What if you have discovered that your risk tolerance is virtually non existant?  Here is a strategy that reduces risks to their bare minimum.  The next article will address those who are willing to take more risk.

Investment Choice

I am assuming that zero risk tolerance means only CD’s under FDIC limits, immediate/fixed annuities under state guarantee limits (typically $100K) and treasury bills, bonds and notes and savings bonds.  If you also want inflation protection then you are limited to inflation protected CDs under FDIC limits, inflation adjusted immediate annuities under $100K, Treasury Inflation Protected securities (TIPs) and I-Bonds.

Unfortunatley, inflation protected CD are virtually non existant and rarely offer yields significantly better than TIPs.  I-bonds limit purchases to 2x$5K/person/year and typically have much lower yields than TIPs.  And lastly there are only a few insurance companies that have inflation adjusted immediate annuities, so if you need to invest more than a few hundred thousand it means taking on insurance company risk.  If you have more than a few hundred thousand dollars that leaves us with TIPs as the best vehicle for providing safe inflation protected returns.

Emergency Fund

Before getting into how to strucutre your investment, make sure to put aside an emergency fund.  You are going to be creating a paycheck for yourself, and just like when you are working, it is important to have an emergency fund for the unexpected need.

How long does your money need to last? 

The typical retired couple has around a 10% chance that one of them will live to age 100.  So unless you have health issues or family history that suggests you are different than the norm, I would recommend planning on having your money last until age 100 (97 if unmarried).  This means a 65 year old couple should plan on having their money last 35 years.

Structuring your Invetments

If you can stay under the insurance guarantee amounts, using an inflation adjusted immediate annuity is by far the simplest way to go.  It has the further benefit of aggregating mortality risk so the insurance company can provide a higher standard of living than you could on your own without taking additoinal risk.

For larger sums of money where you are not willing to take on insurance company risk and here is how to create a TIPs ladder for your paycheck.  First, go to any site that provides an amotization schedule (e.g., http://www.bretwhissel.net/amortization/amortize.html) and put in the amount of money you have for creating your paycheck, the number of years and the real interest rate that TIPs are paying (currently around 3%).  The result is a year by year listing of how much interest will be paid each year and how much principal will suplimenting that payment.

Pmt Principal Interest Cum Prin Cum Int Prin Bal
1 16539.29 30000.00 16539.29 30000.00 983460.71

2 17035.47 29503.82 33574.76 59503.82 966425.24

3 17546.53 28992.76 51121.29 88496.58 948878.71

4 18072.93 28466.36 69194.22 116962.94 930805.78

5 18615.12 27924.17 87809.34 144887.11 912190.66

6 19173.57 27365.72 106982.91 172252.83 893017.09

7 19748.78 26790.51 126731.69 199043.34 873268.31

8 20341.24 26198.05 147072.93 225241.39 852927.07

9 20951.48 25587.81 168024.41 250829.20 831975.59

10 21580.02 24959.27 189604.43 275788.47 810395.57

11 22227.42 24311.87 211831.85 300100.34 788168.15

12 22894.25 23645.04 234726.10 323745.38 765273.90

13 23581.07 22958.22 258307.17 346703.60 741692.83

14 24288.51 22250.78 282595.68 368954.38 717404.32

15 25017.16 21522.13 307612.84 390476.51 692387.16

16 25767.68 20771.61 333380.52 411248.12 666619.48

17 26540.71 19998.58 359921.23 431246.70 640078.77

18 27336.93 19202.36 387258.16 450449.06 612741.84

19 28157.03 18382.26 415415.19 468831.32 584584.81

For example, with an initial $1 million and 3% real return, the annual paycheck would be $46,539.  In the first year $30,000 of that would be interest and $16,539 would be principal.  So you would buy $16,539 worth of TIPs that mature in one year (this will end up being rounded because bonds are denominated in $1000 bundles).  Looking at the table you see that year two has $29,503 in interest, so you would buy $17,035 woth of TIPs that mature in two years.  You would continue buying TIPs for each year’s maturity until you had gone out 20 years (the longest term TIPs) and would put the remaining balance $584,584 in the 20 year TIPs.

For the next 20 years, this portfolio requires no maintenance.  Maturing treasuries and interest payments will supply you with an inflation adjusted living stipend.  After 20 years you will need to recreate the ladder.  If interest rates have gone down, your living standard will go down a little, but just like a mortgage which is mostly interest at the beginning and principal at the end, a lower interest rate 20 years down the line will have a much smaller affect than it would have if it changed today.  You also have the option to annuitize a portion of the remaining funds if you want to boost your living standard further.  Since there are fewer years of life left at this point, the insurance company risk also becomes significantly smaller.