How to invest 300k for a 40 year old who needs to live off of it.

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 checking account. 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.
Thanks! -Ryan
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snipped-for-privacy@gmail.com wrote:

The important aspect of this is not having a down year in the beginning.
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 time (inflation)? 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.
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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 income requirements.
--Bill
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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.
Good luck
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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 professional advice.
Elizabeth Richardson
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Elizabeth,
Thanks. I did not know that settlements weren't taxable. I'll have to file that one away.
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Elizabeth,
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 spendable dollars.
Is this correct or am I still missing something.
Thanks
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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 $300k principal.
Elizabeth Richardson
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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! -Ryan
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snipped-for-privacy@gmail.com wrote:

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. JOE
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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.
Best Regards, -- Todd H. http://www.toddh.net /
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snipped-for-privacy@toddh.net (Todd H.) writes:

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 adjusted).
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 live on).
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
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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 http://www.moneychimp.com/articles/index_funds/small_value.htm ) 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.
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Jose Bailen wrote:

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...
-Will
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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: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html ) 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 statistically significant.
This webpage at Harvard describes the caveats of the Monte Carlo simulation: http://www.eecs.harvard.edu/~ellard/Q-97/HTML/root/node38.html
"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.

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Jose Bailen wrote:

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.
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Jose Bailen wrote:

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 outcome.

