How to Invest a Windfall

A strategy for getting the most from a single lump sum


Suppose you get a "windfall"—a disability settlement, say, or the sale of a business or an inheritance. Is there a way to invest that money so it will take care of you for the rest of your life?

To answer this question, begin by looking at the sociopolitical climate. Whatever you do, it must be done in that climate—in the real world—and the most serious error you can make is to fail to see the world as it really is. The central fact to recognize is that for the rest of our lives, societal policy—currently manifested in inflation and taxes—will continue to confiscate savings and severely penalize those who create jobs or anything else. Even if serious efforts were under way, it would take some time to change that. And certainly no individual can change the present societal climate. So the task here is to find a means of defense or escape.

Most published material on investment fails when studied in the light of even a modestly long life. Few schemes offer satisfactory results for longer than about 5 to 10 years—not many even approach the high end of this range. And that is clearly not good enough.

So what, then, is to be done with the "windfall"—or with what is left after transaction taxes (capital-gains tax, for one) have taken a piece, often more than half? First, understand that a substantial part of what is left is already effectively confiscated by future inflation and tax liabilities planned for you.

How much? It varies with the investor's age. But in all cases, the investment should be divided into Portfolio A and Portfolio B, and planning is for the investor's lifetime, not forever (as it is for institutions). The part already, effectively confiscated is A. B can produce spending money.

For an investor under about 30 years of age, part A will be about three-quarters of the total. For each year over 30, until age 55 or so, an investor can knock off one percentage point. So a 40-year-old who gets a windfall would put 65 percent of it in Portfolio A. There seems to be no further decline below 50 percent for people past their mid-50s, at least until ages in the 80-plus range are reached, if then. Older investors are concerned with a shorter time, and hence available returns are lower—and they have less chance of hitting a "bleep" in the curves and so getting back some of their own.

The investor between the ages of 30 and 55 cannot, however, transfer one percent a year from A to B. Once the program is set up, A and B live separate lives. (An endowment-fund trustee for a famous college once wrote on this matter. He said that since the college was tax-exempt and had a flow of new capital from affluent alumni, it could, despite its orientation to perpetuity, "avail itself" of an "unusually high" 35 to 40 percent of income from endowment. The rest had to be retained to replace what societal policy had destroyed by inflation and other means.)

Understand, too, that there are no one-decision investments, so there is no real "retirement." Trading and churning are disastrous, but even a "retired" investor still has to stay on top of investments to stay in business. Also, maybe—perhaps usually—the first personal investment should provide and maintain a roof over one's head on a low-profile basis with minimum "involvement." It should at least be considered before moving on to the question of how to put a one-time lump of capital to long-term use.

Portfolio A should be invested for after-tax current yield—probably in municipal bonds. Its income must be reinvested every year. All this portfolio does is replace capital destroyed by wastrel governments. What looks like income and is taxed like income is not income. The "income tax" on this "income" is really a tax on a tax—capital is being destroyed, and then government levies a tax on the destruction. You pay both and deduct neither.

Think of the matter in terms of bread. If you spend the "income" from all your investments, each year you must live on less bread (because inflation eats at your original capital). In effect, then, you have spent—and lost—some capital and have less next year. No matter how high you start, you'll fall into poverty—or at least feel poor.

Variations in "inflation indices" and similar statistical indicators are not to be taken too seriously, much less produce complacency. And Portfolio A investments should be chosen with the intention of holding to maturity—you're not "playing the market."

Now for Portfolio B: Also invest this for best current yield, again intending to hold each piece to maturity. At this writing, preferred stocks of pretty good utilities are probably the best bet, followed by tax-exempt bonds. Within limits, you might include in this portfolio some tax gimmicks, like utility stocks that pay return-of-capital dividends.

Some may object to this strategy of "working the system." Municipal bond-issuing agencies and utilities are creatures of government, and both are running Ponzi games—chain letters—that would get anyone else in jail. But my advice is to find a competent thief and buy his stock—New York City GO (general obligation) bonds, for instance. Bothered by the bad press? The fact is, New York City tried to default on notes—not bonds—and even that did not work. If it runs itself through bankruptcy, a court will heave out the thieves in city hall and install its own thieves. You can then count on the incumbents to protect their license to steal. So the bonds are safe—not because the politicians are honest, but precisely because they are not. And as long as bad press leads many around the country to sell their bonds cheap, buy them—cheap.

Portfolio B is to produce spendable income. Remember, for most, B is only part of the total windfall investment. If you feel you need more money, join the club. The question is not what you need or would like or deserve but what you have and what you can do with it. Do you want to be in poverty in a few years just to have more to spend this year?

Bonds, when used, should have staggered maturities to avoid grouping capital gains and for better reinvestment results. Usually, the longer the maturity, the better the yield. The investor need not live to see the bonds mature—all that's important is current yield.

