I'm now working on a column for Advisor Perspectives in which I review existing knowledge (preview: the best work I've seen comes from the Asset Dedication team of Stephen Huxley and J. Brent Burns) and also investigate how long one might want their bond ladder to be. For that, I will be using Treasury Strips. In that column I will not be getting too much into the details of how to actually construct a bond ladder for retirement income. The purpose of this post is to explain how to build a ladder of TIPS to provide retirement income.
The difference between bond ladders as they are usually discussed and a bond ladder for retirement income, is that with retirement income the idea is to spend the income thrown off by the ladder each year. This means that you set up the bond ladder to generate the amount of planned income you desire. With a traditional bond ladder, you wouldn't spend the income, but reinvest it to lengthen the bond ladder. With bond ladders for retirement income, you would generally lengthen the bond ladder using other resources, such as stock investments, rather than using the income provided by the bond ladder.
For anyone actually seeking to build a bond ladder with TIPS, I highly recommend Harry Sit's book, Explore TIPS. He provides all the details needed to actually go out and buy TIPS. My discussion here is more technical in the sense that I'm explaining what you would need to buy, but I'm not getting into the mechanics of how you would actually go about making those purchases (opening a brokerage account, etc.).
I'm getting the raw data for this explanation from the Wall Street Journal's Market Data Center. They provide a daily report of wholesale prices from the secondary markets for all of the outstanding TIPS issues. [Note: one of the issues that Harry's book explores is how household investors will need to pay a mark-up above these prices, so building the bond ladder could cost a couple percentage points more than the prices I'm reporting]. This is the data available for December 18, 2013:
There are a lot of details to note from this data. First, though the Treasury is again issuing 30-year TIPS such that we can find maturities out until 2043, they had stopped that for a period, and there are no TIPS maturing in 2024, 2030-31, and 2033-2039. This actually complicates things a bit. If we try to build a 30-year bond ladder, we need to make assumptions for what to do about the missing years. The common assumption I've observed is that one buys more of the TIPS for the later available maturity date and assumes they can be sold off at their accrued value at the earlier date assuming that there are no changes in interest rates until that time. For example, to cover 2024, one buys more of the 2025 issue and then sells it in 2024 to get the income desired for 2024. This does leave someone exposed to interest rate risk: if rates rise, the income they will receive from selling their TIPS early will be less than otherwise. But it's the best we can do within the constraint that we are only using TIPS. Strips do provide a work-around for this issue, since one can get stripped coupon payments for years when no bonds mature, but they do not provide inflation protection. The general benefit of building a bond ladder for retirement income is that when you hold the bonds to their maturity dates, you know exactly how much you are going to get.
Next, we need to know what all of these columns are:
Maturity is the maturity date when principal and the final coupon payment is provided.
Coupon is the coupon rate paid by the TIPS. This is one of the most confusing aspects of bonds for people to understand. When the bond is issued, it pays a set coupon rate. For a regular Treasury bond, if the coupon rate is 2% and then face value is $1000, then the bond pays coupons of $20 per year. Usually these are paid semi-annually. Two coupon payments of $10 in this case. Note: the coupon rate NEVER changes. Interest rates can change. But that will affect the yield, not the coupon rate. If interest rates rise, then the price that the bond can be sold at will decrease, raising the underlying yield to maturity to match the increasing interest rate. But if I buy a $1000 face value bond on the secondary market for only $700 and it has a 2% coupon, it is important to understand that my coupon income will be based on 2% of $1000, not 2% of $700. Though this may seem basic and simple as I explain it, I assure you that this can be a huge source of confusion.
Next are the bid and asked columns. Bid is the price TIPS can be sold for, and Asked is the price they can be purchased for... in the wholesale market. The difference in prices is the spread made by the party helping to conduct the exchanges between buyers and sellers. Again, household investors will experience lower bids and higher asked than reported here as they are not participating directly on the wholesale market. For these prices, they are referenced in terms of face values of $100, though bonds usually have face values of $1000.
The Chg column is just how much change there was in the asked price since the previous day.
Next, the yield is the yield to maturity based on the asked price. This is the return that the investor would get for buying the bond today and holding it to maturity. If the Asked price is 100, then the yield would be the same as the coupon. If the asked price is above 100, then the yield will be less than the coupon, and if the asked price is below 100, then the yield will be higher than the coupon. Why? This gets back to the point I was stressing before about how the coupon never changes. The bond provides a promise for a fixed set of payments. It pays all of the fixed coupon amounts and it repays the face value at the maturity date. These payments NEVER change. But bonds can be sold and resold on secondary markets prior to the maturity date. If I pay $900 for a bond providing a fixed set of promised payments, then I'm going to get a higher return on my $900 investment than if I paid $1,100 for the same set of promised payments. So lower asking prices imply higher yields, and vice versa. Note that these yields are expressed in real terms for TIPS.
