 Blue Chip Stocks 9% 2% 10 Growth Stocks 11% 0% 12

To begin, select File from the menu and then New to clear the screen. Then enter the Scenario and Investment Parameters on the main screen as follows:

Income Strategy Generator assumes that annual income will increase each year by the Anticipated Inflation rate. The message in red that reads, Fixed Rate dropped below entered minimum in year 16, simply indicates that a 100% allocation to fixed-rate investments, earning a 0% return will not workwhich is not surprising. Let’s determine the Fixed Rate Total Return next. Steve will create an income ladder of fixed-rate investments using bank certificates of deposit (CDs). Since his shortest stock holding period is 10 years, his income ladder plus stock dividends will have to provide his desired income for 10 years. Assume that he is able to purchase CDs with the following annual yields and corresponding maturity dates:

Chapter 3: BChapter 3: BChapter 3: BChapter 3: Basic Investment Income Planasic Investment Income Planasic Investment Income Planasic Investment Income Plan

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CD Yields Years to Maturity Annual Yield

1 3.00% 2 3.25% 3 3.50% 4 3.75% 5 4.00% 6 4.25% 7 4.50% 8 4.75% 9 5.00%

It may seem like we are missing a yield rate for a 10-year CD. But the principal from a 10-year CD would not be available for income until the eleventh year. The principal from the CD that matures after 9 years will help support income during the tenth year. Similarly the principal from the 1-year CD will support income during the second year, and some cash will be needed for income during the first year. Next, click where it says “Fixed Rate” on the main screen. This will open the Fixed Rate Investments window shown below. Enter the CD yield rates for years 1 through 9. The software will compute an Estimated Yield to Maturity of 4.33% for the series of yield rates as entered. This is an estimate of the average annual yield, or total return, for the fixed-rate investments that Steve will purchase.

Click “Use Calculated Value” and then the OK button to close the window.


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Notice that the 4.33% rate has been transferred to the main screen. It is grayed to indicate that a calculated value from the previous screen is being used.

Optimizing the Investment Allocation Now is where it becomes more interesting. We need to determine how much capital to invest in each investment category to meet Steve’s needs, while ensuring that he will not be forced to sell stocks before the end of the holding periods. Click the button on the top right corner of the main screen labeled, “Optimize Investment Alloc ation”. The following window will appear:


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As a starting point, we will determine the allocation of capital that provides the highest projected ending capital after 30 years. We will use the default optimization to reallocate for maximum ending capital. The Preserve Capital and Consume Capital options are not applicable for this optimization. Next change the “Allocate to Nearest” field to 1 %. This will generate the most precise allocation. Then click the “Calculate Optimum Investment Allo cation” button. After comparing thousands of scenarios, the software determines that an allocation of 44% Fixed Rate, 0% High Yield Stocks, 19% Blue Chip Stocks, and 37% Growth Stocks provides the highest possible projected ending capital of $1,961,085.

Click the Use Results button to return to the main screen. The optimized allocation will be transferred to the main screen as follows:


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This allocation is optimized in the sense that it provides the highest projected ending capital. But it may not be the smartest allocation overall. It is heavily weighted toward growth stocks and does not include any high-yield stocks. Therefore the calculated allocation should always be viewed as a reference point. We will assume that Steve is not comfortable having so much of his capital allocated to growth stocks and that he would prefer a more balanced allocation. Try manually entering alternate allocations to see how much the projected ending capital is lowered. Note: You may notice that many allocations do not work and a message is often displayed that reads, Fixed Rate dropped below the entered minimum. This can occur even when the portfolio has not been depleted. This is due to the rules associated with transferring capital from stocks after the holding periods. In Chapter 5 we will explain these rules in detail. Assume that after trying a variety of different allocations, Steve settles on 35% Fixed Rate, 25% High Yield Stocks, 20% Blue Chip Stocks, and 20% Growth Stocks. Enter these allocation percentages as follows:


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His projected ending capital is reduced from $1,961,086 to $1,306,849. This is a big reduction, but the added diversification offers some advantages. The high-yield stocks provide additional selling options when it comes time to sell stocks to extend the income ladder. Also growth stocks can be a higher risk category. Steve is comfortable with a portion of his capital invested in growth stocks, and he appreciates their potential for higher growth, but he doesn’t want to be overly dependent on this category. Even with this more diversified allocation, Steve’s portfolio is projected to grow considerably. But actual dollar values can be misleading after 30 years of inflation. Click View on the menu and select “Adjusted Value Dollars” from the p ull-down menu. Or simply press F8.

This will cause the software to display all future dollar values as inflation-adjusted values. This is a powerful feature that gives perspective to seemingly large future dollar amounts.


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Notice now that Steve’s projected ending capital is $538,404 when adjusted for estimated inflation of 3%. So while his portfolio is projected to increase considerably over the 30-year period in terms of actual dollars, the purchasing power, or value, of his portfolio is only projected to increase slightly when adjusted for inflation. A message toward the bottom of the screen indicates that the ending balance has been adjusted for inflation.

Scenario Detail Next we will look more closely at Steve’s plan. Click the Plus button on the bottom right corner of the main screen. The following Current Scenario window will be displayed:


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This window displays a year-by-year summary of projected results for the scenario. The first row shows the initial values. All other rows show year-end values. Scroll down to see all 30 years of the scenario. Notice that the Desired Income increases 3% per year. Click the “Adjust Results for Inflation” checkbox at the bott om of the window.

Notice now that the Desired Income appears constant ($25,000 each year), reflecting that the inflation-adjusted purchasing power remains the same from year to year. Try selecting and unselecting the “Adjust Results for Inflation” sett ing and notice the effect that it has on all columns. Click the Assets Graph tab to see the scenario pres ented in a graphical form.


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The graph is a stacked bar chart. The value of each investment category is represented by the height of its colored bar. The four bars stacked on top of one another show the total value of the portfolio at the end of each year. Notice how the fixed-rate category, shown in green, is gradually depleted and then periodically replenished. In Chapter 5 we will describe how the Income Strategy Generator transfers capital from one category to another. The mathematical model assumes that stocks appreciate at a constant rate. This is of course not true in real life. We know that stocks will have good and bad years and that their appreciation will likely be a bumpy ride. It must therefore be understood that stocks will probably be sold at different times and in different amounts compared to the plan. But the plan provides important benchmarks for making these decisions. We will say more about this toward the end of this chapter.

The Income Ladder Now let’s look more closely at how income will be funded. Earlier $175,000, or 35% of total capital, was allocated to fixed-rate investments, and we said that Steve’s fixed-rate investments will be a series of bank CDs. But how much should he invest in 1-year CDs? How much should he invest in 2-year CDs and so on? We need to build the ladder. We also need to take into account the expected dividend income from high-yield and blue-chip stocks. Click on the Cash Flow tab of the Current Scenario window. This schedule shows the amount of income that is projected to come from stock dividends and the amount of income that must be funded by the income ladder. The income ladder must fund the amounts in the Withdrawals column.


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The software offers a wide variety of reports. Next we will take a peek at the report that provides the income ladder. Click File on the menu and select Print.

This will open the Print Report window shown below.

Make sure the Investment Details selection is check ed, and click the Print Preview button. Of course you can also print a hard copy if desired.


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The Fixed Rate report is shown below and includes the income ladder that is appropriate for Steve.

Caution: The income ladder that is generated by the software assumes that the annual yield rates are the same as, or nearly the same as, the annual interest rates. If fixed-rate investments are purchase at a significant discount or premium, such that the annual yield rates are different than the annual interest rates, then the calculated ladder will not provide the desired income. See Chapter 11 for a discussion of yield vs. interest rate. A bank or investment firm can assist in creating an appropriate income ladder when the yields and interest rates are significantly different.


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The column titled “Investment Needed” shows the amounts that Steve should invest in each CD. For example he should purchase a CD in the amount of $12,415 that will mature after one year and provide an annual yield of 3%. He should purchase another CD in the amount of $13,202 that will mature after two years and provide an annual yield of 3.25%, and so on. Steve will also need $18,000 in cash or short-term investments to fund income during the first year. We have covered a lot of ground. Let’s review progress so far. We have allocated capital in such a way that Steve will enjoy guaranteed income from an income ladder for 10 years. The ladder plus projected dividends provide his total desired annual investment income of $25,000 increasing 3% each year. He will have 10 and 12-year stretches to select favorable times to sell stocks to buy more bank CDs. We’ll say more about extending the income ladder toward the end of this chapter. Looking back at the Fixed Rate report, we see that it costs $145,996 to purchase all of the CDs in the income ladder. An additional $18,000 is need for income during the first year. $145,996 plus $18,000 is $163,996. This is the total cost of the 10-year income ladder. Earlier $175,000 was allocated to fixed-rate investments for the income ladder. Why was this more than needed? Remember, we manually adjusted the investment allocation to achieve a desired level of diversification. In doing so we allocated a little more capital to fixed-rate investments than needed. The surplus fixed-rate capital could be invested in a 10-year CD to get a jump-start on income for year 11. Otherwise the allocation could be adjusted to redirect the surplus to one or more of the stock categories. It should be noted that while income from the ladder is guaranteed, dividend income is not. Stock dividends are generally more predictable that stock prices, but nevertheless there is some risk with divided income. Another option would have been to reinvest dividends and then fund all of the desired income with the income ladder. This can be achieved by setting the dividend rates to 0% and then increasing the amount of capital allocated to fixed-rate investments.

Testing Minimum Stock Holding Periods The plan is coming together, but we need to talk about how to manage it in the real world where stock prices do not appreciate at predictable and constant rates. We need to consider that stocks will probably be sold to extend the income ladder before the end of their holding periods. Most people do not wait for every last morsel of food in their cupboards to be eaten before they go grocery shopping. The same instincts should be developed for purchasing fixed-rate investments to extend the income ladder. But there is a cost to selling stocks earlier and maintaining a more balanced portfolio. To see this, let’s return to our example and change all of the holding periods to one year as shown next:


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This represents a best-case situation where the market fully cooperates and Steve is able to sell stocks at favorable prices every year to extend his income ladder. This isn’t likely to be the case, but it places a lower bound on projected ending capital. Projected ending capital in inflation-adjusted dollars is now reduced from $538,404 to $376,279. This is the cost of re-balancing the portfolio every year. It needs to be emphasized that it is not likely that stocks could be sold every year at favorable prices. Try other holding period assumptions and notice the effect on ending capital. To achieve this range of results, Steve also has to avoid selling stocks when they have not achieved the benchmark values established by his original plan (i.e., the plan with long-term holding periods). This leads to the important topic of navigating.

Navigating Steve will have 10 years before he is forced to sell stocks to extend his income ladder. The benchmark values in his plan will be key to deciding whether or not it is a favorable time to sell. As long as he can sell investments after they have achieved or exceeded the performance projected by his plan, he will stay on course. It is difficult to give a formula that applies in every situation, but in general the key questions that should be asked when deciding whether or not to sell stocks are:

1. Has actual performance met or exceeded the plan benchmark performance? 2. Are stocks at or above trend-line? (See Chapter 12) 3. Am I beyond the minimum planned stock holding period? 4. Am I nearing the maximum planned stock holding period? 5. Are interest rates at favorable levels for purchasing additional fixed-rate investments?


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The answer may not be yes to all questions, and each individual situation needs to be evaluated separately, but in general the more yes’s, the more likely it is time to sell some stocks to extend the income ladder. Recall that Steve’s planned benchmarks are as follows:

Let’s assume that Steve is six years into his plan, and his stock categories have the following actual values compared to the projected plan values. For this comparison it is important to look at actual-dollar values from the plan and not inflation-adjusted values. Steve’s

Actual Values after 6 Years

Projected Plan Values after 6 Years

(actual dollars)

High Yield Stocks $143,000 $158,165 Blue Chip Stocks $145,000 $150,073 Growth Stocks $208,000 $187,041

High-yield and blue-chip stocks are below plan, but growth stocks have had a great run and are higher than the projected plan value. Steve would likely want to take advantage of this opportunity to sell some growth stocks. The trick is to avoid getting caught up in the psychology. At the six-year mark, Steve may be inclined to think that the high-yield and blue-chip stocks are lousy investments. After all, they have underperformed. He may be tempted to sell them in favor of keeping the better performing growth stocks, which at this point look like the winning investment category. But assuming that he owns a well-diversified selection of quality high-yield and blue-chip stocks, and his total return estimates were reasonable, then these stocks will likely be winning investments someday too. Of course if Steve has a small, poorly diversified selection of high-yield and blue-chip stocks, then it is possible that they are in fact lousy investments. The importance of good diversification cannot be overemphasized!


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Assuming that Steve’s stock portfolio is well diversified, he would be wise to sell some growth stocks and use the proceeds to purchase more bank CDs to extend his income ladder. In doing so he will give the high-yield and blue-chip stocks more time to reach their benchmark values, while taking advantage of a great opportunity to sell his growth stocks. One approach would be to sell the amount that is over and above the projected plan value. But more likely, Steve should take greater advantage of the opportunity. He originally allocated $100,000 to growth stocks. The inflation-adjusted equivalent value after 6 years is $119,405 assuming inflation of 3% (we will show a quick method for calculating this in the next chapter). He could choose to sell the amount that is over and above the original inflation-adjusted value. This is $208,000 - $119,405 or $88,595. This would extend his income ladder enough to provide about three more years of certain income, giving him a total of 7 more years for high-yield and blue-chip stocks to achieve their benchmark values. A worst-case situation occurs when none of the stock categories offer favorable selling opportunities during the stock holding periods. When this happens it is often necessary to adjust the plan and lower income. This risk can be reduced by assuming realistic stock rates of return, planning for longer stock holding periods, and by incorporating good diversification into the plan. While there are certainly times when stocks trend downward together, better diversification generally improves the likelihood of owning one or more stocks (or mutual funds) that offer favorable selling opportunities. We can expand on the diversification of the three stock categories in a variety of ways. For example the Blue Chip Stocks category could be comprised of a portfolio of individual stocks. Click the Blue Chip Stocks category on the main scr een to open the following window:


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Here we have demonstrated how this window could be used to account for a portfolio of individual stocks within the overall Blue Chip Stocks category. Even if the category is down as a whole at a particular point in time, perhaps one or more of the individual stocks will have achieved the projected 9% rate of return and offer a favorable selling opportunity. Alternatively one might choose to own a variety of mutual funds within a given category. Remember that while owning one mutual fund achieves part of the diversification goal, owning multiple mutual funds will provide more options to pick from when it is time to sell. The investment categories can also be renamed if necessary to better reflect the total diversification within a category. For example one might choose to rename the Growth Stocks category “Small & Mid Cap” and then invest in a variety of funds that fit this description as shown next:

The new name will appear on the main screen, on the investment scenario summaries, and on the reports. For most individuals and even professional planners, it is not realistic to manage a portfolio of individual growth stocks. The research that is required to make good buying decisions in this category is complex and time consuming. Mutual funds will likely be the better option for growth stocks.


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Depending on one’s expertise and commitment, it may be reasonable to select and manage a portfolio of blue-chip or high-yield stocks. This approach has the advantage of offering many selling options. If stocks are invested in mutual funds, it is a good idea to plan for longer stock holding periods. Whereas shorter stock holding periods may be acceptable if one has the ability to sell individual stocks from a diversified portfolio.

You can cherry pick individual stocks, but you can’t cherry pick from a mutual fund.

It takes some skill to decide what to sell, how much, and when. There is a free Excel-based tool available at www.ISGplanning.com called Practice Navigator that allows you to practice making these decisionswhile building those nerves of steel to overcome the psychology!