As well as being staggered, maturities should run until the investor is at least 70 years old. This may be impractical for younger investors, but for most it is possible.

There is a hazard to watch for, however—calls. Utility preferreds and most bonds, even many municipals, are callable. A call, in an income portfolio, is bad news. And don't let a broker tell you about your "profit" when the call price is higher than the original price—that only makes it worse. A bond or preferred stock is called only when market conditions are such that its holder cannot reinvest the proceeds as profitably—the call is for the purpose of reducing interest outlays, which are investors' income. And the tax on that so-called profit just makes the investor's decline deeper.

Only a few available securities are non-callable, but there are some nearly call-proof ones. One class is the old, low-coupon, long bonds. When their call price is equivalent to 4 percent or 5 percent money, there will be few calls. And with sinking funds, as each tranche is retired the issuer will buy in the market as long as high interest rates hold down the market price of the bonds; so there will be few calls until nearly all of the bonds have been retired.

What about common stocks? Few are recommendable, and then only in things like utilities. There is little expectation of real price increases here, because the prospects for the US industrial economy are not good. Some utility commons—capital-intensive, rather than labor-intensive, and outfits that have already bought their legislatures—are the only equities worth serious thought.

This strategy, of course, assumes taking advantage of all the tax angles in sight—Keogh plans and IRAs and utility-dividend reinvestments, for instance—and taking Social Security when and if it is paid. (Yes, it will be paid—but in what coin and with what strings? The same applies to huge IRA payouts—they'll have to be in funny money, for the promise is not fulfillable.)

Yes, these investments do put money right into the viper's den—right into government itself, local government. But remember, one of our basic assumptions is that the productive economy is increasingly burdened (by government) and is not surviving. So the rule still is: Find a competent thief and buy his stock. And what else is a local bond? (But beware incompetent thieves: Cleveland defaulted on $15 million.)

Another angle is stripped bonds, or "zeroes." They have value, but they are almost too good—so good that the IRS is demanding tax in advance on the repayment of principal, which it classifies as interest. Don't start crusades. For now, municipal zeroes of your home state are okay for the purpose of buying yourself a "raise" at intervals, when these proceeds can be used profitably to buy annuities. But look into single-payment, one-life, nonrefunding, conditional deferred annuities from insurance companies to do the same thing, and comparison-shop. Insurance company investments are mostly marginal or less, but check them out anyway.

The money yielded by Portfolio A should not be spent but should be placed in a money fund or interest-bearing checking account. Set up a separate account in a separate bank if you have to, but don't spend this money. At suitable intervals—annually, at the longest—this money earned from Portfolio A should be reinvested for best current yield. Whatever it buys—bonds, annuities in later years, and so on—should then go into B.

Interest and other income from investments in Portfolio B is for spending. Obviously, when you buy an investment with Portfolio A's earnings and put it in Portfolio B, the cash flowing from B increases. And each increase, once established, does not reverse.

When the IRA or Keogh account must be liquidated at age 70, it will usually be most profitable to buy an immediate non-refunding annuity. And thereafter, each year, before reinvesting this annuity income, compare the after-tax yield between annuities and other available investments (generally, municipal bonds).

By that time, too, some long bonds may be maturing or even may be called, and reinvestment of the proceeds in annuities merits comparison shopping. As always, the comparison basis is after-tax current yield. But a maturing, sold, or called bond from A should be reinvested in A, and one from B should be reinvested in B.

If an investor lives long enough, it may be profitable to sell, in small pieces, parts of each portfolio not yet matured to reinvest in annuities, to increase both current income in B and reinvestment cash flow in A.

The object of the strategy I recommend is to get the most disposable income possible, subject to the requirement that it be sustainable in real terms as long as the investor lives. Income in current dollars is meaningless. If the investor lives to a very old age and societal conditions continue to worsen, he will need accelerating gains in current dollar income—hence the recommendation to buy annuities in later years, where level annual reinvestment produces accelerating gains.

The investor must reconcile himself to seeing half or more of his capital—and, hence, apparent "income"—devoted to repairing each year's damage—to replacing what is taken by governments via taxes and inflation to buy the votes of increasingly numerous improvident ones. He need not like the idea, but he ignores it at grave peril. He must forgo spending much of what looks like income so that real spendable income will be maintained. Agreed, if the investor lives long enough—90 or 100 years, say—he may leave very little estate, for by then he will have bought annuities (not all at once, of course). But the planning here is for a lifetime, not perpetuity.

Normally, portfolio A will not increase in value except to the extent that bonds bought at a discount rise to par as maturity approaches. Portfolio B will normally increase in value as long as reinvestment is in bonds. It will then level off as reinvestment is in annuities. Both portfolios will decline as capital is converted into annuities. And if the investor lives long enough, he will have effectively "taken it with him."

John Kneiling is a columnist for Trains.