That final point brings us to the final column: Accrued Principal. This is a unique term for TIPS. The accrued principal is the inflation-adjusted principal since the TIPS was issued. The special points about TIPS are that the coupon rate is actually paid on the accrued principal, not the nominal initial $1000 principal. As well, at the maturity date, the investor receives the accrued principal back, not the nominal $1000. This is how the inflation adjustments are incorporated: a real coupon rate is paid on an inflation-adjusted amount and and inflation-adjusted amount is returned at the maturity date.
Another point about this data. If I was constructing it, I would have made one difference. The ask price is in terms of 100, but when you purchase the TIPS, you have to pay in terms of the accrued principal, not in terms of 100. The way I would have presented the asked price in that table is:
"Actual" Asked Price = [Asked] x [Accrued Principal] / 1000
And one final point about this data. Coupon payments are made every 6 months. When you buy the TIPS, you also have to pay any interest that the previous owner would have earned since the last coupon payment up until the data they sold it to you. I believe this is what really throws off the pricing for the TIPS maturing on January 15, 2014. The Yield is artificially high by quite a bit because the purchaser is going to also have to pay about 5/6 of the coupon payment to the previous owner (which, for review, would be 0.5 x 2% x $1265 = $12.65). There is just a month left until maturity.
When I construct my bond ladder below, I will ignore this "accrued interest" problem because it is a rather minor issue, but it does effect that 2014 TIPS a lot. My bond ladder will use the first available TIPS maturing in each year except for 2014. In this case, I use the TIPS maturing in July 2014. Based on what I just wrote, this is the yield curve I have available for constructing the TIPS ladder for retirement income:
Now we are ready to actually construct the bond ladder and determine its cost. To do this, we work backward. One more simplification I am now going to make to reduce the complexity of the explanations is to assume that coupons are paid only once per year rather than twice per year. I'm also going to assume we can buy fractions of bonds, when in reality we can only get as close as possible to our income goal in increments of $1,000, since fractions of bonds cannot be bought and sold. Let's construct a ladder to provide $10,000 of inflation-adjusted income for 30 years between 2014 and 2043.
Starting at 2043, we need to buy enough shares of TIPS to give us $10,000 of inflation-adjusted income that year. This involves buying the TIPS maturing in 2043, which has a coupon of 0.625%, an asking price of 77.14, a yield of 1.596%, and accrued principal of $1016. The accrued asking price is this $783.74 out of $1000. In real terms based on today's accrued principal, and with my simplification that only one coupon payment is made per year instead of 2, on Feb. 15, 2043, this bond will pay 1016 x (1 + 0.00625) = 1,022.35 in interest and principal. We want an income of $10,000. So we need to buy 10000/1022.35 = 9.78 shares. Given the wholesale accrued asking price, these shares cost us 9.78 x 783.74 = $7,664.98. Actually, these numbers have been rounded. In my computer, the precise cost without rounding is $7,666.09. In other words, paying $7,666.09 today entitles you to $10,000 of REAL income on Feb. 15, 2043. The amount you actually receive on that date in nominal terms will actually be larger to the extent that we experience inflation over the next 30 years.
Now we move to 2042. We want $10,000 of real income for that year too. The trick is that we have to account for the fact that the 2043 maturing TIPS we just purchased is going to give us coupon payments of 9.78 shares x 0.625% coupons x 1,020 accrued value = $62.11 of income in every year for years 1-29 as well. So we can subtract that from what we need to purchase. We need to buy enough 2042 bonds to provide real income of $9937.89 in 2042.
And so this process goes, working backward to 2014. Actually, for 2014, we will have $4280.32 of real income coming from all of the coupons for bonds we purchased which are maturing between 2015-2043. So we only need to purchase enough 2014-maturing bonds to get $5719.68.
That is the logic behind the following table, which shows our menus of purchases to obtain a 30-year TIPS ladder:
Now for some final comments on this table. Note that the cost of building a 30-year TIPS ladder providing $10,000 of annual real income is $247,588.14. This is scalable. If you want $50,000 of real income, the cost is 5 times greater ($1.24 million), etc. Also, this is an approximation due to some simplifying assumptions I've listed throughout the post. Note that this cost with regard to the $10,000 income represents a 4.04% withdrawal rate. With the bond ladder, nothing will be left at the end of the 30th year though. Actually, interest rates have been rising in recent months, and 4.04% is currently the payout rate on an inflation-adjusted SPIA for a 65-year old couple with joint and 100% survival benefits. Also, for what it's worth, the implied return on the $247k to get these cash payments is 1.29% in real terms. That's the current "riskless" rate of return for 30 years of retirement income. There is still longevity risk though.
Please watch this blog for more on bond ladders in the future...