Summary That’s the gist of it. Hopefully these first three chapters have provided a basic understanding of the Defined Withdrawals strategy. It’s really quite simple. The income ladder replaces salary to provide a dependable source of income for a predetermined number of years. The remainder of the portfolio is invested in stocks for the long-term. For many, this is similar to the situation that existed prior to retirement when salary provided current income, and a 401(k) or similar plan was allowed to grow for the future. It is the certainty of the income ladder that allows an investor to manage uncertain investments like stocks with a cool head. Let’s review the steps:

1. We entered some assumptions about the investment and scenario parameters, including maximum stock holding periods and the yield rates for bank CDs.

2. We selected an allocation of capital by first optimizing for maximum ending capital, and then adjusting the allocation to achieve more diversification.

3. We reviewed the income ladder of bank CDs to determine how much capital should be invested at each yield rate and corresponding maturity date in order to provide certain income during the stock holding periods.

4. We tested minimum stock holding periods to see how much the projected ending capital would be reduced if stocks were sold more frequently to extend the income ladder.

5. We looked at how additional diversification could be achieved within the broad stock categories to give more selling options when navigating.

In the chapters that follow, we will highlight some of the more advanced software capabilities, demonstrate how to account for other sources of income, and work with some of the real-life complexities associated with taxes and IRA rules. Before reading on, make sure that you are comfortable with the concept of an income ladder. You may want to try developing your own basic investment income plan. Try different


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investment allocations and notice how the scenario is affected. Try the optimization features. Consider how long you would like to be able to hold stocks if necessary before being forced to sell. Then also test minimum stock holding periods to see the effect of selling stocks more frequently. As you experiment, you may notice that in most cases you will not be able to increase income to the point of fully depleting the portfolio. This is due to the restrictions imposed by the default capital transfer rules. We will explain these rules in Chapter 5 and also show how to override them if desired.

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Chapter 4

Sophisticated Retirement Income Plan In this chapter we will revisit Steve’s situation from Chapter 3. But this time we will assume that his total annual income need before taxes is $70,000, and that he would like this amount to increase 3% each year. Fortunately he has some other assets and sources of income including: Social Security, a pension, and an annuity. However these plus his $500,000 in savings are not enough for him to retire in comfort immediately. He has decided to work another five years and contribute aggressively to his 401(k) plan during that time. We will also assume that Steve has reconsidered his risk tolerance and decided that he would be more comfortable with 15-year stock holding periods. In this chapter we will introduce four new features:

• Custom Income Needs schedule • Other Sources of Income schedule • Annuities schedule • Multiple Allocations feature

Let’s start with these assumptions:

Scenario Parameters Beginning Capital $500,000 Annual Income Need $70,000 Payment Period Annual Years in Scenario 35 Anticipated Inflation 3%

Assume that Steve’s capital is currently allocated as follows with blue-chip dividends reinvested:

Investment Parameters Total

Return Dividends Holding Period

Percent Allocated

Fixed Rate 3.00% - - 40% Blue Chip Stocks 9.00% 0.00% 5 30% Growth Stocks 11.00% 0.00% 5 30%

He plans to adjust his allocation prior to retirement in five years. This is the reason for the short initial holding periods. We will plan to reallocate capital after 5 years and then switch to 15-year holding periods. Enter these parameters as follows, except leave the Annual Income Need at $0 for now:

Chapter 4: Sophisticated Retirement Income PlanChapter 4: Sophisticated Retirement Income PlanChapter 4: Sophisticated Retirement Income PlanChapter 4: Sophisticated Retirement Income Plan

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Custom Income Needs Next click on the main screen where it says, “Custo m Income Needs”. An Edit button will appear. Click this button. This will open the custom income schedule.

Steve’s total need is $70,000 per year upon retirement in 5 years. But the $70,000 amount represents his need in today’s dollars. His actual need during year 6 will be higher after 5 years of inflation. On the first line of the schedule, enter a descript ion, the first and last years that income will be needed, and the $70,000 a mount as follows:


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Notice that a button appears next to the $70,000 amount. Click this button to open the following window:

This is a handy present and future value calculator that can be used to quickly adjust the $70,000 amount to its inflation-adjusted equivalent after 5 years. Enter 3.00% for Annual Growth and 5 for the Number of Years. The inflation-adjusted equivalent income is $81,149. This is the actual income that Steve would like to have during his first year of retirement, which will be the sixth year of the scenario. Click OK to accept this value for the custom income schedule.

Hint: In the Navigating section of Chapter 3, we stated that $100,000 adjusted for 6 years of inflation at 3% was equivalent to $119,405. We used the above future value calculator to determine this.


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Notice also that the “Annual Increase” column is set to 3%. Therefore the $81,149 of annual income that begins in year 6 is assumed to increase 3% each year thereafter. This schedule can be used to enter income needs that do not span the entire scenario or do not trend with the assumed inflation rate. For example there may be a need to fund a college education during select years. Some may also want to divide their income needs into those that are likely to remain constant vs. those that are likely to increase with inflation. Some expenses do not increase with inflation, such as a fixed-rate home mortgage. Others may increase faster than the inflation rate, such as medical costs. For even greater control, click “Add Yearly Income Needs” on the lower left corner of the custom income schedule. Another Edit button will appear. Click this button to open another schedule that allows income needs to be entered on a year-by-year basis. Income needs entered on this second schedule are added to income needs entered on the first schedule. The second schedule is particularly useful for one-time income needs and needs that change from year-to-year by arbitrary amounts. The combined schedules offer complete flexibility to define one’s annual income needs.


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Click OK to return to the main screen.

Notice that when values are entered on the custom income schedule, the “Annual Income Need” field on the main screen is grayed and indicates “Custom”. At this point we are getting a message to indicate that the Fixed Rate funds are insufficient. But this is not a surprise. We haven’t entered Steve’s other sources of income yet.

Other Sources of Income Steve has elected to begin Social Security in year 8, and he estimates the initial value to be $24,000 per year increasing with inflation. He is also fortunate to have a pension that will begin paying $20,000 per year upon retirement in year 6. However the pension is a fixed annual amount that will not increase with inflation. Click on the main screen where it says, “Other Sour ces of Income”. An Edit button will appear. Click this button to open the following window:


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We will enter Steve’s other sources of income on this schedule. But this schedule has a dual purpose. We can also enter the 401(k) contributions that Steve will make during the five years prior to retirement. Let’s do this first. Assume that Steve’s combined 401(k) contribution and company match will total $15,000 during the first year and that Steve will plan to increase this amount 3% each year up to retirement. Also assume that these contributions will be allocated in the same percentages as his current overall allocation of capital, which is 40% Fixed Rate, 30% Blue Chip Stocks, and 30% Growth Stocks. He will stop contributing to his 401(k) upon retirement after 5 years. Enter the following:

Next we will enter the Social Security payments and pension in the same wayexcept the Social Security payments will span years 8 through 35, and the pension will span years 6 through 35. We will assume that both are used entirely to support income, and therefore should be allocated 100% to Fixed Rate on this schedule (realizing that this probably represents a checking or money market account). Enter the Social Security and pension income as fol lows:


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Notice that in the lower left corner there is an “Add Yearly Amounts” option. Clicking this and then the Edit button that appears will open another schedule where other sources of income and investment contributions can be added on a year-by-year basis. This is similar to the secondary custom income schedule. Click OK to return to the main screen.


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Annuities Steve has also purchased an annuity. The annuity will begin paying $10,000 per year for life during the sixth year and then increase 3% per year. Click on the main screen where it says, “Include Annuities”. Another Edit button wil l appear. Click this button to open the following window:

This schedule is similar to the “Other Sources of Income” schedule, except that it allows for annuities that will be purchased in the future as well as annuities that are already owned. Steve already owns his annuity, so he will leave the Cost column at $0 and the Year Purchased column at 1. If he were planning to purchase another annuity sometime in the future, he could enter a Cost and Year Purchased to account for this. In this case the funds to purchase a new annuity would be withdrawn from the Fixed Rate category at the end of the indicated year. Enter the annuity that Steve already owns as follows:

Click OK to return to the main screen.


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At this point we are no longer getting an insufficient funds message, and the ending capital in inflation-adjusted dollars is a whopping $1,519,319. This seems too easy, and it is! We haven’t yet accounted for the fact that Steve would like 15-year stock holding periods during retirement.

Multiple Allocations Feature The Multiple Allocations feature allows different investment parameters and different investment allocations to be defined for different times during the scenario. In effect we can divide a scenario into two or more successive scenarios. We will use this feature so that Steve can assume one set of investment parameters and allocations before retirement and another after retirement. At retirement he will assume the following:

Investment Parameters Total

Return Dividends Holding Period

Percent Allocated

Fixed Rate 5.00% - - ? High Yield Stocks 8.00% 4.00% 15 ? Blue Chip Stocks 9.00% 2.00% 15 ? Growth Stocks 11.00% 0.00% 15 ?

He has increased the fixed-rate total return assumption (compared to Chapter 3) since his income ladder will include more long-term investments to accommodate the longer stock holding periods. He hasn’t yet decided what the allocation of capital will be when he retires.


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Click Multiple Allocations in the upper right corne r of the main screen. Then click the Add Allocation button that appears in the cente r of the screen. In the window that appears, enter 5 to reallocate capital at the end of the fifth year.

Click OK. Now make sure the tab labeled “5” is hig hlighted in yellow. And enter the investment parameters upon retirement as shown below:

Once these values are entered, click the tab labele d “0” to see the initial investment assumptions. Then click back to the tab labeled “5” to return to the screen as shown above. The investment parameters and allocations on the year-0 tab will apply during years 1 through 5. The investment parameters and allocations on the year-5 tab will apply during years 6 through 35. Note that reallocations always trump holding periods. In other words when a reallocation of capital is defined, it will override any previous holding period assumptions. Notice the message to indicate insufficient funds in the fixed-rate category during year 17meaning that this allocation will not work. Steve could use the optimization features to help determine an appropriate allocation during retirement. But this time let’s assume that he has a good idea of the allocation that he wants. He manually enters some different allocations and settles on 50% Fixed Rate, 20% High Yield Stocks, 20% Blue Chip Stocks, and 10% Growth Stocks. The Fixed Rate allocation is higher than it was in Chapter 3 to support the longer holding periods. Make sure that the year-5 tab is selected (highlighted in yellow), and enter these allocation percentages as shown next:


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With this allocation Steve’s projected ending capital is $737,586 in inflation-adjusted dollars. Finally we need to determine what happens if the stock market cooperates and allows Steve to sell stocks at favorable prices more frequently in order to maintain a more balanced portfolio. We will test an extreme case by changing all of the stock holding periods to 2 years. It is not likely that the market will cooperate to such an extent that stocks could be sold every two years at favorable prices, but this will help to bracket his expected results. Again with the year-5 tab highlighted, change all of the holding periods to 2 years.

We see that the cost of maintaining a balanced portfolio is to reduce his projected ending capital to $519,092 in inflation-adjusted dollars. We will assume that this is an acceptable result.


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Navigating Revisited In the previous chapter we indicated that Steve should hold out for favorable stock selling opportunities to extend his income ladder. But what happens after that? Let’s say that he encounters a great selling opportunity after 6 years, and sells some stocks to extend his income ladder. Then what? At this point Steve should update his plan. He should re-adjust his investment assumptions and allocations to reflect the current situation. Retirement income planning should never be a one-time event, but rather an ongoing process. Even if the original plan was created for a 30-year period of time, it probably will not have a 30-year shelf life! Whenever there are significant changes, such as a reallocation of capital, the plan should be updated. If a given category of stocks has underperformed, it may be reasonable to assume higher rates of return going forward (see Chapter 12). Likewise if a category of stock has outperformed, it may be due for a correction in the future, in which case one should assume lower rates of return going forward. No amount of planning can ever predict the future of financial markets. The secret is to always give yourself some time and flexibility so that you’re not forced to make desperate and unfavorable decisions.

Summary Upon retirement Steve projects that he will have capital totaling a little over $800,000. Realistically he will want to revisit his plan at retirement and possibly make some modifications depending on the actual value of his portfolio at that time. But overall he has developed a robust plan. During his first year of retirement, his income will be provided by the following sources: Source 1st Year Income Dividends $9,756 Income Ladder $41,393 Annuity $10,000 Pension $20,000 Total $81,149

Two years later Social Security will kick in and reduce the burden on his investment portfolio. His overall income is planned to increase 3% each year. Provided he is able to sell stocks to extend his income ladder when they have achieved or exceeded their target values, he should expect to have between $1.4 million and $2.1 million (actual dollars) remaining after 35 years. And he has the luxury of 15-year stock holding periods to wait for those opportune times to sell. Finally he has a significant cushion of capital remaining in the event that income is needed longer than expected, or he is forced to sell stocks when they have not met expectations. Click the Plus button to view the investment scenario, or print the reports to further explore the details of this plan.

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Chapter 5

Maximum Income Plan In this chapter we will again revisit the example from Chapter 3. But this time we will assume that Steve wants to withdraw the maximum amount of investment income, even if it means fully depleting his portfolio after 30 years. The goal of this chapter is to offer insight. In fact the resulting plan will be quite poor. You may be surprised to see how sensitive the projected ending capital is to the level of income withdrawn. Another goal of this chapter is to explain the inner workings of the Income Strategy Generator. We will show how capital is transferred from one investment category to another after the stock holding periods. Finally we will show how to override the default transfer rules using the Multiple Allocations feature. To begin, enter Steve’s Scenario and Investment Par ameters from Chapter 3 as follows:

Scenario Parameters Beginning Capital $500,000 Annual Income Need $25,000 Payment Period Annual Years in Scenario 30 Anticipated Inflation 3%

Investment Parameters

Total Return Dividends

Holding Period

Percent Allocated

Fixed Rate 4.33% - - 35% High Yield Stocks 8.00% 4.00% 10 25% Blue Chip Stocks 9.00% 2.00% 10 20% Growth Stocks 11.00% 0.00% 12 20%

With Adjusted Value Dollars selected from the View menu, the main screen should appear as follows:


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Next click the Optimize Investment Allocation butto n in the upper right corner of the screen.

Select the option called, “Find the highest income available from the investments.” Then select Consume Capital and ente r 1% in the field labeled, “Allocate to Nearest”. Click the “Calculate Optimu m Investment Allocation” button at the bottom of the screen. This optimization requires a lot of calculations. Depending on the speed of your computer, it may take a while to complete. This optimization will produce a maximum income of $27,094 and a corresponding Ending Capital of $424,316 (inflation-adjusted dollars). But wait, we indicated that it was okay to consume capital. Why didn’t the software choose a higher income with lower ending capital?

Chapter 5: Maximum Income PlanChapter 5: Maximum Income PlanChapter 5: Maximum Income PlanChapter 5: Maximum Income Plan

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To understand this, we have to explain how the Income Strategy Generator transfers capital at the end of the stock holding periods. Click the Use Results button to return to the main screen. The screen should appear as follows with an allocation of 44% Fixed Rate, 0% High Yield Stocks, 38% Blue Chip Stocks, and 18% Growth Stocks.

Next click the Plus button in the lower right corne r of the screen to see the Current Scenario window.

