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A High Certainty Income Plan With Glaring Holes

A long discussion yesterday in my Singapore Financial Independence Telegram group caught my interest. A member (let’s call him A) was wondering whether we could have a better passive income plan than the one he worked out.

By better, it means the plan gives a more certain income out come for his family.

I can smell that this plan can end up pretty disastrous but I thought it will be a nice exercise for us to think through together.

The Very High Certainty Income Plan

A gives the following scenario: Suppose you won $1 million in TOTO (our lottery) and want to create a passive income stream.

The requirement for the income stream needs to be:

  1. Very easy to implement, so A’s spouse, who is not into finance, can implement it.
  2. Have very high-income certainty.

So A’s very high certainty income plan looks like this:

  1. Take $400,000 out of the $1 million to put in Singapore Savings Bond that averages 3% yearly. This will lock in a ten-year tenor.
  2. Take $400,000 out of the $1 million to invest in 10-year government-like securities. Let’s say the yield that you can lock in is 3% yearly.
  3. The last $200,000 is invested in a three-year fixed deposit in rates we cannot control.
  4. They need the income generated from the Singapore Savings Bond and the 10-year government-like securities. They would only spend income and not capital. The buffer comes from the interest from fixed deposits.
  5. The SSB and 10-year govt securities would guarantee income for ten years.
  6. They expect to only need the income from 65 to 85, so that is a 20-year duration.

Some members of my group suggested that they should top up to CPF Enhanced Retirement Sum (ERS) to enjoy a predictable income and hedge their longevity risk.

But alas, they expect that by the time they turn 55 and 65, the CPF goalpost will shift. So the CPF is out of the question.

I can see many conservative retirees coming up with plans like this.

But plans like these have serious flaws.

Let me try to go through some of them.

A Suggested Plan Need to Work Over Different Time Periods

I find many assume that many assume financial conditions we experience are more stable than reality.

And so, the figures we use today will stick or be low volatile such that it is safe to use them in our current planning.

You might think otherwise if you see some of the case studies I bring up. If conditions are not so stable, you have to factor them into your plan correctly.

If a plan is suggested today, it should primarily work in other periods if the investment securities and the infrastructure are available.

If not, then isn’t such a plan risky?

This is a pervasive critique of other passive income plans suggested to me. They only work in current conditions.

First Case Study: 1981 to 2010

If this high-certainty plan works from today till twenty years later, then if we experience financial conditions like other periods, the plan should work.

A did not say the family income demands, so we have to know what is presented. Basically, income demands are a big part of the plan.

I assumed that their income demands are based on their income from the Singapore Savings Bonds and 10-year government bonds. Their buffer is the interest from the fixed deposit.

So, they can retire if their income needs can be satisfied by the two main income sources.

Now, we can simulate this if we have some returns and inflation data to work with. Let us suppose we implement this in the United States.

At first glance, the Singapore Savings Bonds may be challenging to simulate but it may be easier than we think. He plans to spend the average of the SSB yield. Now, I wonder how he plans to implement this.

Here is the latest SSB yield schedule:

Currently, the curve is relatively flat. The actual interest you will receive is the top row (Interest %), which changes over time. If you plan to spend this in reality, most likely, you would plan that the 2.95% covers your income requirements.

The monthly SSB you applied is not too different from the ten-year government bond, which is part of his plan.

  1. Both do not hedge against inflation during this ten-year tenor.
  2. Both eventually suffer from reinvestment risk.

Now, if we assume that the yield-curve to be relatively flat, we can use the annual returns of the 6-month US Treasury Bill as the yield that A will get if he invests in the SSB-equivalent, 10-year government bond and fixed deposit. If the yield curve is not flat, then he would get a variation of this, but even if that is the case, I am quite sure it won’t change the results below.

In the first case study, we assume A and his spouse lived through thirty years, similar to 1981 to 2010.

Now, I am aware that they expect their longevity to be only 20 years and we can look at how their plans will fare if it is twenty years.

1981 to 2010 was a secular equity bull market followed by a challenging equity sequence, but this applies less to their plan because all the securities are bond or cash-like.

The average inflation during this period is 3.16% per year. (I deliberately choose a period of average inflation instead of the brutal inflation period.)

The starting interest rate in 1981 was 17% and based on my data, the inflation has started to come down. Inflation started off at 8.9% but by the end in 2010, inflation got down to 1.5%. The return on US Treasury bill started at 17.6% but eventually ended at 0.4%.

Based on A’s plan, $400k will invest in SSB-like stuff that will give him close to $70k a year in income for 10-years, $400k will invest in 10-year govt bonds locked in with $70k a year coupon for 10 years, and the other $200k will earn an interest of $35k in the first year. In all, the $1 million portfolio will earn a certain income of $170k! The securities were very, very high quality issues which don’t run a risk of default.

This simulation is even better than A’s plan today.

Now let us take a look at the outcome:

How A’s plan will go if they live through a period like 1981 to 2010.