Bond ladders are a lot of work and in the end, you are out your principal. Second, when you consider your social security income, you may have the majority of your assets in fixed-income type investments, limiting diversification. The $247K outlay could easily be invested in several asset classes using ETFs that yield greater than 4% while preserving principal over the time period. Yes there is some greater risk and volatility. Starting early one could build a dividend portfolio that easily will exceed the 4% rate.
ReplyDeleteI wouldn't consider dividends to be a substitute for bonds in a paycheck portfolio. Don't get me wrong, I am a big fan of dividends, but bonds are a unique security. Bonds are a legal obligation to pay specific coupon payments and then return principal at a specific time.
DeleteAs Professor Huxley describes below, an investor can time out maturities so that a bond portfolio can deliver specific cash flows at a specific time. And if the portfolio is built with CDs and govt agency bonds, it will be extremely predictable (barring a complete governmental meltdown). That means that day an investor builds a dedicated income portfolio, he/she will know exactly when and how much the portfolio will deliver (of course with TIPS, the how much moves around with inflation, but is assumed to be in real dollars whereas an agency portfolio will be in nominal).
Although dividends are mostly reliable and certainly an important part of total return, I would not want to rely on them for a paycheck. Most of the time, dividends work great. The last 4-5 years of relative stability and low bond yields have lulled investors into higher returning alternatives like dividend paying stocks. But the reason that we recommend bonds as the income component of a portfolio isn't for when the markets are cooperating. It is for when markets are falling apart.
In 2009, dividend paying stocks in the S&P 500 cut their dividends by about 27%. And, by the way, the principal invested in those stocks was also down substantially. Not what I would want for my paycheck. If instead, dividends are shifted to the task of growing the portfolio, the dividends provide a nice stable component to reinvest into more predictable bonds over time. And, any immediate near term cuts in dividends do not affect the investors paycheck.
We are willing to accept the generally lower return on bonds so that they can act as the buttress that holds up the portfolio in poor markets. By using bonds on the front end of the portfolio to deliver the investor's spending needs, the stock side of the portfolio will have time to ride through bad markets and recover, just as we have seen since 08/09. But during the unsettled periods in the market, it is the predictability of bonds that ease the burden on the portfolio and reduce the need to sell something when you don't want to.
When timed out correctly, which is no trivial task, the bonds are like little income soldiers, delivering the investor's target spending needs every year, in the right amount and at the right time regardless of what is happening in the stock or bond markets. With the near-term portfolio cash flows covered with bonds, stocks can be used to fund the later cash flow needs, which allows stocks to do what they do best - grow over time. And when stocks go down, there is no need to panic because the paycheck for the next 5-10 years is already covered predictably with bonds, thus giving stocks time to recover without impacting portfolio cash flows.
A TIPS ladder and a portfolio of stocks, even stocks with high dividends, even stocks with high dividends which have never been cut, have very different risk profiles. You might as well have written "You'll probably do better over thirty years by buying rental property and stock index funds." It's true, but it also doesn't recognize the fact that most people who would consider a TIPS ladder are comparing it to things like an inflation-indexed SPIA and a TIPS Bond fund, not a stock portfolio.
ReplyDeleteThanks for responding to that one!
DeleteI'm not a fan of bond ladders. I explained why toward the end of this Advisor Perspectives article: http://advisorperspectives.com/newsletters13/pdfs/Retirement_Portfolios.pdf The article also has a link to a July 2 Stephen Huxley AP article where he advocates for individual bonds and bond ladders. He responded to my article (it's the second letter in these): http://advisorperspectives.com/newsletters13/pdfs/Letters_to_the_Editor-07162013.pdf His response didn't change my mind, but I make all this available to others who may be interested in evaluating the arguments.
ReplyDeleteJoe,
DeleteI just finished a fascinating set of readings between your column, the Asset Dedication column, and Stephen Huxley's letter about your column. I'm sorry I missed these the first time around.
Two points struck me about your column:
1) it's important to remember that liabilities have a present value as well. If the duration of liabilities (future spending needs) exceeds the duration of the bond fund, then one benefits from rising rates. But how does one calculate the duration of their liabilities? Is it survival-probability weighted?
2) the idea that that after rates rise, the loss to a mutual fund will be followed up by gains as the bond is amortized back up to its face value
But, I think overall, I'm leaning more to the side of being persuaded by Huxley's letter in support of bond ladders. This is a good empirical question to look at cumulative returns on bond funds and how rising rates interact with the active trading inside the fund, the different maturities, and so on.
And also, I was struck by something Stephen wrote:
"Investors are not compensated for any of these risks by holding the bond fund."
This is the same point that Dirk Cotton recently made about sequence of returns risk. It seems that bond funds do present sequence of returns risk to retirees in that they are still spending down after the fund experiences losses, and this is not a compensated risk. But it can easily be avoided through the use of the bond ladder.