Make sure that the “Adjust Results for Inflation” s etting is selected. Notice that $190,000 was initially allocated to Blue Chip Stocks. Then also notice that at the end of 10 years, the Blue Chip Stock category has this same value. This is because the model assumes that Blue Chip Stocks will be sold to extend the income ladder after the 10-year holding period. But


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only an amount over and above the original inflation-adjusted value is sold. The same is true for the Growth Stocks category. Only an amount over and above the original inflation-adjusted equivalent of $90,000 is sold after the 12-year holding period. This is a conservative convention that is designed to preserve the value, or purchasing power, of the portfolio over time. This allows income to be maintained for the long-term. Since each stock category is required to retain its original inflation-adjusted value, the portfolio cannot be depleted. A detailed summary of the capital transfer rules is as follows:

TRANSFER RULES At the end of the growth stocks holding period, any capital over and above the original inflation-adjusted value becomes available for transfer. This capital is prioritized first to replenish fixed rate, second high-yield stocks, and third blue-chip stocks as needed to return these categories to their original inflation-adjusted values. At the end of the blue-chip stocks holding period, any capital over and above the original inflation-adjusted value becomes available for transfer. This capital is prioritized first to replenish fixed rate and second high-yield stocks as needed to return these categories to their original inflation-adjusted values. At the end of the high-yield stocks holding period, any capital over and above the original inflation-adjusted value becomes available for transfer. This capital is transferred to fixed rate as needed to return it to its original inflation-adjusted value.

We prefer these conventions because depleting a portfolio can be a slippery slope. It is often difficult to control the depletion rate in the real world. This puts an investor at increased risk of running out of capital too soon. We will also show by the end of this example that the amount of income to be gained from depleting a portfolio is not as much as one might think. There are a couple of ways to override the default transfer rules when necessary. We will demonstrate one method next. Click the Multiple Allocations checkbox in the uppe r right corner of the main screen. Notice that an Add Allocation button appears in the middle of the screen. Click the Add Allocation button. The following window will appear:

Enter 10 as shown and click OK. The main screen should appear as follows:


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Notice the yellow tab labeled “10” in the middle of the screen. Click the Add Allocation button in the center of the screen again. Enter 20 on the window that appears, and click OK.

The scenario has now been divided into three successive scenarios. The tabs labeled 0, 10, and 20 each represent a different set of investment parameters and allocation percentages. However the values associated with each tab will appear the same at the moment because the 10 and 20-year tabs inherited the investment parameters and allocation percentages of the year-0 tab. Next we will repeat the maximum income optimization that was done earlier in this example. But this time each of the three 10-year time periods will be separately optimized. The software will then have the flexibility to transfer more capital to the fixed-rate category after 10 and 20 years because reallocations override both the capital transfer rules and the stock holding periods.


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REALLOCTION RULE Reallocations override both the default capital transfer rules and the stock holding periods.

Click the “Optimize Investment Allocation” button.

Again select the option called, “Find the highest i ncome available from the investments.” Select Consume Capital and allocate to the nearest 1%. Click the “Calculate Optimum Investment Allocation” button. You may notice that the calculation takes longer now that there are three scenarios to optimize. This time the result will be an income of $31,156 with essentially zero ending capital. Click the Use Results button to return to the main screen. Notice that after 20 years, 100% of capital was allocated to Fixed Rate.


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Click the 10-year tab to see that after 10 years 68 % of capital was allocated to Fixed Rate and 32% of capital was allocated to Grow th Stocks. Click the 0-year tab to see that capital was initially allocated 59% to Fixed Rate and 41% to Growth Stocks.


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Click the Plus button to view the Current Scenario window.

Notice how the allocation of capital changes at the end of year 10 and again at the end of year 20. Also notice that the 12-year holding period for growth stocks was not honored. The reallocation of capital after 10 years trumped the holding period assumption. The Assets Graph tab may also be helpful to visualize the result:

So what have we achieved with this example? The truth is, not very much. We created a plan that is projected to fully deplete Steve’s portfolio in 30 years. But if he sells growth stocks sooner than planned to extend his income ladder, he may deplete his portfolio significantly faster than expected. If he waits until the end of the 10 and 20-year time periods, it may not be a favorable time to sell. The plan is also poorly diversified. Steve has given up both the ability to effectively navigate, and the safety margin of surplus capital.


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Overall this example represents a poor strategy, and one might wonder why we chose to show it. But it points out how sensitive the results can be to the level of income withdrawn. Here the initial withdrawal rate was 6.2%. In Chapter 3, the initial withdrawal rate was 5%. But what a difference in the quality of the plans!

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Chapter 6

Buy-Hold-Transfer Plan This next example will also fully deplete the portfolio after 30 years. But the approach is a little different. It is still not our preferred approach, but the resulting plan does offer some advantages over the plan created in the previous chapter, and the simplicity does hold some appeal. Steve’s portfolio will be divided into three parts. The first part will be used to purchase an income ladder to provide guaranteed income during years 1 through 10. The second part will be invested in blue-chip stocks, all of which will be sold after 10 years to purchase another income ladder. This second income ladder will provide guaranteed income for years 11 through 20. The third part will be invested in growth stocks, all of which will be sold after 20 years to purchase yet another income ladder. This third income ladder will provide guaranteed income for years 21 through 30. How should Steve allocate his capital, and what is the maximum amount of income that he can maintain with this strategy assuming the following?

Scenario Parameters Beginning Capital $500,000 Payment Period Annual Years in Scenario 30 Anticipated Inflation 3%


Total Return Dividends Holding Period Fixed Rate 4.33% - - Blue Chip Stocks 9.00% 0.00% 10 Growth Stocks 11.00% 0.00% 20

This time we will assume that blue-chip stock dividends will be reinvested. The holding period for blue-chip stocks will be set to 10 years because this capital is reserved for income during years 11 through 20. Likewise the holding period for growth stocks will be set to 20 years because this capital is reserved for income during years 21 through 30. Under the File menu, select New, and then enter the Scenario and Investm ent Parameters as shown next:


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Click on Accelerate Transfers, found on the middle left portion of the main screen. An Edit button will appear. Click this bu tton to open the Accelerated Transfers window.

This schedule allows us to manually transfer capital from stocks to the fixed-rate category. These transfers will override both the holding periods and the default transfer rules. Transfers will occur at the end of the year indicated in the Transfer Year column. The Transfer Amount column allows transfers to be defined in terms of either dollar amounts or percentages. If the value entered is 100 or less, it is treated as a percentage. If the value entered is more than 100, then it is treated as a dollar value. The Transfer from Category column simply indicates which stock category the funds will be transferred from. Funds are always transferred into the fixed-rate category.

Chapter 6: BuyChapter 6: BuyChapter 6: BuyChapter 6: Buy----HoldHoldHoldHold----Transfer PlanTransfer PlanTransfer PlanTransfer Plan

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For this example we want to define a 100% transfer from blue-chip stocks at the end of 10 years, and a 100% transfer from growth stocks at the end of 20 years. Enter these transfers as shown next:

Click OK to return to the main screen. Next we will run the same optimization that we ran in the previous chapter. Click the “Optimize Investment Allocation” button.

Select the option called, “Find the highest income available from the investments.” Then select Consume Capital. Alloca te to the nearest 1%, and click the “Calculate Optimum Investment Allocation” button. The result will be an Annual Income of $29,333 and essentially zero ending capital. Click the Use Results button to return to the main screen.


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This result indicates that 56% of capital, or $280,000, should be allocated to the first income ladder of fixed-rate investments. 32% of capital, or $160,000, should be invested in blue-chip stocks, and 12% of capital, or $60,000, should be invested in growth stocks. A relatively small initial investment in growth stocks is able to pay for the third income ladder in part because the assumed rate of return is higher, but also because the investment has 20 years to grow compared to only 10 years for the blue-chip stocks. Again this type of strategy is not our first choice, but it does have some attractive features. The first 10 years of income can be well planned and certain. Income during years 11 through 20 will not likely be exactly as planned. It could be more or less depending on the actual performance of the blue-chip stocks. But the 10-year holding period does help to reduce risk. Similarly, income during years 21 through 30 is dependent on the actual performance of the growth stocks. But here again risk is reduced with a 20-year holding period. Provided that growth stock capital is not consumed earlier and the market returns a reasonably respectable return over 20 years, there will be income during years 21 through 30. The downside of the approach, at least in its pure form, is that it places a lot of pressure on a small number of selling events. If markets are favorable when blue chip and growth stocks have to be sold, life is good. But if markets are down, the investor can take a big hit. We prefer to sell smaller amounts of stock more frequently and at select times to mitigate risk. We also prefer to have a projected surplus of capital remaining at the end of the plan as a contingency against the many uncertainties associated with investment income planning.

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Chapter 7

Yield-Based Withdrawals Plan In this chapter we will switch gears and create a completely different type of plan. The example will use a Yield-Based Withdrawals strategy where income is maintained almost exclusively from stock dividends. The numbers are rather large and will be wishful thinking for most people. But for those who can afford this type of strategy, it is a good option. Assume that Sue has $2,000,000 of capital to invest and that she is able to live comfortably on an annual pre-tax investment income of $50,000, increasing each year with inflation. This represents a relatively low initial withdrawal rate of 2.5%. Her income will be almost exclusively supported by dividends paid on a quarterly basis. She will need a small amount of cash to cover the first quarter’s income. But more significantly, she would like to keep about 10% of her capital in money market accounts in case emergency needs arise. Sue is very conservative! The other 90% of capital will be split evenly between high-yield and blue-chip stocks. Her assumptions are summarized as follows:

Scenario Parameters Beginning Capital $2,000,000 Annual Income $50,000 Payment Period Quarterly Years in Scenario 30 Anticipated Inflation 3%



Holding Period

Percent Allocated

Money Market 1.50% - - 10 High Yield Stocks 8.00% 4.00% 30 45 Blue Chip Stocks 9.00% 2.00% 30 45

Since Sue does not plan to ever sell stocks to support income, the holding periods become irrelevant. She may at times sell shares of stock to purchase other stocks, but she will not have an income ladder, and therefore she will not need to periodically sell stocks to extend it. Click the File menu and select New to begin a new s cenario. Enter the investment assumptions as shown next:


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Even in terms of inflation-adjusted dollars, the portfolio is projected to more than double after 30 years while supporting Sue’s desired income. Someday Sue will have some fortunate heirs! Next click the Plus button in the lower right corne r of the main screen, and then select the Cash Flow tab.

Sue’s dividends actually exceed her desired income. There is however risk associated with divided income. While many established companies are able to consistently increase their dividend payout, there is no guarantee of this. And even if the companies are able to increase their dividend payout from year to year, they may not increase as much as is shown above. We have assumed that dividends will always be a fixed percentage of the high-yield and blue-chip stock values, 4% and 2% respectively. This means that projected dividends are coupled to

Chapter 7: YieldChapter 7: YieldChapter 7: YieldChapter 7: Yield----Based Withdrawals PlanBased Withdrawals PlanBased Withdrawals PlanBased Withdrawals Plan

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the projected annual appreciation of the stock values. We can introduce a more conservative convention and decouple dividend projections from stock appreciation projections by assuming that stock dividends will increase at the inflation rate. Click Edit on the menu and select Inflate Dividends .

Now click the Plus button, and revisit the Cash Flo w tab.

With this setting, dividends appear constant when viewed as inflation-adjusted dollars. Uncheck the “Adjust Results for Inflation” box to s ee that projected dividends do increase at the assumed inflation rate of 3% per ye ar. Sue has developed a relatively conservative plan. Her primary risk hinges on whether dividends will keep pace with inflation. But with a well-diversified portfolio, and a significant source of emergency funds, this should be a low risk. She has several years of income readily available in her money market accounts to cover any gaps in divided income. We should all be so fortunate!

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Preamble to Chapters 8, 9 and 10

Case Studies The examples in previous chapters focused on teaching the Defined Withdrawals strategy and the Income Strategy Generator software. The examples in the next three chapters will build upon these concepts while incorporating real-life complexities such as: • Reallocating capital while minimizing current taxation • Accounting for mandatory minimum IRA distributions post age 70½ • Avoiding early IRA withdrawal penalties prior to age 59½ Chapter 8 is a relatively straightforward example for a couple retiring at age 62. One member of the couple will receive a lump-sum distribution from a qualified retirement plan. They both qualify for Social Security benefits. Chapter 9 demonstrates an example where a person age 65 must aggressively make the most of limited financial resources. Existing investments will be reallocated while carefully considering tax consequences. The plan will also account for mandatory minimum IRA distributions. Chapter 10 is a relatively complex example for a person retiring early at age 53. Here the challenge will be to develop a funding plan that simultaneously avoids early withdrawal penalties from an IRA and maximizes tax deferment. We’d like to point out that these examples were developed for the original edition of our book titled, Financial Retirement Planning with the Investment Scenario Generator, which was published in 1996. Back in 1996 interest rates were considerably higher than they are at the time of this writing. But while financial markets change, the planning process does not. The examples continue to offer insight to the range of circumstances that are often encountered and the types of decisions that have to be made. Therefore we have decided to preserve the original examples largely as they appeared in the 1996 edition. One never knows when higher interest rates will return! It may be interesting to note that as of this writing, it is a relatively poor time to sell most stocks (see Chapter 12 for current trend-lines). But during the past 12 years, since these examples were written, there have been fantastic selling opportunities. Hopefully our fictitious retirees are currently enjoying their extended income ladders and waiting for a better time to sell again!

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Chapter 8

Retirement at Age 62 Let’s assume that a married couple, both age 62, are about to retire. Several months ago this couple visited the Social Security Administration office and determined that they both qualify for Social Security benefits. Their initial combined annual Social Security income will be $13,000. This amount will increase in the future with inflation. We will assume that this couple has sufficient fully paid life insurance such that the proceeds upon the early death of either of them could be invested to provide income to replace reduced Social Security benefits. One of the members of this couple will receive upon retirement a $400,000 lump-sum distribution from a qualified retirement plan. They have savings for financial reserves or emergency funds, but the lump-sum distribution plus Social Security will be their sole source of retirement income. How should they invest the $400,000? This couple has thoughtfully prepared an annual budget, estimating that they currently need an annual income before income taxes of $35,000. Retirement at age 62 could mean a very long retirement. Both individuals could live another 25 plus years. Therefore they must develop a long-term reliable investment income plan. One approach would be to invest in a quality mutual fund that maintains a balance of fixed-rate investments and stocks. They could withdraw 5.5% of their balance in the fund at the beginning of each year ($22,000/$400,000 = 5.5%). However some years the fund may increase in value and other years it may decrease, resulting in variable annual incomes. With a carefully planned budget, variable income does not meet the need. Alternatively this couple could withdraw their desired income regardless of the fund’s performance. This Systematic Withdrawals approach would at times cause them to sell stocks during down markets. Instead we will develop a Defined Withdrawals plan.

The couple assumes that quality blue-chip stock investments, held for a period of up to 12 years, will provide a compound average annual total return of 9.5% including dividends of 3%. Similarly they assume that quality growth stock investments, held for a period of up to 15 years, will provide a compound average annual total return of 11.5%. Over time stocks have provided investors with returns substantially greater than the returns from fixed-rate investments. The risks associated with investing in stocks are reduced by assuming that stocks can be held for the long-term if necessary. At age 62 they are long-term investors.


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Enter the following Scenario and Investment Paramet ers:

Scenario Parameters Beginning Capital $400,000 Annual Income Need $22,000 Payment Period Quarterly Years in Scenario 25 Anticipated Inflation 3.5%



Holding Period

Percent Allocated

Blue Chip Stocks 9.5% 3% 12 0% Growth Stocks 11.5% 0% 15 0%

Now assume that U.S. Treasury obligations have the following yield rates and corresponding maturities:

Years to Maturity % Yield 1 3.50 2 4.15 3 4.75 4 5.30 5 5.60 6 5.83 7 6.15 8 6.40 9 6.50 10 6.55 11 6.75

Since the shortest holding period is 12 years, the income ladder must provide certain income for the first 12 years. The principal for an obligation that matures after 11 years will become available to support income during year 12. We do not need to consider obligations with 12-year maturities, because the principal would not be available to support income until year 13.