While the portfolio generated a total income of $176,070 (column G) in the first year, A would only need $140,000 a year for their income. So they have some buffers and can enjoy a great income.

The income need stayed constant over the 30-years (H). But because two out of the three instruments do not hedge inflation risks, the portfolio gradually loses purchasing power.

Column B shows the inflation progression, which is what we hope we are going through today. The inflation starts off high at 8.9% but gradually moderates down.

The portfolio also suffers from reinvestment risks. If you look at columns D and E, after ten years the income drops from $70k each to $28.7k or a 50% income drop. If this progress further, in 2001, the income drops further from $28.7k to $20.8k.

The income with high certainty falls short of expectations (refer to column K).

In 1994, the total income is $65k, well short of the $140k expectations and they would have to rely on the income buffer which eventually would run out.

Finally, while inflation is moderate and declining, there is still inflation. Column I shows the income required for A to maintain his family’s purchasing power (based on $140k income).

Inflation is also irregular. While inflation is moderate, to maintain purchasing power, the income needs are doubled in 1989 or 8-9 years later.

In the last column, we can see the loss in purchasing power.

A’s solution for this would be to tap upon the capital. But how much capital would you tap upon to salvage your purchasing power?

In the first 20 years, the loss of purchasing power is -4 million.

Second Case Study: 1991 to 2020

Now let us take a look at what happens if A lived through another time period. 1991 to 2020 is a pretty good time period to live through, not just for the great music but also because the average inflation is rather tame. Inflation averages 2.25%.

We observe the highest inflation was around 4.1% in 2007.

The starting 6-month US Treasury Bill Return was 7.2% which eventually went down to 1% in 2020.

Let us take a look at the other data:

How A’s plan will go if they live through a period like 1991 to 2020.

Instead of a total starting income of $176k, the total starting income if A retires in 1991 would only be $71k. The expectations would have to be reduced.

Out of $71k, A’s family need only $57,489 a year.

The income from 10-year government bonds and SSB eventually go down from $28k to $20k ten years later, to $1k (!!) twenty years later. This shows you the reinvestment risk.

A would have built up a buffer for the first ten years, which would come to good use to preserve their $57,489-a-year income requirement.

While inflation is tamer, after 5 years, A’s purchasing power started decreasing.

For the first 20 years, the loss in purchasing power was $624,000. This is less than the 1981 to 2010 sequence, but A has to spend his capital, which may mean less and less capital to generate income.

Why Did the Plan Break Down?

Here are some of the notable flaws to take note of:

  1. Bonds or short-term treasury needs to be reinvested, which presents reinvestment risk. You are subjected to changing interest rates.
  2. The plan might not have taken strong consideration into preserving the purchasing power.
  3. The income is only certain until reinvestment comes along.
  4. Not enough income buffers.
  5. Income is not consistent unless capital is spent.
  6. If capital is spent, how much income would be generated? It adds to the uncertainty.
  7. His income-to-initial portfolio value ratio is not conservative enough.

If we wish to use the same safe instruments to generate income, the solution is to spend a smaller portion of the initial capital. This solution is similar to my other retirement income suggestions. The ratio between your income needs and the portfolio value is critical.

Revisiting the 1991 to 2020 sequence, if A’s family start spending half the initial years’ income, you realize the odds of success increase dramatically:

He would have built up so many buffers that eventually, these retained interest can make up for the shortfall if the reinvested interest rates is not favourable.

Every Plan Has Some Risks and You Have to Choose What Risk You Wish to Live With

Strangely, I think A is not the only one who thinks such a plan would work.

The biggest planning issue is that not many see returns as a spectrum but what they get today will be similar in the future.

I mean, one year ago, the bond rate is closer to 0.5% and this year its closer to 4%.

If there is any indication that you need to think more about this interest rate volatility, this is it.

A can only accept a plan with the following:

  1. No capital loss
  2. Full Liquidity
  3. Super simple so that the spouse can easily implement it
  4. Higher yield than bonds

As far as I know, if such a strategy exist and doesn’t get arbitrage away, everyone will flock to it such that the yield might not be available or it becomes so overvalued that it will likely crash in your face.

A more sensible approach is always to adopt a more balanced portfolio, with less returns expectation but draw an income that is relative to the portfolio capital.

The safest plan usually can only be available for rich people or entities.

If you are interested in retirement planning articles like this, you can check out Planning your retirement section below.

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Sunday 4th of December 2022

For the "safe" plan, everyone is only looking at nominal returns. Inflation is the kliller.

The textbook hedge against inflation is energy, but its hard to put on in real life. You could buy energy producing stocks or trade oil futures. Theres no simple packaged "inflation hedging" product to sell to normies. Maybe the banks will come up with one after a few more years of this.


Thursday 8th of December 2022

The research we did is that there may be a place for commodities futures. The roll yield or expected returns may be worth it. However, it is difficult to implement passively.

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