My mother recently won a lawsuit. She will have about 300k to invest.
She will be able to work part time (25k annually?) and will need about
another 25k annually to live on.
An 8% return on her money seems reasonable, which allows the interest
to make up the missing 25k, but this is best case, and doesn't allow
for compounding the interest. She may need more/make less and need to
dip into the principle to make ends meet.
I know this is a tough spot to be in and there isn't a "winning"
answer, but I'd like to know, in general terms, what a solid plan would
be. Here is what I'm thinking so far:
1) Keep 50k (2 years of expenses) in an very liquid state - maybe a
high interest (4+%) savings account with monthly allocations to a
2) Ladder 150k in safe investments - CDs, T-Bills, etc., reinvesting
as they mature.
3) Invest the remaining 100k in a long term equity investment -
Probably split across a few Index Funds.
I'm hoping that by keeping the 50k relatively liquid I can avoid her
watching her equity account, allowing it to ride out dips in the market
and letting the investment grow over (hopefully) a minimum of 2 years.
I don't have any practical experience with this, but these are the
things I've picked up along the way. I'd appreciate input from someone
a little more experienced. She is a little nervous about just handing
it to an advisor and letting them have their way.
The important aspect of this is not having a down year in the
A few ideas:
start with 5 years in cash- this gives the other portion longer to
compound and ride out a market dip.
of the 5 years in cash, put 2 months in CDs as you suggested, with the
other 3 years in something indexed to inflation (IMO the biggest risk
with 5 years of cash is high inflation at some point).
invest remaining in equities and withdraw in up years only. If this
account is taxable, consider favorable tax treatment of dividends.
for 50k in annual income, is there a need to increase this income over
for the 50k in annual income, is there a way to project expenses going
away over time (like a mortgage, car payment or other debt)?
how long does the 50k in income stream need to be maintained?
When can she collect Social Security? If you know a SS payment is
coming in 20-25 years, consider making sure the 300k lasts until SS
kicks in. Or invest the 300k more aggressively because you know SS
behaves like a cash/bond investment.
How long do you envision this being the situation? If it's permanent,
or for the forseeable future, you're going to need to think about
inflation. If you're looking for an 8% REAL return (i.e. after
inflation), you're looking at a 100% stock portfolio. The average real
return on the S&P 500 from 1987-present is 8.33%. I don't need to tell
you how volatile stocks are.
There's a rule of thumb in financial planning called the Rule of 25.
It says that to earn $1 from your investments, you need $25 invested.
The Rule roughly accounts for inflation. Stated another way, it says
that you can expect a 4% real return on your investments. The Rule of
25 is pretty conservative.
On the plus side, your mom may need less money than she thinks. The
money earned from investments is not subject to payroll taxes. In
addition, qualified dividends and long-term capital gains are taxed at
a rate lower than earned income. If your mother has earned income,
she'll be able to start moving money in to a tax shelter, like an IRA
or 401k. That will also lessen the tax burden, further reducing her
I am not usually a pessimist, but I think what you are asking is
probably not going to turn out like you hope.
$25K a year on $300K is 8.33% average annual return NOT accounting for
taxes or inflation (two of the most important things you should be
considering). Remember both the investment and her earnings will be
taxed. Her earnings should rise with inflation, but her investment will
not. The return you need to ensure that your mother has $50k in
SPENDING POWER every year is much higher and probably not even
attainable if she is invested 100% in equities. 20 years from now she
will need over $45K annually to buy the same things that $25K will buy
today (assuming 3% inflation).
Furthermore, placing $50K in cash and another $150K in CD and t-bills
will reduce risk (which sounds like the appropriate thing to do, if
your Mother will sleep uneasy invested totally in equities) but means
that 2/3 of your principal is invested in vehicles that are almost
guaranteed not to produce your target return. 4% - 6% is common for
these investments which means the remaining $100K has to earn around
15% to get a total return of 8.33% and you will still be losing ground
to inflation and taxes every year.
Of course, as someone else already said, in 23-25 years SSI may
supplement your mother's income but if she retires the benefits will
not even replace the $25K she was earning at work. She will need even
more support from the lawsuit money than before.
In conclusion, you and your Mother should seriously reevaluate your
expectations for this money. Also, while there are many posters on this
site that have educated themselves thoroughly enough that they are more
than capable of handling their investments without paying a financial
planner, I highly recommend you consult one (fee based, not
commisions). You are new to this world and have had a large sum of
money "dumped in your lap." The consequences of learning-as-you-go are
simply too great.
I believe this is incorrect. Her investment will not be taxed. Insurance
settlements are non-taxable events. Only the earnings will be taxed.
The remainder of Kastna's post is spot on. The mother definitely needs to
rethink her income needs. Additionally, this is a situation that screams for
I think I was not clear. I meant the earnings on the 300K would be
taxed every year. So she would need more than 8.33% to have $25K in
Is this correct or am I still missing something.
Yes, all the earnings would be taxable, unless, of course, she were to
invest in something like muni bonds, when she gives up the earnings she so
desperately needs. The MORE than 8.33% escalates if she spends any of the
Thank you all for your input. I think that at this point, I'm going to
seek the advice of a professional. I clearly don't know enough about
what I'm doing to accept liability for her financial future.
I will also stress to her the reality of the situation - that although
this is "a lot" of money, it isn't going to allow her to live in the
lifestyle she was accustomed to when she was working full-time. Maybe
I can convince her that this is only a windfall in terms of catching up
her retirement account to where it should have been if she had been
saving all those years.
Thank you all!
May I stress the point, choose a fee-based pro, not commission based.
And if he suggests any kind of annuity, walk away, and seek out someone
else. The group here would be more than happy to comment on whatever the
pro tells you before you move forward.