Chapter 8: Retirement at Age 62Chapter 8: Retirement at Age 62Chapter 8: Retirement at Age 62Chapter 8: Retirement at Age 62

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Click the Fixed Rate category on the main screen, a nd enter these values as follows:

NOTE: The estimated yield rate of 6.10% in this example will be quite accurate for the first 12 years once the couple purchases the investments and locks in the interest rates. But there is some risk in assuming this rate for years 13 and beyond. Interest rates could decline during this time. Also select the following scenario settings:

Scenario Settings Menu Selection Setting Edit Inflate Dividends Checked View Actual Dollars Checked

Click the “Optimize Investment Allocation” button. Allocate to the nearest 5%. Then click the “Calculate Optimum Investment Alloca tion” button .


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Ending capital is $998,697 in actual dollars and $422,595 in inflation-adjusted dollars. Press F8 to toggle between Actual Dollars and Inflation-A djusted Dollars . Since the ending capital in inflation-adjusted dollars is greater than the beginning capital, no purchasing power has been lost.

Executing the Plan The couple should first arrange for a trustee-to-trustee transfer of the $400,000 from the qualified plan to a self-directed Individual Retirement Account. A trustee-to-trustee transfer would not be subject to either current federal taxation or federal income tax withholding. A rollover of a distribution from the plan within the required 60-day period would also not be subject to current federal taxation. However the rollover distribution, unlike a trustee-to-trustee transfer, would be subject to federal income tax withholding requirements.


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Click the Plus button on the main screen and select the Cash Flow tab to see how much income is projected from blue-chip stock divid ends and how much income must be maintained by the income ladder of U.S. Tre asury Obligations.

Next click File on the menu bar and select Print.


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This will open the Print Report window shown next:

Make sure the Investment Details selection is check ed, and click Print Preview. Then page forward to the Fixed Rate report shown ne xt:


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Caution: The income ladder that is generated by the software assumes that the annual yield rates are the same as, or nearly the same as, the annual interest rates. If fixed-rate investments are purchase at a significant discount or premium, such that the annual yield rates are different than the annual interest rates, then the calculated ladder will not provide the desired income. See Chapter 11 for a discussion of yield vs. interest rate. A bank or investment firm can assist in creating an appropriate income ladder when the yields and interest rates are significantly different.


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In this example the Fixed Rate report details the amount of U.S. Treasury Obligations that must be purchased with each maturity and corresponding yield rate in order to create a 12-year income ladder that supplements the couples projected divided and Social Security income. A $19,000 cash, or short-term investment, is also needed during the first year. So the total cost of the 12-year income ladder is $179,402 (the total of the Investment Needed column) plus $19,000 or $198,402. This is sufficient given that $200,000 was allocated to fixed-rate investments. Earlier the couple indicated a desire for quarterly income payments. A bank or investment firm could help them construct an income ladder to meet this objective. There is now $100,000 to be invested in blue-chip stocks and $100,000 to be invested in growth stocks. Assume that after researching these types of investments, and with some professional assistance, the couple purchases stocks in 20 quality blue-chip companies that provide a combined dividend yield of 3%. The couple also selects two mutual funds invested in growth stocks. This will give the couple numerous selling options over the next 12 years.

Navigating We have not yet investigated the effect of selling stocks prior to the end of the stock holding periods. Change both stock holding periods to 3 years as sho wn below:

Ending capital in inflation-adjusted dollars is reduced to $305,436 after 25 years. The couple decides that this is an acceptable result. Upon executing the plan our couple will sit tight for the first 3 years. After that they will review their stock portfolio on an annual basis and look for opportunities where stocks have met or achieved planned values. In general they will only sell amounts over and above the original inflation-adjusted values.


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For example assume that one of the growth stock mutual funds increases from $50,000 to $86,168 as projected after 5 years. The original $50,000 amount increased each year by the inflation rate of 3.5% becomes $59,384. So the amount that they would sell is $86,168 minus $59,384 or $26,784. This leaves the original purchasing power remaining to grow again for the future. Upon selling the stocks, or in this case shares of the mutual fund, the couple would purchase additional U.S. Treasury obligations to fund income during years 13 and beyond. To summarize the couple’s plan: • They will use 50% of their portfolio, or $200,000, to purchase an income ladder of U.S.

Treasury obligations. The income ladder will provide certain income for 12 years. The amount of income will increase each year by the projected inflation rate of 3.5%.

• They will invest 25% of their portfolio, or $100,000, in a diversified portfolio of 20 blue-chip

company stocks. These stocks will provide dividend income of 3% that is projected to increase with inflation.

• They will invest 25% of their portfolio, or $100,000, in two quality growth stock mutual

funds. • They will plan to sit tight and let their investments grow during the first three years. • After year 3, and before the end of year 12, they will review their plan annually to determine

whether one or more stocks or mutual funds have met or exceeded plan. If so, they will sell the amount that is over and above the original inflation-adjusted value. They will use the proceeds to purchase additional U.S. Treasury obligations, or other suitable fixed-rate investments, to extend their income ladder.

• Once a portion of a given stock or mutual fund is sold, they will typically not consider selling

more of it again for another 3 years. • They anticipate the value of their portfolio after 25 years to be between $305,436 and

$422,595 in inflation-adjusted dollars and between $721,821 and $998,697 in actual dollars. • In the event that stocks do not perform as planned during the stock holding periods, the

couple understands that they will have to create a new plan and likely lower income. We are partial to the navigating metaphor because it conveys the inherent uncertainty and need to periodically adjust course when investing in financial markets. But another metaphor is sometimes helpful. In a sense our couple has planted some investments that they later intend to harvest. The secret is to give the investments a chance to grow and not to pick them before they are ripe!

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Chapter 9

Retirement at Age 65 The investment approach in this example is relatively aggressive. It focuses on making the most of limited resources and the need to reallocate existing assets while considering tax consequences.

Current Situation The starting point is to determine the nature of available financial resources and estimate future income needs. Both can and may have to be adjusted. Assume investments and savings as follows: Market Value

Short-Term Certificates of Deposit (average yield 6%) $47,000

Utility Stocks $33,000

Individual Retirement Account (IRA) $63,000

U.S. Savings Bonds (current redemption value) $9,000

Cash Value Life Insurance $16,000

Total $168,000 Additionally assume current annual Social Security of $12,000 and an annual pension benefit of $8,000. But unlike Social Security, the pension benefit will not increase in the future with inflation. After a careful review of living expenses, this person has concluded that an annual income of about $30,000 before taxes is needed. Are the resources adequate? A better understanding of the resources is required. Assume that the IRA is invested in a U.S. government bond fund that has a current annual yield of 7%. The U.S. Savings bonds have a current yield of 6% with an original cost of $4000. If redeemed, there will be $5000 of taxable income ($9000 less $4000). Similarly the utility stocks cost $14,000. If they are sold there will be a $19,000 taxable gain ($33,000 less $14,000). The current annual dividend yield on the utility stocks is 6%. The life insurance is a whole-life insurance policy with a face value of $40,000 and a current cash value of $16,000. The annual premium is $325 after applying policy dividends to reduce


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the annual premium. Before addressing this insurance policy, let’s review the current anticipated income by source:

Source

Annual Income

Certificates of Deposit $47,000 x 6% = $2,820 Utility Stocks $33,000 x 6% = $1,980 IRA $63,000 x 7% = $4,410 U.S. Savings Bonds $9,000 x 6% = $540 Pension $8,000 Social Security $12,000 Total $29,750

Current estimated annual income is only slightly below the desired $30,000 amount. However, less than one-half of this person’s income (Social Security and dividends from utility stocks) provides some protection from inflation. Let’s look at some calculations. Beginning capital available for allocation before considering the cash value of the life insurance is $152,000 ($168,000-$16,000). Enter the following scenario parameters, investment parameters, and scenario settings:

Scenario Parameters Beginning Capital $152,000 Annual Income Need $30,000 Payment Period Quarterly Years in Scenario 15 Anticipated Inflation 3.5%


Total Return Dividends Holding Period Fixed Rate 6% - - High Yield Stocks 8% 6% 6 Blue Chip Stocks 9% 3% 8 Growth Stocks 11.5% 0% 10

Scenario Settings

Menu Selection Setting Edit Inflate Dividends Checked View Actual Dollars Checked

ChaptChaptChaptChapter 9: Retirement at Age 65er 9: Retirement at Age 65er 9: Retirement at Age 65er 9: Retirement at Age 65

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The main screen should appear as follows:

Next, click where it says “Other Sources of Income” on the main screen. An Edit button will appear. Click this button to open the Other Sources of Income window.

Enter the Social Security and pension amounts as sh own above for years 1 through 15. Notice that the “Annual Increase” colu mn is set to 3.5% for the Social Security payments and 0% for the pension. T his is because Social Security is expected to increase with inflation whi le the pension will not. Since both will be used to fund immediate income, they ar e allocated 100% to Fixed Rate.


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For retirement planning purposes, the $8,000 pension is similar to owning a long-term bond that cannot be sold or reallocated. Click OK to close the window. Then click “Optimize Investment Allocation” button on the main screen. Reallocate for maximum ending capital. Choose a precision of 5%, and click OK.

The main screen will display these results:

Beginning capital is allocated 65% to Fixed Rate and 35% to Growth Stock. Ending capital is $79,707 in inflation-adjusted dollars and $133,537 in actual dollars. Press F8 to toggle between adjusted and actual values. Let’s assume that this is not an acceptable result. Our retiree decides that the allocation is weighted too heavily toward fixed-rate investments and capital is depleted too fast. Also current investments are not aligned with this allocation.

Exploring Reallocation Options Let’s first consider some reallocation options. Assume that the utility stocks are sold. This produces taxable income of $19,000 ($33,000 minus their original $14,000 cost). Assume that the savings bonds are redeemed, increasing taxable income by another $5000 ($9000 minus their original $4000 cost). Total taxable income is then $24,000 ($19,000 plus $5,000). Assume that the taxes on this income total $7,000. Further assume that the life insurance policy is canceled without tax consequences. After the payment of income taxes, investments and savings can be summarized as follows:


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Investments Amount Sale of Utility Stocks $33,000 Cancelled Life Insurance $16,000 Redeemed U.S. Savings Bonds $9,000 Certificates of Deposit $47,000 IRA $63,000 Less Taxes -$7,000 Total $161,000

Enter the new value of $161,000 for the Beginning C apital on the main screen. Next assume that our retiree has reconsidered income needs and decided to decrease the initial $30,000 value to $28,750, in part due to cancellation of the insurance policy. Enter the new value of $28,750 for the Annual Incom e Need on the main screen. Next assume that our retiree manually tries some different investment allocations and eventually settles on 45% Fixed Rate, 25% Blue Chip Stocks, and 30% Growth Stocks. Enter these percentages as shown below:

Ending capital is now projected to be $131,496 in inflation-adjusted dollars and $220,301 in actual dollars. (Note: if your ending capital values differ slightly, make sure the Inflate Dividends setting is checked on the Edit menu.)


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Next we will determine how much ending capital is reduced if the portfolio is rebalanced more frequently. Assume that if selling conditions are favorable, our retiree will rebalance no more than once every three years for each of the two selected stock categories. Change the holding periods for Blue Chip Stocks and Growth Stocks to 3 years as shown next:

Note that the cost of maintaining a more balanced portfolio (assuming favorable stock selling conditions in the market) is to reduce projected ending capital to $118,639 in inflation-adjusted dollars and $198,762 in actual dollars. Press F8 to see the ending capital in actual dollars. We’ll assume that this is an acceptable result.

Mandatory IRA Distributions After Age 70½ This person would want to enjoy tax deferment on the IRA as long as possible. However at age 70½ this person will be forced to start drawing some funds from the IRA due to federal rules. If all of the IRA funds are invested in stocks, the person may be forced to sell stocks sooner than planned. Therefore it would be a good idea to hold a portion of fixed-rate investments in the IRA, and this portion should be sufficient to provide the mandatory income withdrawals post age 70½. We will assume that $20,000 will be used to purchase fixed-rate investments within the IRA and strategically selected such that fixed rate investments purchased with these funds will mature post age 70½ while fulfilling the mandatory withdrawal requirements. The remaining funds in the IRA will be used to purchase stock mutual funds. The remaining cash and proceeds from the certificates of deposit will be split to purchase the balance of the fixed-rate investments required to fund the income ladder and the balance of stocks required to achieve the initial desired allocation.


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Stock mutual funds not held in an IRA could produce surprise income tax consequences as investment managers reallocate stocks within the mutual fund. This is true even when income is not withdrawn. Therefore it may be desirable to purchase a portfolio of individual quality stocks with the funds not held in the IRA. With this goal in mind, assume the following allocation of capital: Individual

Retirement Account

Personal Account

Percentage

Total

Fixed Rate $20,000 $32,450 45% $72,450 Blue Chip Stocks $20,000 $30,250 25% $40,250 Growth Stocks $23,000 $25,300 30% $48,300

Totals $73,000 $88,000 100% $161,000 Inflation-adjusted income is now protected for the next 10 years. Further there is a reasonable amount of capital invested on a tax-deferred basis in both stock categories that can be transferred to fixed-rate investments in the future as opportunities arise. If the retiree is not comfortable selecting or managing individual stocks, a tax-deferred annuity could be purchased where the annuity allows stocks to be purchased within the annuity. The selected annuity should further provide the option to transfer capital from stocks to other investments including fixed-rate investments.

This is an aggressive plan. Purchasing power is likely to be significantly depleted after only 15 years, at which time our retiree would only be 80 years old. But with limited resources our retiree decides that it is worth it and wants to make the most of the next 15 years. Depending upon health, other life circumstances, and actual future investment results, our retiree will re-evaluate the plan at age 80, realizing that retirement income may need to be reduced at this time in order to avoid running out of capital too soon.

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Chapter 10

Early Retirement at Age 53 This example will detail a plan for a financially successful person who has decided to retire at a relatively early age. Retirement at age 53 is potentially a very long retirement and may require complex planning due to tax considerations and the number of changes in life circumstances yet to occur. This example will include: • A home mortgage note that will be fully paid after age 60 (after eight years). • Estimated annual Social Security benefits of $16,355 at age 62. • Significant funds in an Individual Retirement Account that are subject to federal early

withdrawal rules if distributions are taken before age 59½. • A tax-deferred annuity that is also subject to federal early withdrawal rules for distributions

taken before age 59½. • Blue-chip stocks that have a market value considerably greater than cost. • The intent to maintain a life insurance policy with a significant premium relative to other

income needs.

Summary of Assets Assume this person’s nest egg is $675,000 and composed of the following: Market Value Tax-Deferred Fixed-Rate Annuity (8%) $100,000 Individual Retirement Account (IRA) $350,000 Blue Chip Stocks (original cost $25,000) $78,000 Short-Term Bank Certificates of Deposit $147,000 Total $675,000

All amounts listed represent the replacement cost of the assets. However if converted to cash, only the certificates of deposit could be converted without tax consequences. Therefore these assets must be handled with care so that current taxation does not unnecessarily reduce the amount invested.