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.
-Will
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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):
    High 1927    36.26 1928    41.17 1929    -36.05 1930    -46.15 1931    -51.64 1932    1.54 1933    118.31 1934    8.97 1935    52.36 1936    73.92 1937    -51.21 1938    26.1 1939    -3.64 1940    -9.39 1941    -4.81 1942    35.1 1943    92.27 1944    50.58 1945    72.67 1946    -7.59 1947    5.16 1948    -2.22 1949    20.72 1950    50.01 1951    12.54 1952    8.14 1953    -6.55 1954    62.37 1955    23.54 1956    6.71 1957    -15.77 1958    69.77 1959    18.13 1960    -5.75 1961    30.61 1962    -9.26 1963    28.93 1964    22.78 1965    41.31 1966    -8.02 1967    69.17 1968    46.43 1969    -25.75 1970    6.21 1971    14.46 1972    7.13 1973    -27.34 1974    -18.33 1975    58 1976    59.67 1977    23.21 1978    21.63 1979    37.93 1980    21.78 1981    17.41 1982    41.18 1983    47.58 1984    8.43 1985    33.04 1986    14.3 1987    -6.14 1988    30.72 1989    17.08 1990    -24 1991    40.64 1992    35.28 1993    26.55 1994    0.43 1995    32.29 1996    23.52 1997    38.42 1998    -1.14 1999    8.13 2000    21.83 2001    22.41 2002    -8.8 2003    64.01 2004    22.74      Average    19.9 Standard dev    31.8 Max    118.31 Min    -51.64
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Just checked/updated the information provided by the Ken French data library (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html ). These are the returns of different investment styles from 1927-2005. They are not inflation-adjusted. "Low" means low book-to-market portfolios (i.e., growth portfolios) while "high" means high book to market portfolios. These are annual data for average value-weighed portfolios (equally weighted portfolios give even better average returns, but also greater volatility):
Average Value Weighted Returns -- Annual         Small            Big     Low    2    High    Low    2    High 1927    31.59    26.74    33.79    44.26    23.55    31.79 1928    31.88    40.42    42.43    46.51    31.79    25 1929    -46.73    -30.7    -36.81    -19.54    0.76    -4.4 1930    -35.79    -32.19    -45.38    -26.38    -29.29    -43.35 1931    -41.33    -48.31    -51.66    -35.88    -60.22    -57.89 1932    -5.04    -8.53    3.61    -7.32    -16.73    -4.33 1933    166.14    119.96    125.42    44.23    89.36    114.81 1934    34.17    19.78    8.03    10.75    -2.9    -21.77 1935    47.95    75.87    53.8    42.06    47.13    50.77 1936    38.34    48.9    74.95    26.42    37.94    48.55 1937    -48.77    -48.65    -50.44    -34.35    -31.93    -40.71 1938    46.68    43.98    25.54    33.12    20.33    25.69 1939    10.08    1.24    -3.97    7.59    -3.46    -13.17 1940    -1.68    -1.65    -10.49    -9.67    -3.87    -2.5 1941    -16.58    -10.83    -4.68    -12.58    -5.31    -1.18 1942    16.94    27.98    35.26    13.54    17.41    33.4 1943    46.31    54.97    93.32    21.61    33.96    43.81 1944    40.41    40.22    50.44    16.03    21.76    42.58 1945    63.62    60.02    72.48    31.72    38.71    49.84 1946    -12.44    -9.64    -7.44    -7.18    -1.65    -8.18 1947    -8.52    -2.3    5.18    3.54    4.55    8.81 1948    -7.86    -6.96    -2.69    3.71    1.6    4.75 1949    24.51    22.67    21.51    23.38    15.9    16.95 1950    31.1    31.9    51.05    22.64    31.37    56.99 1951    16.78    15.19    12.33    20.02    25.13    13.4 1952    7.18    9.97    9.23    13.04    13.39    20.26 1953    0.42    -0.97    -6.4    2.26    0.53    -7.96 1954    42.9    61.1    63.28    47.77    48.2    77.77 1955    14.71    20.64    23.89    28.63    18.93    29.51 1956    7.96    7.76    5.98    6.57    13    4.32 1957    -16.93    -14.8    -16.18    -8.9    -8.15    -23.19 1958    76.07    57.72    69.42    41.45    45.58    72.04 1959    20.02    20.38    17.96    13.12    9.97    18.98 1960    -2.72    -0.93    -5.74    -2.2    8.16    -8.68 1961    21.08    30.37    31.35    26.38    26.61    29.18 1962    -19.92    -15.47    -9.35    -10.75    -5.8    -3.29 1963    7.56    16.57    28.96    21.9    17.15    32.81 1964    8.08    17.61    23.05    14.46    20.42    19.52 1965    35.72    33.31    41.83    13.46    10.04    22.69 1966    -5.81    -6.07    -7.35    -10.83    -5.87    -10.46 1967    89.73    72.72    67.92    29.16    15.8    31.84 1968    32.58    40.45    46.22    3.96    15.84    26.79 1969    -24.48    -22.98    -25.93    3    -16.96    -16.41 1970    -21.27    -7.89    6.52    -5.71    8.05    10.32 1971    26.22    21.15    14.52    24.22    5.86    13.41 1972    -0.06    7.84    7.1    21.48    11.01    18.71 1973    -45.51    -32.72    -27.51    -21.65    -8.83    -4.17 1974    -32.35    -26.39    -18.39    -29.3    -22.86    -23.1 1975    60.91    58.08    57.9    34.32    41.9    55.18 1976    38.51    47.13    60.18    17.35    41.07    44.22 1977    18.64    18.46    23.22    -9.57    -0.81    1.4 1978    17.5    21    22.05    6.96    6.89    3.74 1979    49.19    36.83    38.34    16.49    23.4    22.95 1980    52.4    30.62    22.33    35.41    36.55    16.45 1981    -10.88    13.78    17.28    -7.57    -7.44    14.16 1982    19.36    33.56    41.18    21.64    17.97    27.28 1983    19.58    40.26    48.07    14.59    25.23    27.2 1984    -13.87    2.35    8.32    -0.66    5.69    15.82 1985    28.87    34.89    32.75    32.5    32.22    31.49 1986    2.39    9.96    14.17    14.64    20.09    21.32 1987    -13.43    -4.14    -6.11    7.41    3.36    -2.2 1988    14.51    28.26    30.73    12.67    17.75    25.79 1989    19.63    17.97    16.46    36.2    25.36    29.33 1990    -18.7    -17.52    -23.57    1.14    -5.52    -13.49 1991    53.62    46.63    40.64    43.04    22.18    27.54 1992    4.65    22.53    35.19    6.31    9.77    23.53 1993    10.61    20.29    27.2    0.85    16.9    22.31 1994    -6.7    0.24    0.15    2.6    1.01    -5.71 1995    28.8    28.37    32.74    37.75    38.63    36.57 1996    9.28    22.43    24.07    22.58    25.53    14.67 1997    10.01    31.73    38.4    30.65    37.08    27.01 1998    -1.49    -5.58    -1.36    39.47    7.51    20.3 1999    46.6    21.71    7.75    26.79    5.82    -0.69 2000    -23.39    19.3    22.12    -13.51    16.9    20.9 2001    -0.12    16.8    22.51    -14.59    -1.28    -0.68 2002    -32.1    -11.72    -9.05    -22.57    -15.29    -25.13 2003    54.71    49.92    64.06    27.9    30.7    27.93 2004    15.11    20.37    21.38    7.48    14.76    20.05 2005    -0.66    8.85    9.16    4.06    8.26    11.62
Average    13.9    17.5    19.9    11.5    12.8    15.7 STDEV    33.9    29.1    31.9    20.4    21.4    27.1 Max    166.14    119.96    125.42    47.77    89.36    114.81 Min    -48.77    -48.65    -51.66    -35.88    -60.22    -57.89
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Jose Bailen wrote:

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?

True, but...

....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...
-Will
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