Good luck to you.
What's so wrong with annuities for an older investor such that the
suggestion of them is worthy of a litmus test?
I honestly don't much about annuities other than I know someone in her
70's that has at least one somewhere who is generally pretty sharp
with her money.
The biggest problem is probably that when one says "annuities"
there are many different things that can mean. Mainly, two
variables implying four different types - deferred vs. immediate
and variable versus fixed (the latter potentially inflation
A traditional pension, once it starts paying out, is basically
an immediate fixed annuity. And potentially a very useful tool
for a risk-averse investor who needs a predictable cashflow (ie. to
Unfortunately, the thing folks need to be very wary of - the
thing which is often pushed (ie. sold very hard) is the
deferred variable annuity. I'm much harder pressed to come
up with scenarios where a deferred VA is the right choice.
Sadly, they are sold all the time and very often to folks
for whom they are entirely innapropriate.
Plain Bread alone for e-mail, thanks. The rest gets trashed.
No HTML in E-Mail! -- http://www.expita.com/nomime.html
A way to meet your mother's income objective is to invest in a
portfolio of small value stocks.
On average, the rate of return of such a portfolio has been 12.13
percent in REAL terms during the last 78 yrs (see
Of course, the down side is that you need to accept relatively volatile
returns (for instance., you may get a return of 60 percent one year and
minus 20 percent the next year)
This should provide the desired income, even after accounting for taxes.
But for how long? The Monte Carlo retirement simulator at the same site
above only gives a 44% chance that her money will last 30 years. The
volatility of returns is killer when you're drawing down...
The results of the Monte Carlo simulation are too pessimistic. An
exercise I made some time ago is to download the historical data
supporting these results (they are available at the Ken French website:
and, for 30 yrs periods, the lowest average real rate of return of the
typical small cap value portfolio was 8.1 percent (that was the 30-yr
period from 1946 to 1975) -the highest was the 30-yr period that ended
in 1961-. There are 49 30-year period observations -all the 30 year
periods starting the one that ended in 1956, so the results are
This webpage at Harvard describes the caveats of the Monte Carlo
"A few very important caveats about these equations:
They should not be used with small n. The assumptions upon which they
are based break down when n is less than 30.
Similarly, they should not be used with probabilities that are
extremely near zero or one unless a large number of samples are drawn.
One rule of thumb is that the estimate should be based on at least 5
trials with both outcomes- so if you are estimating the probability of
an event that has a very low true probability, you may have to take a
large number of samples before you have any evidence at all that the
probability is non-zero- but if you happen to draw a positive sample in
one of the first trials and stop soon thereafter, your probability
estimate may be wildly high.
These equations are pessimistic. Assumming that the previous two
conditions are met, they generally give margins of errors that are too
wide (or suggest that you should perform more trials than you really
need to). Personally, this is the direction I prefer to err in- I would
rather believe that my estimate is less accurate than it is, instead of
thinking that it is more accurate than the facts would support.
However, if you are trying to perform the absolute minimum number of
trials necessary to achieve a given level of confidence, you may wish
to find a tighter bound.
The Lowest rate of return may have been 8.1% over 30 years, but Will's
point that the volatility of the 8.1% is still on target. Many times
over 30 years this would negative, IMO. There would be many occurances
the small cap would be negative, and if those years occurred early in
the cycle, it would compound problems even more.
But average arithmetic returns are misleading. It is the volatility
that matters when you are drawing down, especially early on as Jim
pointed out. Remember that you're in a non-commutative regime if you
are drawing down - order matters.
n was 1000 in this case.
The probabilities tested were not near zero or one.
There were ~440 trials with a positive outcome, and ~550 with a negative
Given that the simulation does not use fat tails, I'd guess that the
results are optimistic.
I admit 1000 trials sounds low, but it sounds like you are suggesting it
only ran ~10 trials.
Fair enough. But there is another important caveat of the Monte Carlo
simulator: it assumes that the distribution of returns does not change
over time. In fact, if you use a Hodrick-Prescott filter (that provides
a better trendline than just the average), you may appreciate that the
average return of the small cap value portfolio has been increasing
over time (not by much, but even small changes mean a lot when composed
many years). Also, the volatility of these returns have decreased
somewhat: the largest volatility of small cap value stocks returns were
in the first 11 years of the sample (the 1927-1937 period). The
absolutely-worst yearly performance of small cap value stocks was in
1931 -a decline of 51.86 percent- while the best performance was in
1933 -a return of 118.31 percent-. In the last 30-yr period
(1966-2005), the worst performance was in 1973 (minus 27.32 percent)
and the best was 1967 (69.17 percent). Since the 1973-1974 period,
there has been only one year with a double digit decline in small cap
value returns - 1990, with a 24 percent decline, which was followed by
a (positive) return of 40.64 percent the next year-
I don't think that the Monte Carlo simulator -that uses only the
average and the standard deviation for the whole sample- takes into
account changes in the distribution in different subsample periods, as
well as the fact that in almost every case very bad outcomes one year
were immediately followed by excellent returns the next year.
These are the small cap value returns data downloaded from the Ken
French website (they are not inflation-adjusted):
Standard dev 31.8
Hey, I was using your inputs. I don't claim to know how the
distributions will change in the future. Do you want to assume lower
volatility and lower returns?
....if I define "very bad" outcomes as losing money and "excellent
returns" as > 10% then excellent returns followed losing years 57% of
the time in the data series you presented in the previous post. But I
would expect to get > 10% returns 62% of the time with a random draw
against a normal distribution with the same mean and standard deviation
as the series you presented. So it seems that a Monte Carlo would have
excellent returns following very bad years more often than your series.
Does this make the Monte Carlo optimistic?
Always, always, always check my math...
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