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The tax-deferred fixed-rate annuity was purchased years ago for $50,000. The current 8% annual yield is guaranteed for only one more year. This annuity can be redeemed or annuitized without surrender charges. We will assume that the annuity will be annuitized with quarterly payments of $1800 ($7200 annually) to be received for the rest of this person’s life.

Summary of Income Needs A careful review of this person’s current annual income needs before income taxes is $45,000. But this amount includes the home mortgage. Income needs will decrease after the mortgage is paid. Also only a portion of this amount needs to increase with inflation since both the mortgage payments and the insurance premiums are fixed. The home mortgage note is at a 6.0% annual interest rate with monthly payments of $625 or $7500 annually. The mortgage note will be fully paid at the end of eight years. We will assume that the mortgage note will not be prepaid due to its relatively low interest rate. The annual premium for the whole-life insurance policy is $3750. The cash value was not included in the nest egg summary because it will be considered available for emergency needs only. The policy provides low interest rate loans up to the amount of the policy’s cash value. The ability to borrow these funds is a potential source of cash for an emergency without incurring any current tax liability. Current before-tax living expenses minus the mortgage and insurance premium are then:

$45,000 - $7500 - $3750 = $33,750 Start by selecting File and then New from the menu to clear any previous inputs. Click on “Custom Income Needs” on the main screen. Then click the Edit button that appears. Enter the current annual living expe nses, annual mortgage payment, and annual life insurance premium on the w indow that appears as shown below:

Chapter 10: Early Retirement at Age 53Chapter 10: Early Retirement at Age 53Chapter 10: Early Retirement at Age 53Chapter 10: Early Retirement at Age 53

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For this example we will develop a 25-year plan. So the Last Year is set to 25 for both the living expenses and life insurance premium. Notice that the last year is set to 8 for the mortgage because it will be fully paid at the end of the eighth year. Notice also that the “Annual Increase” is set to an assumed inflation rate of 3.5% for the living expenses and 0% for the mortgage and life insurance. Click OK to return to the main screen.

Investment Assumptions Recall that we decided to annuitize the $100,000 fixed-rate annuity. So we will subtract it from the total capital. Beginning capital for the scenario then becomes $675,000 - $100,000 or $575,000. We will account for the annuity later on the Annuity schedule. Enter the following Scenario Parameters, Investment Parameters, and Scenario Settings:

Scenario Parameters Beginning Capital $575,000 Payment Period Quarterly Years in Scenario 25 Anticipated Inflation 3.5%

Investment Parameters Total Return Dividends Holding Period Blue Chip Stocks 9.5% 3% 12 Growth Stocks 11% 0% 15

Scenario Settings

Menu Selection Setting Edit Inflate Dividends Checked View Actual Dollars Checked


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The main screen should appear as follows:

Notice that the “Annual Income Need” field is grayed and indicates “Custom” because we previously entered custom income needs. Assume that a portion of income will be funded with an income ladder of U.S. Treasury obligations, and that U.S. Treasury obligations are currently available with the following annual yields and corresponding maturities:

Years to Maturity % Yield 1 3.50 2 4.15 3 4.75 4 5.30 5 5.60 6 5.83 7 6.15 8 6.40 9 6.50 10 6.55 11 6.75

This person wants to be able to hold blue-chip stocks for up to 12 years if necessary. During this time income will be provided by a combination of laddered U.S. Treasury obligations and other sources. U.S. Treasury obligations maturing after 11 years will support income during year 12. There is no need to consider a 12-year yield because the principal from an obligation maturing after 12 years would not be available to support income until year 13.


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Click the Fixed Rate investment category on the mai n screen and then enter the previous values on the Fixed Rate Investments windo w as shown next:

The estimated yield to maturity should be 6.10%. This represents an estimate of the average annual yield that the person will achieve with the first income ladder of U.S. Treasury obligations. A precise calculation of the yield would require knowing the exact amounts that will be purchased at each yield rate and corresponding maturity date. Since this person desires quarterly income, obligations may be purchased that mature at intermediate points during the years. But for planning purposes, the above estimate will be completely acceptable. Click “Use Calculated Value” and then click OK.

Other Sources of Income This person has two other sources of income that we must account forSocial Security beginning at age 62, and the fixed-rate annuity. Click where it says “Other Sources of Income” on th e main screen. Then click the Edit button that appears. Enter the annual Soc ial Security income as follows:


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We are assuming that this person recently turned 53 years old and will therefore turn 62 after another 9 years. Therefore Social Security income will begin in year 10. Notice that the “Annual Increase” value has been set to an assumed inflation rate of 3.5%. Since the Social Security payments will be used entirely to fund current income, and not invested in stocks, the payments are allocated 100% to Fixed Rate. Click OK to close the window. Click where it says “Include Annuities” on the main screen. Then click the Edit button that appears. Enter the fixed-rate annuity as follows:

If we were planning to purchase an annuity in the future, we could enter the cost and the year that it will be purchased. But since the annuity in this example is already owned, the “Cost” is left at $0, and the “Year Purchased” has no effect on the scenario. Notice that the “Annual Increase” column is left at 0% because this annuity provides a fixed annual payment of $7200 each year (or $1800 quarterly). Click OK to close the window.


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Allocating Capital Click the “Optimize Investment Allocation” button o n the main screen. Then select the option called, “Reallocate for maximum e nding capital”. Allocate to the nearest 1% and click the “Calculate Optimum Investm ent Allocation” button. The resulting allocation will be 55% Fixed Rate, 15% Blue Chip Stocks, and 30% Growth Stocks as shown next:

Ending capital is $1,666,472 in actual dollars and $705,162 in inflation-adjusted dollars. Press F8 to see the inflation-adjusted results. At this point some review may be helpful. Click the Plus button in the lower right corner of the main screen and then select the Cash Flow ta b.


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Uncheck the “Adjust Result for Inflation” checkbox. Blue-chip stock dividends are shown increasing at a 3.5% assumed annual inflation rate. The Withdrawals column represents the amount of income that must be provided from investments. Notice that it decreases after the eighth year when the mortgage is paid and again after the ninth year when Social Security kicks in. The Annuities column shows the fixed $7200 annual income payment provide by the annuity. The Other column, which is short for “Other Sources of Income”, shows the Social Security payments beginning in year 10. In some cases the Total Income provided by a portfolio may exceed the Desired Income, but in this case they are matched. Click the Assets Graph tab and check “Adjust Result s for Inflation”.

Notice that the portfolio is projected to decline in value (inflation-adjusted dollars) during the first 9 years, but that it then increases in value after the Social Security payments begin to replace a portion of the retirement income. Since it is unlikely that stocks will be held the full duration of the stock holding periods, we will test minimum holding periods next. Click the Close button to return to the main screen and change the 12-year and 15-year stock holding pe riods to 3 years each.


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This reduces projected ending capital to $550,897 in inflation-adjusted dollars and $1,301,904 in actual dollars. We will assume that this is an acceptable outcome. In reality it is not likely that blue-chip and growth stocks will offer favorable selling opportunities every three years. But this person will want to pay special attention to the range of ending capital results that could occur, because it is likely that investment income will be needed beyond this 25-year plan. In this example we are showing how a 25-year plan might be developed in this situation to test whether early retirement is feasible, but realistically a reallocation of capital may make sense whenever significant life changes occur. It would add some complexity to the example, but one could use the multiple allocations feature to plan for a different allocation of capital after Social Security begins to supplement income. More capital could then be allocated to stocks which over time would likely result in higher ending capital.

Early Federal Withdrawal Rules In the previous chapter we had to pay special attention to the mandatory IRA withdrawal rules post age 70½. The person in our current example will eventually have to do the same, but this will not be an issue during the first 12 years. It is the first 12 years that we have to focus on funding first, since this person wants to be able to hold blue-chip stocks for up to 12 years if necessary. During the first 12 years this person has to pay special attention to the early withdrawal rules in order to avoid federal tax penalties for early withdrawals from both the IRA and the tax-deferred annuity. Accordingly it may be helpful to first review the early federal withdrawal rules:


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EARLY FEDERAL WITHDRAWAL RULES 1. A person can withdraw funds at anytime from an IRA or an annuity contract

(subject to early surrender charges of the insurance company). 2. If funds are withdrawn before age 59½, the amount withdrawn will be subject to

both the regular income tax and, unless an exception applies, a 10% early withdrawal penalty tax.

3. The 10% penalty tax will not apply if the withdrawals are substantially equal

periodic payments made at least annually as described in Rev. Rul. 2002-62. 4. The proper substantially equal periodic withdrawal payments must continue for at

least 5 years and at least until the person turns age 59½ to avoid the 10% penalty. There are provisions for retroactively imposing the penalty tax and interest thereon for failure to comply. For an IRA there are different acceptable methods for calculating withdrawals over life expectancy. For non-qualified annuities (those not purchased as part of an employee plan), the Internal Revenue Service has interpreted the rules in a Private Letter Ruling taking the position that an annuity contract must be annuitized with distributions fixed for future periods. Specifically the IRS has stated that distributions from a non-qualifying annuity contract under a systematic withdrawal option, even though the payments are substantially equal periodic payments, will not qualify for the equal payment exception unless there is an established schedule of future payments. There are also exceptions to the penalty tax for withdrawals due to death and disability.

There are different acceptable methods for calculating early withdrawals from IRAs over life expectancy to avoid the penalty tax. Professional assistance should be sought for these calculations and for understanding the details of these rules. In this example we will assume that annual withdrawals of 9% or $31,500 from the IRA qualify as an exception to the penalty tax.


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Recall the Cash Flow tab that was shown earlier. The Withdrawals column indicates the income amounts that must be funded with fixed-rate investments, which for this example we are assuming will be U.S. Treasury obligations.

We need to figure out the amount of U.S. Treasuries that will be held within the IRA and the amount that will be held outside the IRA. We will create a table as shown below and start by entering the amounts that are not arbitrary.

Year Age

Total Income from U.S. Treasuries

(Withdrawals Column)

Income from U.S. Treasuries

Held in the IRA


Not Held in the IRA 1 53 $35,213 $31,500 $3,713 2 54 $36,303 $31,500 $4,803 3 55 $37,432 $31,500 $5,932 4 56 $38,600 $31,500 $7,100 5 57 $39,810 $31,500 $8,310 6 58 $41,061 $31,500 $9,561 7 59 $42,357 $15,750 8 60 $43,697 9 61 $37,585 10 62 $22,666 11 63 $23,581 12 64 $24,527

We know the income amounts that must be provided by U.S. Treasuries are the amounts from the Withdrawals column on the Cash Flow tab of Income Strategy Generator. Further we know that $31,500 must be withdrawn annually from the IRA up to age 59½. The right-most column then shows the additional income that is needed from U.S. Treasuries held outside the IRA. The remaining amounts are somewhat arbitrary since post age 59½ the person is no longer


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required to withdraw a specific amount from the IRA. Therefore there are many acceptable options. However one important consideration is that it will likely be advantageous to own growth stock mutual funds within the IRA. This will prevent surprise taxes when fund mangers sell stocks in favor of other stocks within the mutual fund. Again this is somewhat of an arbitrary decision, and there would be many other options, but let’s try funding income of $31,500 for nine years from U.S. Treasury obligations within the IRA. Assume that the balance of the IRA will be invested in growth stocks. Given this assumption, we can complete the table as shown next. We will explain the reason for the colored highlighting momentarily.

Year Age




Held in the IRA


Not Held in the IRA and Annuity

1 53 $35,213 $31,500 $3,713 2 54 $36,303 $31,500 $4,803 3 55 $37,432 $31,500 $5,932 4 56 $38,600 $31,500 $7,100 5 57 $39,810 $31,500 $8,310 6 58 $41,061 $31,500 $9,561 7 59 $42,357 $31,500 $10,857 8 60 $43,697 $31,500 $12,197 9 61 $37,585 $31,500 $6,085 10 62 $22,666 $0 $22,666 11 63 $23,581 $0 $23,581 12 64 $24,527 $0 $24,527

Earlier in this example a total of $316,250 was allocated to fixed-rate investments. But we need to determine how much of this should be held in the IRA and how much should be held outside the IRA. We can easily create an income ladder for the amounts held in the IRA (highlighted in green) and determine how much capital needs to be invested to fund this income ladder. This will be our next step. But precisely funding the income amount in the right-most column is trickier. This is because the income needs are significantly higher in later years. If we create a standard 12-year income ladder, it will generate more interest income during the early years than is required. This in turn will increase taxes and reduce the amount of capital invested. So instead we will divide the right-most column into two sections as designated by the yellow and blue highlighting. An income ladder will be used to fund the amounts highlighted in yellow. We will use another tax-deferred annuity to fund the amounts in blue.


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Our final task for this example is to figure out how much capital is required to fund the green, yellow, and blue portions of the funding plan. We will start with the U.S. Treasuries held in the IRA and highlighted in green. For these next steps we need to start with a cleared screen. You may want to save your work first. Then select File and New to clear all entries. Next enter the following Scenario Parameters:

Scenario Parameters Beginning Capital $0 Annual Income Need $31,500 Payment Period Quarterly Years in Scenario 9 Anticipated Inflation 0%

Then click the Fixed Rate category to open the Fixe d Rate Investments window and enter the following yields for years 1 through 8:

Click “Use Calculated Value” and then click OK to r eturn to the main screen.


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Make sure that capital is allocated 100% to Fixed R ate on the main screen. Notice the button next to the Beginning Capital field on t he main screen. Click this button to open the following window:

With Consume Capital selected the Income Strategy Generator determines that $223,893 is the amount needed to fund 9 annual payments of $31,500. Click the Use Value button to return to the main screen. Click the Plus button o n the main screen and then select the Assets Graph to see that $223,893 invest ed at an average annual yield of 5.68% is just enough to fund the 9 annual paymen ts of $31,500.


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Year Age




Held in the IRA



1 53 $35,213 $31,500 $3,713 2 54 $36,303 $31,500 $4,803 3 55 $37,432 $31,500 $5,932 4 56 $38,600 $31,500 $7,100 5 57 $39,810 $31,500 $8,310 6 58 $41,061 $31,500 $9,561 7 59 $42,357 $31,500 $10,857 8 60 $43,697 $31,500 $12,197 9 61 $37,585 $31,500 $6,085 10 62 $22,666 $0 $22,666 11 63 $23,581 $0 $23,581 12 64 $24,527 $0 $24,527

Next we will figure out how much capital is required to fund the amounts highlighted in yellow. Since this will be a 7-year income ladder, we will estimate the average yield using U.S. Treasury yields for maturities ranging from 1 through 6 years. Again remember that the principal from an obligation maturing after 7 years would be available to provide income during the eighth year. So we do not need to include a 7-year yield rate, even though we are creating a 7-year income ladder. Click Close if necessary to return to the main scre en. Click the Fixed Rate investment category to open the Fixed Rate Investme nts window. Delete or enter 0 for the 7-year and 8-year Annual Yield Rates. Th e Estimated Yield to Maturity should be 5.25% as follows:


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Click “Use Calculated Value” and then OK to return to the main screen. Next we need to enter the desired income amount hig hlighted in yellow on our funding plan table. Click “Custom Income Needs” on the main screen. Then click the Edit button that appears to open the cust om income schedule. Next click “Add Yearly Income Needs” in the lower left c orner. Another Edit button will appear. Click this button. This will open another schedule that allows arbitrary income amounts to be entered on a year-by-year basi s. Enter the yellow highlighted values from the funding table in the Ac tual Dollars column as shown:

The inflation-adjusted dollar values on this schedule are the same because inflation is set to 0%. Click OK to close this window, and then click OK ag ain to return to the main screen. Again make sure that capital is allocated 100% to F ixed Rate. Then click the button next to the Beginning Capital field on the m ain screen to open the following window:

With Consume Capital selected, the required Beginning Capital to fund the yellow highlighted income amounts in our funding plan is $40,935.


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Note: This calculation assumes that U.S. Treasuries will be laddered to provide quarterly income. If you go to the Fixed Rate report and look at the income ladder, the total capital required is slightly higher because the Fixed Rate report assumes an annual ladder. Finally we have to determine the cost of the fixed-rate annuity that will be needed to fund the income amounts highlighted in blue on our funding plan table.

Year Age




Held in the IRA



1 53 $35,213 $31,500 $3,713 2 54 $36,303 $31,500 $4,803 3 55 $37,432 $31,500 $5,932 4 56 $38,600 $31,500 $7,100 5 57 $39,810 $31,500 $8,310 6 58 $41,061 $31,500 $9,561 7 59 $42,357 $31,500 $10,857 8 60 $43,697 $31,500 $12,197 9 61 $37,585 $31,500 $6,085 10 62 $22,666 $0 $22,666 11 63 $23,581 $0 $23,581 12 64 $24,527 $0 $24,527

Assume that the tax-deferred annuity offers an average annual yield of 6.5%. Enter 6.5% for the Fixed Rate Total Return on the main screen. Th en change the “Years in Scenario” field to 12. Next click the Edit button next to “Custom Income N eeds”. Then click the Edit button next to “Add Yearly Income Needs”. Click th e Clear All button. Then enter the amounts highlighted in blue from the funding pl an as follows:


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Click OK to close the window, and then click OK aga in to return to the main screen. Now that we have estimated an appropriate yield and entered the desired income amounts, again click the button next to the Beginni ng Capital field to open the following window:

With Consume Capital selected the beginning capital that is required to fund the desired income amounts highlighted in blue on the funding plan table is calculated to be $47,879. This amount will be used to purchase a tax-deferred annuity with the first payment beginning in year 8. Note that if we tried to construct a standard income ladder of individual U.S. Treasury obligations, it would generate interest income during years 1 through 7 that is not needed. This is the reason for funding the amounts highlighted in blue with a tax-deferred annuity.

Year Age




Held in the IRA



1 53 $35,213 $31,500 $3,713 2 54 $36,303 $31,500 $4,803 3 55 $37,432 $31,500 $5,932 4 56 $38,600 $31,500 $7,100 5 57 $39,810 $31,500 $8,310 6 58 $41,061 $31,500 $9,561 7 59 $42,357 $31,500 $10,857 8 60 $43,697 $31,500 $12,197 9 61 $37,585 $31,500 $6,085 10 62 $22,666 $0 $22,666 11 63 $23,581 $0 $23,581 12 64 $24,527 $0 $24,527

In summary we have concluded that $223,893 is required to fund the amounts highlighted in green. $40,935 is required to fund the amounts highlighted in yellow, and $47,879 is required to fund the amounts highlighted in blue. The total of these three amounts is $312,707. Recall that $316,250 was originally allocated to Fixed Rate investments. This amount is slightly higher than necessary because the optimal allocation was only calculated to the nearest 1%. This slight


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difference should not be a concern, and in reality the amounts required to fund the 12-year income plan will differ slightly depending upon the actual investments selected and corresponding maturity dates.

Summary We are now able to summarize the plan: Individual

Retirement Account

Personal Account

Percentage

Total

Fixed Rate • U.S. Treasuries $223,893 $40,935 • Tax-Deferred Annuity $47,879

55% $316,250

• Surplus $3,543 Blue Chip Stocks • Already Owned $78,000 • To be Purchased $8,250

15% $86,250

Growth Stocks • Purchase in IRA $126,107 • Tax-Deferred Annuity $46,393

30% $172,500

Totals $350,000 $225,000 100% $575,000 The total amount required to be invested in fixed-rate investments is approximately $316,250, but this will depend slightly upon the actual investment and maturity dates selected. An additional $8250 of blue-chip stocks should be purchased from the proceeds of the short-term bank certificates of deposit to bring the total blue-chip stock allocation to $86,250 or 15% of invested capital. Assume that $126,107 is invested in a couple of growth stock mutual funds within the IRA. Another $46,393 should be invested in growth stocks outside the IRA to bring the total growth stock allocation to $172,500 or 30% of invested capital. We will assume that these growth stocks are invested in a tax-deferred annuity to maximize tax deferment. These values total $575,000. The original $100,000 annuity that was annuitized is no longer included in the summary of invested capital. But the income payments from this annuity were accounted for on the Annuity schedule. A whole-life insurance policy also offers a source of emergency funds. We have carefully reallocated existing investments to achieve a desired income and desired allocation of capital while avoiding the early IRA withdrawal penalties.

This person’s portfolio could be managed to further enhance tax deferment after age 59½. For example payments scheduled to be received post age 59½ from the IRA during years 7 through 9 could be redirected to purchase blue-chip stocks within the IRA. As blue-chip stocks are purchased within the IRA, blue-chip stocks held outside the IRA could be sold for income. This


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will provide additional tax deferment when blue-chip stocks are later sold to purchase additional fixed-rate investments. Taxable income in years 7 through 9 is also reduced. The principal proceeds from the redemption of the U.S. Treasury obligations purchased from the redemption of the original short-term certificates of deposit will not be taxable. Interest on these obligations will be taxable. Lastly a portion of the annuity payments will not be taxable. In this example we chose to annuitize the $100,000 tax-deferred annuity. One could also select a tax-free exchange of this annuity for an annuity that is invested in stocks. In that case one should plan for no withdrawals from the annuity prior to age 60. A plan could also be developed using a portion of the short-term bank certificates of deposit to pay off all or a portion of the mortgage. There are countless alternative plans. Congratulations for making it through this complex example! Retirement income planning can be rather complex. But imagine trying to develop this plan without the Income Strategy Generator!

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Chapter 11

Income Ladders In Chapter 1 we showed how a desired level of income could be met with a combination of interest and principal from a ladder of bank certificates of deposit (CDs). But we did not show how to determine the maturity values of the investments that make up the ladder. Most people will not need to know how this is done. One can either use the annual income ladder calculated by the Income Strategy Generator, or for more complex ladders, a bank or investment firm can help with the calculations. For those who are mathematically inclined and interested, we will explain the calculations in this chapter. But first a topic that will be helpful to many is yield vs. interest rate.

Yield vs. Interest Rate Yield is the calculated rate of return based upon the market value of an interest-bearing investment and the scheduled principal and interest payments that will be received from the ownership of the investment. That’s a mouthful. So what does it mean? The concept is easier than it sounds. Assume that a broker is selling a bond that matures after one year with a maturity value of $10,000. The bond also offers a 4% annual interest rate. After one year the total payout is $10,400. Now assume that the broker sells this bond for $9900. Therefore the total return after one year is more than just the $400 of interest. It also includes the $100 difference between the maturity value and the purchase price. In other words the $9900 investment offers a total return of $500. The yield is therefore $500/$9900 or 5.05%. In this example the yield is higher than the interest rate because the bond is purchased at a discount. The reverse could also be true if the bond were to be sold at a premium relative to its maturity value. Why would a broker be willing to sell a bond for less then its maturity value? It may be that market interest rates have increased since the bond was first issued. If so, the broker might have to offer a discount in order to compete with newly issued bonds that offer higher interest rates. Another possibility is that the quality has changed. Perhaps the bond is a corporate bond and the credit rating of the company has been lowered. The discounted price might be offered to compensate for increased credit risk. When a bond, or other fixed-rate investment, is first issued, the interest rate and yield are essentially the same. There may be a slight difference due to interest on interest. But if bonds are purchase at a discount or premium relative to their maturity value, then there can be a significant difference between the yield and the interest rate. If an investor purchases only newly


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issued bonds, or other fixed-rate investments, and always holds them to maturity, then the difference between yield and interest rate has little consequence. Always enter yield rates on the following window:

However when performing calculations to construct an income ladder, one should use interest rates rather than yield rates. The yield rates will affect the purchase price of the income ladder, and therefore the amount of capital that should be allocated to the Fixed Rate category, but interest rates will determine the interest income provided by the ladder. The income ladder calculated by the Income Strategy Generator assumes that the yield rates and interest rates are essentially the same. This would be the case for newly issued bank CDs held to maturity (though there may be a slight difference due to interest on interest). When using investments that have significantly different interest rates and yield rates, a bank or investment firm can help to create an income ladder that provides the desired income. Or one could also perform the calculations described in the next section.

Chapter 11: Income LaddersChapter 11: Income LaddersChapter 11: Income LaddersChapter 11: Income Ladders

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Income Ladder Calculations In this example we will demonstrate the calculations needed to create a simple 4-year income ladder. The first year’s income will start at $30,000 and increase 3% each year thereafter to compensate for inflation.

Year Desired Income 1 $30,000 2 $30,899 3 $31,827 4 $32,782

If part of the desired income were to come from stock dividends, we would first subtract the projected dividend income. But for simplicity we will assume that the ladder must provide all of the desired income. Assume that bank CDs are available with the following interest rates and corresponding years to maturity:

Years to Maturity Annual Interest Rate 1 1.0% 2 2.0% 3 3.0%

The principal from a CD that matures after one year is available for income during the second year. Likewise the principal from a CD that matures after two years is available for income during the third year. Part of the trick in doing these calculations is to keep the years straight and always remember that the principal becomes available for income after the year the investment matures. The other trick is to work backward, starting with the last year. We will first determine how much should be invested in the CD that matures after three years. We start with the last year because there are fewer unknowns. The 1-year and 2-year CDs will have already been consumed, so the maturity value of the 3-year CD plus its interest must provide all of the desired income during the fourth year. Stated in mathematical terms, this becomes:

Maturity Value3yrCD + Interest3yrCD = Desired Incomeyr4 = $32,782

The interest will be 3% of the Maturity Value. So we can re-write the equation as:

Maturity Value3yrCD + (0.03 X Maturity Value3yrCD) = $32,782


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With a little algebra, the equation can again be rewritten as:

Maturity Value3yrCD X (1 + 0.03) = $32,782 Solving for the Maturity Value gives:

Maturity Value3yrCD = $32,782 / 1.03 = $31,827 The total income during the fourth year can be summarized as:

Years to Maturity

Principal

Interest

Total

3 $31,827 + $955 (0.03 x $31,827) = $32,782 The maturity value for the 2-year CD can be calculated in the same wayexcept for one difference. Principal and interest from the 2-year CD will be supplemented by $955 of interest from the 3-year CD. We can use nearly the same equation that we used previously, except that $955 needs to be subtracted. The equation for the 2-year Maturity Value is:

Maturity Value2yrCD = (Desired Incomeyr3 - $955) / (1 + Interest Rate2yrCD) Or:

Maturity Value2yrCD = ($31,827 - $955) / 1.02 = $30,267 We always divide by 1 plus the interest rate that corresponds to the maturity date. In this case it is 1 + 2% or 1.02. The total income during the third year is provided by a combination of the 3-year and 2-year CDs as follows:

Years to Maturity Principal Interest Total

3 $0 + $955 (0.03 x $31,267) = $955 2 $30,267 + $605 (0.02 x $31,827) = $30,872

Total $31,827 The maturity value for the 1-year CD can be calculated in the same way except now we have to subtract the annual interest from both the 2-year and 3-year CDs. The equation for the 1-year Maturity Value is:

Maturity Value1yrCD = ($30,899 - $955 - $605) / 1.01 = $29,049

Chapter 11: Income LaddersChapter 11: Income LaddersChapter 11: Income LaddersChapter 11: Income Ladders

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The total income during the second year is provided by the 3-year, 2-year, and 1-year CDs as follows:

Years to Maturity Principal Interest Total

3 $0 + $955 (0.03 x $31,267) = $955 2 $0 + $655 (0.02 x $31,827) = $605 1 $29,049 + $290 (0.01 x $29,049) = $29,339

Total $30,899 So there we have it. The calculations are not difficult once the pattern is understood. Again the secrets are to:

1. Work backwards. 2. Remember that each CD contributes interest until it matures. 3. Remember that the principal for each CD is not available for income during the year that

it matures, but rather after the year that it matures. 4. Use interest rates rather than yield rates if the investments will be purchased at a

significant discount or premium to their maturity value. The income from this ladder can be summarized as follows:

Beginning of Year

Principal (Maturity Value)

Total Interest Desired Income

1 $30,000 $0 $30,000 2 $29,049 $1,850 $30,899 3 $30,267 $1,560 $31,827 4 $31,827 $955 $32,782

Quality The purpose of an income ladder is to provide certain income. Therefore only high quality fixed-rate investments should be used. Examples include U.S. Treasury obligations and FDIC insured bank certificates of deposit. Some fixed-rate investments will offer higher interest rates to compensate for the credit risk of the borrower. In other words if there is a chance that the borrower will not make good on the promise to pay, then the borrower often offers a higher interest to compete with other higher quality fixed-rate investments. But the income-focused investor should not take the bait. It is the certainty of the income ladder that make the uncertainty of the stocks manageable. There are private organizations such as Standard & Poor’s Corporation and Moody’s Investment Service, Inc. that rate the creditworthiness of many issuers of fixed-rate investments.


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Chapter 12

Stock Trend-Lines Trend-lines can help investors decide whether or not it is a favorable time to buy or sell stocks. The technique is especially helpful when trying to decide whether or not it is time to sell stocks to extend an income ladder, or in other words when navigating. If the investment income plan is viewed as the navigator’s map, then trend-lines are the compass. In this chapter we will describe the use of trend-lines, but also offer some cautions. Trend-lines do not work equally well in all situations.

Examples The Dow Jones Industrial Average is a composite index that tracks the value of thirty industrial stocks. The value of the index is shown plotted over a 20-year span below: This graph uses a linear scale, which means that there is equal distance between index values from 1000 to 2000, 2000 to 3000, 3000 to 4000, and so on. But stock indices and stock values are often plotted on a logarithmic or log scale. The same Dow historic values are shown next plotted on a log scale:

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Notice now that there is decreasing distance between 1000 and 2000, 2000 and 3000, 3000 and 4000, and so on. Instead there is equal distance between 1000 and 10,000 compared to 10,000 and 100,000. When a log scale is used, a straight line can be drawn on the graph that best represents, or best fits, the data. This line is called a trend-line (statisticians often call it a regression line). The next graph shows the same Dow historic index values plotted on a log scale with a trend-line added:

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Chapter 12: Stock TrendChapter 12: Stock TrendChapter 12: Stock TrendChapter 12: Stock Trend----LinesLinesLinesLines

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The line is not a guess. It is mathematically calculated. The calculations are beyond the scope of this book, but suffice to say that the calculation minimizes the sum of all distances from the data values to the trend-line. The charting features in Microsoft Excel offer this option, and in fact this is how the trend-lines were calculated for the examples in this chapter. The trend-line is often a better estimator of value than the market. If stocks are trading above a long-term trend-line, then they are more likely overvalued. In other words it means that they are priced high relative to historic trends. This may represent a favorable time to sell. The previous graph suggests that April of 2000 would have been a highly favorable time to sell Dow industrial stocks and likewise an unfavorable time to buy these stocks. Here are a couple more examples of trend-lines for popular indices:

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All three of these trend-lines suggest that stocks were trading below their long-term trends in April of 2008. However the higher prices during 1999-2000 are pulling the trend-lines upward. If this could have been an anomalous time period, it is possible that stocks are actually trading closer to their true trend as of April 2008 than it appears. This is the first of several cautions for interpreting trend-lines. April of 2000 would have been a fantastic time to sell. Now it doesn’t take a genius to conclude this in hindsight! But was this apparent at the time? This next graph shows what the 20-year NASDAQ trend-line looked like in April of 2000.

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It was readily apparent at the time that NASDAQ stocks were trading well above their long-term trend. The clue was available in real-time to indicate that April of 2000 was a great time to sell. It is not always easy to overcome the psychology of these moments. There is a strong temptation to hold out for even higher prices when stocks are on a roll. But the wise income-focused investor should not be greedy. It is best to take the favorable selling opportunities when they come, especially if the income ladder has been significantly depleted. Stock prices sometimes tumble rapidly, and the higher they get above their long-term trend, the more likely this is to happen. The trend-line technique works well for broad stock indices. It can also be applied to some large-company stocks that have exhibited steady growth over long periods of time. A good example is a company like 3M. This next graph shows a trend-line for 3M stock adjusted for dividends and share splits: Notice how well the stock tracks the tend-line. This is one criterion for determining the validity of a trend-line analysis.

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Here are a couple more examples of companies that have exhibited consistent growth: If a company’s stock is trading at or above trend, as was the case for Exxon in April 2008, one can conclude that it is a reasonable selling opportunity because this is an assessment of the current price relative to past performance. The conclusion is not dependent on future results. Of course Exxon may outperform its historic trend and present an even better selling opportunity in the future. But this would not invalidate a conclusion that April of 2008 presented a reasonable selling opportunity for Exxon.

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Of course there is no guarantee that a company will continue to track a historic trend-line. Past performance is never a guarantee of future results. When a company is trading below trend, there is always more risk in concluding that it is not the right time to sell, or that it is the right time to buy, because these conclusions depend on future results and assume that the stock will catch up with its historic trend. This leads to some cautions. Take a look at this next graph for a fictitious company that we will call Growth Co. The 20-year trend-line suggests that it was trading well below trend in April of 2008. But this may not be the case. A more careful review suggests that the stock may have been following one trend for a period of time, and then something changed. This is a common phenomenon. Often companies start in a growth phase and trade at a high multiple of earnings for a period of time. Eventually the company matures and is no longer able to sustain the growth rate. When this happens, the trend may change as the company’s valuation catches up with its new status as a blue-chip stock instead of a growth stock. It is also possible for a company’s future prospects to fundamentally change due to: competition, changing technology, consumer preferences, changing laws and regulations, company management, etc.

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Guidelines Following are some general guidelines for using trend-line analysis: 1. Trend-lines generally work well for broad stock indices such as the NASDAQ, Dow, and

S&P 500, but beware of world events or other unique situations that might cause stocks to misbehave relative to their normal trends for a period of time.

2. Trend-lines often work well for large companies with steady growth. But it is generally not a

good idea to rely on this technique for stocks that are trading at price-to-earning valuations significantly higher than the average S&P 500 stock.

3. The technique does not work well for small-company stocks, growth stocks, or stocks that

have yet to establish a clear long-term trend. 4. Just because a stock is trading below trend does not mean that it will not trade lower in the

future, and likewise just because a stock is trading above trend does not mean that it will not trade higher in the future. Always remember that past performance is not a guarantee of future results. The technique is most effective for identifying reasonable, but not necessarily optimal, selling opportunities

5. When stocks are trading below their long-term trend, a decision to hold out for a better

selling opportunity should always be balanced with the amount of time that stocks can be held before they must be sold. For example someone with 10 years of certain income remaining from an income ladder can be choosier than someone whose income ladder is nearly depleted.

6. 20-year trend-lines are a good rule-of-thumb. But it is sometimes insightful to look at even

longer time periods. One always has to balance the benefit of more data with the relevance of older data.


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Compound-Trend Analysis So far we have focused on the technique for the purpose of determining when to sell stocks to extend an income ladder, but the technique can also be insightful when creating an initial investment income plan. Let’s say that a person is on the brink of retirement, owns a significant quantity of stocks, and a trend-line analysis suggests that stocks are overpriced. In this situation it would be wise to assume modest stock rates of return and longer holding periods, because the higher priced stocks may be due for a correction. Conversely if stocks are trading well below their long-term trend, it may justify more aggressive rate-of-return assumptions and shorter holding periods. Interest rates are another important consideration. When market interest rates are high, it costs less to purchase or extend an income ladder. If one is on the brink of retirement with a portfolio significantly invested in stocks, it is helpful to evaluate the starting point based upon the following Compound-Trend Analysis: The chart is divided into four sections by two diagonal lines. The diagonal lines represent trend-linesone for stocks and one for interest rates. The top section represents the best-case starting point for an investor with significant stock investments. Both stocks and interest rates are above trend. This means that stocks are highly valued and therefore can be sold at favorable prices to purchase an income ladder of fixed-rate investments offering higher interest rates. Here the investor wins twice. Stocks can be sold at favorable prices, and the income ladder can be purchased relatively cheap. But this situation will not likely last long. Either stock prices or

Stock

s

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s

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Interest Rates

Portfolio may be overvalued and interest rates are favorable. Use conservative estimates for stock rates of return and longer holding periods while locking in

favorable interest rates.

Portfolio may be overvalued,

and interest rates are not favorable. Use conservative

estimates for stock rates of return and

medium holding periods.

Portfolio may be undervalued,and interest rates

are favorable. Use more aggressive

estimates for stock rates of return and medium holding

periods.

Portfolio may be undervalued and interest rates are not favorable. Use more aggressive estimates for stock rates

of return and shorter holding periods.


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interest rates, and possibly both, will fall. So it is wise to choose conservative estimates for future stock rates of return and longer holding periods while locking in the favorable interest rates. Most people will not get to start with this ideal situation. The bottom section represents the worst-case starting point for an investor with significant stock investments. Stocks are priced low and therefore must be sacrificed at bargain prices to purchase an income ladder with less than desirable interest rates. Here the investor loses twice. But this situation may justify more aggressive estimates for future stock rates of return along with shorter holding periods. Shorter holding periods may be justified for two reasons: If stocks are undervalued, they are more likely to increase in value in a shorter timeframe. Also there is little incentive to lock in low interest rates for a long period of time. The left section represents a medium situation where stock prices are high, but interest rates are low. This situation calls for conservative estimates for future stock rates of return and medium holding periods. The right section represents the inverse medium situation where stock prices are low, but interest rates are high. This situation may justify more aggressive estimates for future stock rates of return along with medium holding periods. It is this combination of stock prices and interest rates relative to historic trends that often determines one’s true readiness to comfortably retire.

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Chapter 13

Reference

System Requirements In order to run the Income Strategy Generator, you will need: • A personal computer running Windows 98 or later. • A printer (optional).

Installing the Income Strategy Generator 1. Insert the program disk into your CD drive. 2. If setup does not start automatically when you insert the CD into the drive, click Start on the

Windows taskbar. Then click Run and type D:\setup.exe (substituting your drive letter for D) and click OK.

3. Follow the on-screen instructions to finish the installation.


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Main Screen Layout

Section 1 – Scenario Parameters The first section of the main screen includes the following five Scenario Parameters:

Beginning Capital – The total amount of capital initially available to invest. Annual Income Need – The initial desired annual income. The Income Strategy Generator assumes that the annual income will increase each year by the entered inflation rate unless the Custom Income Schedule is used. Payment Period – The Payment Period is used to select both the number of income payments per year and also the frequency of contributions to the portfolio when using Other Sources of Income and Annuities. The Income Strategy Generator assumes that income payments are withdrawn at the beginning of the Payment Period. Type the first letter of the desired Payment Period, use the arrow keys, or click with the mouse to make your selection. The program defaults to Quarterly payments.

1→

3→→→→

←2

←4

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Years in Scenario – The total number of years that will be considered in the analysis. Anticipated Inflation – The assumed average annual inflation rate. Section 2 – Investment Parameters The second section of the main screen displays rows that correspond to the four types of Income Strategy Generator investment categories: • Fixed Rate • High Yield Stocks • Blue Chip Stocks • Growth Stocks

Total Return – The projected average annual total return assuming annual compounding and including dividends if applicable. Dividend Rate – The initial annual dividend yield paid as a percentage of the corresponding value of the stock category. Future projected dividends depend on the Inflate Dividends setting on the View menu (see Chapter 7). To assume that dividends will be reinvested, enter 0% for the Dividend Rate. It is assumed that dividends are paid on a quarterly basis. Holding Period – The maximum number of years that stocks can be held if necessary. See Chapter 1 for a more detailed explanation. Percent Allocated – The percentage of Beginning Capital that is initially allocated to the corresponding type of investment. Multiple Allocations – This feature allows you to reallocated capital mid-way through a scenario. See Chapters 4 and 5 for examples.


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Renaming and Detailing the Investment Categories While the authors prefer the Fixed Rate, High Yield Stocks, Blue Chip Stocks, and Growth Stocks categories for investment income planning purposes, these categories can be renamed for those who prefer a different categorization. The picture below shows an example of an alternate categorization. Notice that when you hover the mouse over a given category, it switches from black to white text as shown for the Fixed Rate category:

Click the button when it is highlighted with white text to open a window such as the one shown next for the Fixed Rate category:

The name of the category can be changed on this window. This window also allows you to estimate an average yield to maturity (total return) for a series of fixed-rate investments. If you do this and click “Use Calculated Value”, it will be transferred to the main screen and used in scenario calculations. Some examples of alternate names for the Fixed Rate category include: • Income Ladder • Bank CDs • Fixed Income • Bonds


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The category will always assume some type of quality fixed-rate investments that are structured in such a way as to be available for income when needed. See Chapter 1 for an explanation of how this is accomplished using income ladders. It is not appropriate to use this category as an alternate stock category. You can also specify a Minimum Allowed threshold on the Fixed Rate window. For example if 30% is entered in the Minimum Allowed field, this will force the Fixed Rate category to always retain at least 30% of its original value on an inflation-adjusted basis. This is a convenient feature for those who want to build an extra margin of safety into their plans. When manually adjusting investment allocation percentages, a message is sometimes displayed on the main screen that reads, “Fixed Rate dropped below entered minimum in year__”. This message indicates that income cannot be maintained without reducing fixed-rate capital below the Minimum Allowed percentage on the Fixed Rate window or without violating the default transfer rules (see Chapter 5). The message does not necessarily mean that total capital has been depleted. You can also click on the stock categories to open a window like this:

Here again the name of the category can be changed. Note that these windows will always retain their original category name, but the new name, Small Cap Stocks in this example, will appear elsewhere in the program and on summary reports.


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The stock categories can be renamed to include any type of variable investment. Some examples include: • Value Stocks • Balanced Fund • International Stocks • Bond Funds. See Chapter 1 for a distinction between individual bonds held to maturity vs. bond funds. The previous window also allows you to list the specific investments in a given category. Accessing the Optimization Features Finally the Optimize Investment Allocation button is located just above the Investment Parameters section of the main screen.

Clicking this button opens the following window that offers a variety of powerful optimization features:


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Section 3 – Schedules The third section of the main screen includes the following schedules:

Clicking on the schedule name checks and unchecks the box to the left of the schedule. When the box is checked, an Edit button appears to the right of the schedule. You can open the window and edit the corresponding schedule by clicking on this Edit button. When the box to the left is unchecked, the schedule is deactivated and will not be included in scenario calculations. Custom Income Needs – This schedule allows you to customize annual income requirements. Other Sources of Income – This schedule allows you to take into account other sources of income. It can also be used to enter contributions to a portfolio for wealth accumulation calculations. Include Annuities – This schedule allows you to specifically account for annuity income and plans to purchase annuities in the future. Accelerate Transfers – This schedule allows you to override the default stock transfer rules. For example if you would like to assume that 100% of blue chip-stocks will be sold to purchase fixed-rate investments at the end of a given year, you can specify this transfer on this schedule. Section 4 – Initial Allocation and Scenario Results The fourth section of the main screen provides a summary of the Initial Allocation and Scenario results.

The pie chart shows the initial allocation of capital. The amounts are detailed in the Starting Balance column. The final amounts and total ending capital are shown in the right-most column.


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A message at the bottom of the section indicates when the final results have been adjusted for inflation.

Notice the in the lower right corner. This is a very important button. Clicking this button opens the Current Scenario window. This window provides detailed information about the current scenario.

Menus The upper left corner of the main screen includes the File, Edit, Calculate, View, and Help pull-down menus. Below the menu is a tool bar for the frequently used Open, Save, Print, and Help functions.

The File Menu

Create a New File – On the File menu, click New. The program clears all previous entries and resets all default values. Open an Existing File – On the File menu, click Open. The Open Inputs dialog box appears. In the File name box, enter the name of the file to open. Be sure you have selected the proper drive and folder for your desired file.


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Reopen a File – On the File menu, click Reopen File. The program lists recent files. Select the file that you want to work with from the list. Save a File – On the File menu, click Save. The Save Inputs File dialog box appears. In the File name box, type a name for the file. The program automatically adds an .ISG extension to the file name. Select the drive and folder in which to save the file. Save an Existing File under a New Name – Open an existing file or create a new file. On the File menu, click Save As. The Save Inputs File dialog box appears. In the File name box, enter a name for the new file. The program automatically adds an .ISG extension to the file name. Select the drive and folder in which you want to save the file. E-mail Data File – If your data is saved to a file, this option will allow you to e-mail the current data file. Create Desktop Icon – This option will create a program icon on your desktop. Location of Data Files – This option allows you to change the default location for files to be saved. Data File Encryption – This option encrypts data files for secure e-mailing. Report Options – This option allows you to define heading, margin, and other optional report features. Printer Setup – These options allows you to adjust various print options. Print – On the File menu, click Print. The print dialog box appears. You can print to a printer for a paper copy, or to an html or WK1 file to work on the report in another application, such as for a website or Excel. The WK1 file format was created by Lotus some years ago and can be imported into all major spreadsheet programs. Exiting the Program – On the File menu, click Exit. The program closes. Note: Be sure to save the open file before clicking the Exit command.


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The Edit Menu

Fixed Rate Investment Category – This option will open a window that allows you to rename the Fixed Rate investment category, calculate an average yield to maturity for a series of fixed-rate investments, and specify a minimum allowable percentage of Fixed Rate investment capital compared to the original inflation-adjusted value. When a series of yields are entered on this window, the Fixed Rate report will include an income ladder. High Yield Investment Category – This option will open a window that allows you to rename the High Yield Stocks investment category and list investments in this category. The “% of Category” column must total 100%. Clicking “Use Calculated Values” will transfer the calculated “Annual Rate of Return” and “Annual Dividend Rate” to the main screen. Blue Chip Investment Category – This option will open a window that allows you to rename the Blue Chip Stocks investment category and list investments in this category. The “% of Category” column must total 100%. Clicking “Use Calculated Values” will transfer the calculated “Annual Rate of Return” and “Annual Dividend Rate” to the main screen. Growth Stock Investment Category – This option will open a window that allows you to rename the Growth Stocks investment category and list investments in this category. The “% of Category” column must total 100%. Clicking “Use Calculated Values” will transfer the calculated “Annual Rate of Return” and “Annual Dividend Rate” to the main screen. Custom Income Schedule – Use this schedule to customize income requirements, when for example, one portion of income has to increase with inflation and another does not. You can also account for income that is needed during some years and not others. A second scheduled can be accessed by clicking “Add Yearly Income Needs”. This second schedule allows you to enter income needs on a year-by-year basis in either actual or inflation-adjusted dollars. Income will be withdrawn at a frequency that corresponds with the Payment Period selection on the main screen. Values on both schedules are only included in scenario calculations when the “Custom Income Needs” checkbox is checked on the main screen. See Chapter 4 for an example using this schedule. Other Sources of Income – Use this schedule to enter other sources of income or contributions to the portfolio. A second schedule can be accessed by clicking “Add Yearly Amounts”. This


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second schedule allows you to enter income or contribution amounts on a year-by-year basis in either actual or inflation-adjusted dollars. Amounts will be added at a frequency that corresponds with the Payment Period selection on the main screen. Values on both schedules are only included in scenario calculations when the “Other Sources of Income” checkbox is checked on the main screen. See Chapter 4 for an example using this schedule. Annuities – Use this schedule to enter either existing annuities or annuities that will be purchased in the future. For annuities that are already owned, leave the Cost and Year Purchased inputs set to their default values of $0 and 1 respectively. It is assumed that annuity payments will be made with a frequency that corresponds with the Payment Period selection on the main screen. For annuities purchase in the future, the Cost is subtracted from the Fixed Rate category at the beginning of the Year Purchased, and the first payment occurs in the next period. Values on this schedule are only included in scenario calculations when the “Include Annuities” checkbox is checked on the main screen. See Chapter 4 for an example using this schedule. Accelerate Transfers – Use this schedule to transfer either a dollar amount or percentage of capital from any of the three stocks categories to the fixed-rate category. Transfers are made at the end of the Transfer Year. Transfer Amounts less than or equal to 100 are treated as percentages. Transfer Amounts greater than 100 are treated as dollar amounts. Transfers defined on this schedule are only included in scenario calculations when the “Accelerate Transfers” checkbox is checked on the main screen. See Chapter 6 for an example using this schedule. Inflate Dividends – When this option is checked, future projected annual dividend income will increase each year at the entered inflation rate. When this option is not checked, future projected annual dividend income will be a fixed percentage of the capital in the stock investment category. The Calculate Menu

Recalculate Investment Scenario – The Income Strategy Generator automatically recalculates the current scenario whenever a change is made to one of the inputs and the Enter or Tab key is pressed. While making changes a button appears at the bottom of the screen to indicate that the calculation is not current. To update calculations, you can select “Recalculate Investment Scenario” from this pull-down menu, press F9, click the button that appears at the bottom of the screen, press the Enter key, or press the Tab key. Allocate Investments – Selecting this feature from the pull-down menu is the same as selecting the “Optimize Investment Allocation” button on the main screen. This feature allows you to


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optimize the allocation of capital for maximum ending capital, maximum income, or minimum beginning capital. For the maximum income and minimum capital calculations, you have the option to preserve or consume capital. However the Consume Capital selection will not override the transfer rules described in Chapter 5. As a result, capital will not be fully consumed in most cases. See Chapters 5 and 6 for a couple techniques to override the default transfer rules. The “Allocate to Nearest” field allows you to adjust the precision of the optimization calculations. Higher percentages will be less precise, but will also take less time to calculate. Lower percentages will be more precise, but will take longer to calculate. Calculate Annual Income – Use this feature to calculate the maximum annual income. This calculation will not adjust the investment allocation. The Consume Capital option associated with this calculation is limited by the default transfer rules described in Chapter 5. Therefore capital will typically not be fully consumed. See Chapters 5 and 6 for a couple techniques to override the default transfer rules. The Preserve Capital option associated with this calculation depends upon whether Actual Dollars or Adjusted Value Dollars is selected. If Actual Dollars is selected, then the actual dollar value of the portfolio will be preserved. If Adjusted Value Dollars is selected, then the inflation-adjusted value of the portfolio will be preserved. Calculate Beginning Capital – Use this feature to calculate the minimum beginning capital needed. This calculation will not adjust the investment allocation. The Consume Capital option associated with this calculation is limited by the default transfer rules described in Chapter 5. Therefore capital will typically not be fully consumed. See Chapters 5 and 6 for a couple techniques to override the default transfer rules. The Preserve Capital option associated with this calculation depends upon whether Actual Dollars or Adjusted Value Dollars is selected. If Actual Dollars is selected, then the actual-dollar value of the portfolio will be preserved. If Adjusted Value Dollars is selected, then the inflation-adjusted value of the portfolio will be preserved. Calculate Years in Scenario – Use this feature to calculate the maximum number of years that income can be supported. This calculation will not adjust the investment allocation. The Consume Capital option associated with this calculation is limited by the default transfer rules described in Chapter 5. Therefore capital will typically not be fully consumed. See Chapters 5 and 6 for a couple techniques to override the default transfer rules. The Preserve Capital option associated with this calculation depends upon whether Actual Dollars or Adjusted Value Dollars is selected. If Actual Dollars is selected, then the actual-dollar value of the portfolio will be preserved. If Adjusted Value Dollars is selected, then the inflation-adjusted value of the portfolio will be preserved.


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The View Menu

Current Scenario – Select this option to view the scenario details and graphs. This has the same effect as clicking the Plus button in the lower right corner of the screen. Actual Dollars – Select this option to view all future dollar amounts as actual dollars. Adjusted Value Dollars – Select this option to view all future dollar amounts as inflation-adjusted dollars. Show Quick Start Menu – Select this option to view the Quick Start menu. The Help Menu

Help for this Screen – Select this option (or press F1) for help with the current screen. FAQ – Select this option to view frequently asked questions. Tutorial – Select this option to view the tutorials. Contents – Select this option to open the help document to the contents page. Brentmark on the Web – Select this option to visit Brentmark’s web page or to e-mail technical support. Brentmark Product Line – Select this option to see a listing of Brentmark’s available software.


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License Agreement – Select this option to open the license agreement. Technical Support – Select this option for Brentmark’s technical support contact information. About – Select this option for program version information.

Function keys F1 Accesses the program’s online help system F2 Saves current information in a data file F3 Opens data files that have been previously saved F4 Activates the Optimize Investment Allocation feature F5 Activates the Calculate Annual Income feature F6 Accesses the program’s printing options F8 Toggles between viewing future results as actual dollars and inflation-adjusted dollars F9 Recalculates the Current Scenario

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Chapter 14

Summary The United States is on the brink of a great national experimentto see if millions of baby boomers can successfully maintain investment income from capital that has been accumulated in 401(k) and similar plans. We are moving away from professionally managed pension plans, and assigning new responsibilities to the population at large. The challenge is greater than most people realize. It is not easy to maintain steady, dependable, and long-term income while investing in financial markets that are anything but steady and dependable. Standard investment strategies were not designed for the new objective. Modern Portfolio Theory is a wonderful solution to a different problem. The natural and automatic approach of systematically withdrawing funds from a diversified portfolio is rife with pitfalls. Outcomes are difficult to predict due to the strong effect that market variability has when selling investments for income. A Systematic Withdrawals approach is also destined to give back all of the benefits of dollar-cost averaging. But perhaps the biggest problem with Systematic Withdrawals is not mathematical, but rather psychological. It takes great discipline to hold investments when they are down and resist the temptation to buy the latest star performers. Individuals who embark upon a Systematic Withdrawals course will be especially prone to this risk. They will tend to fixate on keeping the value of the portfolio up, even though it should be expected to cyclically rise and fall. Without the psychological buffer that comes from multi-year income certainty, they will panic and make costly mistakes. The Defined Withdrawals strategy is not complicated. The portfolio is simply divided into two portions. The objective of the first portion is to provide certain income for a known number of years. The objective of the second portion is to provide the growth that will be required to support income during later years. It is the income certainty of the first portion that allows an investor to manage the second portion with a cool head. But while the Defined Withdrawals strategy itself is not complicated, real-life income plans and personal financial situations can be. People frequently have variable income requirements and other non-investment sources of income. Inflation needs to be factored in at all stages of the planning process. And determining the proper balance of income-generating and growth investments for a given person’s financial situation is not trivial. It requires a powerful tool.


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With this latest version of the Income Strategy Generator we have strived to provide a tremendous amount of flexibility without adding a lot of screen-on-top-of-screen complexity. The examples in this book only touch the surface of what can be done with the software. We hope you will further explore the possibilities. Have a great journey!

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Update Policy Major updates (to add new features) for the Income Strategy Generator™ may be issued from time to time. Registered users will be notified when such updates are available.

Technical Assistance The most effective way to receive technical support is to contact Brentmark by e-mail. An e-mailed technical support request will usually result in a more detailed answer to your question by the most appropriate person. Limited telephone support is available in special circumstances. If you choose telephone support, your request will be handled by Brentmark staff in a reasonable amount of time given the volume of requests and the availability of staff. Except in cases of unusual urgency, contacting Brentmark by e-mail will lead to the best support. Send messages to [email protected]. Please include the words Technical Support in the subject line and the name and version of the Brentmark product (both are generally displayed in the upper left hand corner of the program’s main screen and also in the About box which is accessed from the Help Menu). Be sure to include your name and postal address with phone number as well as your e-mail address. If your technical issue involves calculation issues, it is advisable to include a copy of a data file with your e-mail. (Many Brentmark programs include an E-mail data file option on the File Menu.) You should expect to receive an e-mail acknowledging receipt of your e-mail within one business day followed by a later response to your questions. You should expect a response by e-mail or telephone, whichever makes the most sense given the nature of your question or technical issues. Telephone support Call (407) 306-6160 (this is an Orlando, Florida number) and select the appropriate support option. If your call goes to voice mail, please leave a message and be sure to let us know how to contact you. Telephone support is normally available Monday through Friday from 10:00 AM to 5:00 PM Eastern Time (voice mail messages may be left at other times). Please have the name of the Brentmark product and version number available when calling. Fax support Send your fax to (407) 306-6107. This is an Orlando, Florida phone number. Be sure to let us know how to contact you. We recommend that you include both an e-mail address and a telephone number. Postal mail support Send postal mail to: Brentmark Software 3505 Lake Lynda Dr Ste 119 Orlando, FL 32817-8333

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Index

A

Accelerate Transfers, 131, 135 Actual Dollars, 137 Adjusted Value Dollars, 137 Allocate Investments, 135 Annual Income, 126 Annuities, 135

B

Beginning Capital, 126 Blue Chip, 12

C

Calculate Annual Income, 136 Calculate Beginning Capital, 136 Calculate Years in Scenario, 136 Current Scenario, 137 Custom Income Schedule, 134

D

Dividends, 127

F

Federal Withdrawal Rules, 98 Files

Create New, 132 E-Mailing, 133 Encryption, 133 Location, 133 Open Existing, 132, 133 Save, 133 Save As, 133

G

Growth, 12

H

High Yield, 12 Holding Period, 127

I

Include Annuities, 131 Inflate Dividends, 135 Inflation, 127 Interest-Bearing Obligations, 1, 109 Investment Category

Blue Chip, 134 Fixed Rate, 134 Growth Stock, 134 High Yield, 134

M

Main Screen Section One

Annual Income, 126 Beginning Capital, 126 Inflation, 127 Payment Period, 126 Scenario Years, 127

Section Three Dividends, 127 Holding Period, 127 Multiple Allocations, 127 Percentage, 127 Total Return, 127

Section Two Accelerate Transfers, 131 Include Annuities, 131 Other Sources of Income, 131 Use Custom Income Schedule, 131

Multiple Allocations, 127

O

Other Sources of Income, 131, 134

P

Payment Period, 126 Percentage, 127 Printer Setup, 133 Printing, 133

Q

QuickStart Menu, 137


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R

Recalculating, 135 Report Options, 133

S

Scenario Years, 127 Stocks, 115 System Requirements, 125

T

Total Return, 127

U

Use Custom Income Schedule, 131

Y

Yield, 109

License Agreement Brentmark Software, Inc. (“Brentmark”) is willing to license the Software only upon the condition that you accept all of the terms contained in this Software License Agreement. Please read the terms carefully. By opening the product package and/or installing the Software, you will indicate your agreement with them. If you are entering into this agreement on behalf of a company or other legal entity, your acceptance represents that you have the authority to bind such entity to these terms, in which case “you” or “your” shall refer to your entity. If you do not agree with these terms, or if you do not have the authority to bind your entity, then you should return the software for a full refund. The Software is protected by intellectual property laws including United States copyright law and treaties. The Software is licensed, not sold.

Grant of License

General License Grant to Install and Use Software. You may install and use one copy of the Software on a single computer, device, workstation, terminal, or other digital electronic or analog device ("Device"). You may make a second copy of the Software and install it on a portable Device for the exclusive use of the person who is the primary user of the first copy of the Software. A license for the Software may not be shared. Alternative License Grant for Storage/Network Use. As an alternative to the rights granted in the previous section, you may install a copy of the Software on one storage Device, such as a network server, and allow individuals within your business or enterprise to access and use the Software from other Devices over a private network, provided that you acquire and dedicate a license for each separate Device from which the Software is accessed and used. A license for the Software may not be used concurrently on different Devices. Limitations on Reverse Engineering, Decompilation, and Disassembly. You may not reverse engineer, decompile, or disassemble the Software, except and only to the extent that such activity is expressly permitted by applicable law notwithstanding this limitation.

Limited Warranty

Brentmark Software, Inc. warrants the physical diskette(s) enclosed herein to be free of defects in materials and workmanship for a period of sixty days from the purchase date. If Brentmark receives notification within the warranty period of defects in materials or workmanship, and such notification is determined by Brentmark to be correct, Brentmark will replace the defective diskette(s). The software and book are based on the application of a particular methodology of managing investments for retirement planning. Other methodologies and theoretical models for investing exist in the investment world, and some of these may be more suitable for some people under


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certain circumstances. The methodology of the software and book must therefore be seen as tools for analyzing individual situations based on this methodology, and not as a guarantee of any particular investment strategy or result. The user of the software and book assumes responsibility for determining whether the software and book will achieve the result desired by the user. The user assumes full responsibility for selecting all investments under the user's plan. The entire and exclusive liability and remedy for breach of this Limited Warranty shall be limited to replacement of defective diskette(s) and shall not include or extend to any claim for or right to recover any other damages, including but not limited to, loss of profit, data or use of the Software, or special, incidental or consequential damages or other similar claims, even if Brentmark has been specifically advised of the possibility of such damages. In no event will Brentmark’s liability for any damages to you or any other person ever exceed the lower of suggested list price or actual price paid for the license to use the Software, regardless of any form of the claim. BRENTMARK SOFTWARE, INC. SPECIFICALLY DISCLAIMS ALL OTHER WARRANTIES, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO, ANY IMPLIED WARRANTY OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. Specifically, Brentmark makes no representation or warranty that the Software is fit for any particular purpose and any implied warranty of merchantability is limited to the 60-day duration of the Limited Warranty covering the physical diskette(s) only (and not the Software) and is otherwise expressly and specifically disclaimed. The limited warranty gives you specific legal rights; you may have others that may vary from state to state. Some states do not allow the exclusion of incidental or consequential damages, or the limitation on how long an implied warranty lasts, so some of the above may not apply to you.

Governing Law and General Provisions

The License Statement and Limited Warranty shall be construed, interpreted and governed by the laws of the State of Florida and any action hereunder shall be brought only in Florida. If any provision is found void, invalid or unenforceable it will not affect the validity of the balance of this License and Limited Warranty that shall remain valid and enforceable according to its terms. If any remedy hereunder is determined to have failed of its essential purpose, all limitations of liability and exclusion of damages set forth herein shall remain in full force and effect. This License and Limited Warranty may only be modified in writing signed by you and a specifically authorized representative of Brentmark. All rights not specifically granted in this statement are reserved by Brentmark.

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