So, you are still leaning to the side of using bond funds rather than bond ladders? Thanks for the discussion.
Wade,
DeleteI admit that I have not spent a great deal of time studying the details of how bond ladders work, because the whole concept doesn't make sense to me. What is the liability stream one is matching to with the ladder? If it's lifetime expenses, one doesn't know how long the lifetime will be. What are the all-in costs, including advisor expenses for managing a bond ladder? Even if one knew the duration of the expenses one is matching to, expenses will surely vary from plan, which negates the benefit of precisely laddering to match future expenses. I much prefer SPIAs over bond ladders because they provide a steady income stream and match the longevity.
As for calculating the duration of liabilities--there is a Macaulay duration formula where, if one wanted to be precise, one could calculate a present value of the retirement cash flows weighted by the duration of the flows (based on a life expectancy estimate). The main point is that for investors who will probably be more comfortable with intermediate term bonds than with long-term bonds, the liability duration will exceed the asset duration by a wide margin (except for the very old).
In this investment environment I think it makes sense for investors to use funds and keep the average duration in the 3 - 5 year range. I don't see any value being added by going to the extra work and expense of laddering because the liability being matched is not at all precise and likely of significantly longer duration than the bonds.
Or maybe this is the way to look at it--say person A owns a bond fund with a 5 year duration and person B owns a bond ladder with a duration that also calculates out to 5 years. Rates suddenly jump by 200 basis points. The value of the bond fund drops by 10% and the market value of the bond ladder also drops by 10%. I don't see the bond ladder magic.
Joe,
DeleteI think an important distinction between time segmentation and essentials-vs-discretionary is that time segmentation builds a front-end income floor for the whole lifestyle goal with fixed income, while essential-vs-disretionary builds a lifetime income floor for essential needs with SPIAs. So the point isn't to build a bond ladder to last the precise lifetime. The idea is to keep rolling the ladder out further as time passes, as this is how one allocates to fixed income.
About expenses varying from the plan, this is an issue for any strategy. But with the front-end bond ladder approach, you can always spend from the growth portion of the portfolio if expenses end up being higher than planned. I don't see this as being an issue to distinguish between strategies. This mostly speaks to making sure one keeps a stockpile of liquid financial assets to cover the unexpected.
I can respect the preference for SPIAs over bond ladders, but given that one isn't going the SPIA route, what I've been interested in looking at here is the issue of bond ladders vs. bond funds.
I can understand the concern that bond ladders are more complicated than bond funds, but if you otherwise might see the value of bond funds, we can work to provide clear instructions about all the specifics for getting the bond ladders going. It is worthwhile to investigate the issue of how the mark-up costs for building a bond ladder compare to the fact that bond funds are probably getting institutional pricing on their bond purchases.
About your last paragraph, yes the bond ladder experiences a paper loss. But the point is that for a retiree (as opposed to a professional bond trader), this paper loss can be ignored. As the ladder matures, it will provide the income it was meant to. With sequence of returns risk, I'm not yet convinced that the bond fund will also be able to support the same desired income stream. I guess this is a point which could be simulated out in a spreadsheet. Given your scenario, how much income does each strategy end up supporting?
Wade,
DeleteYou make a good clarifying point about essential/discretionary versus time segmentation. I'm very comfortable with essential/discretionary and have never gotten comfortable with time segmentation, so perhaps that's the crux of the issue. I can't see the value of bond ladders in an essential/discretionary framework. SPIAs do the job in the essential zone and bond and stock fund mixes seem fine to me for discretionary.
So maybe it's as simple as that distinction, and maybe the contest is between essential/discretionary and time segmentation rather than bond funds vs. laddering.
I think I'll just stop at that for now.
I'm not saying you believe this, but as a general grievance...I am sick of people saying owning a group of individual bonds protects you from rising rates while a bond fund (a group of individual bonds) does not. Matching duration with obligation insulates you from interest rate risk. It can be done with bond latters or bond funds.
ReplyDeleteThanks for making this succinct point. But in the context of the retirement income problem, I'm not sure when can match duration with obligation. If the duration of liabilities is determined using survival probabilities, then with each passing year the duration of the liabilities is going to adjust just as the remaining life-expectancy adjusts, both in a non-linear way. Getting a portfolio of bond mutual funds with a duration that evolves in the same way then sounds to be just as complicated as building a bond ladder. Though perhaps this could be another alternative.
DeleteI'm certainly not an expert on taxation, but wouldn't this have odd tax results if done outside a tax-sheltered account such as an IRA? It is my impression that the additions to principal are subject to current income taxation. If this is correct, isn't the holder required in the first year to pay tax on all the additions to the later years? This wouldn't matter if the ladder is in a tax-deferred account, but otherwise ...
ReplyDeleteTIPS and Treasury Strips do both have some problems with taxable phantom income in a taxable account. Holding them in tax-deferred accounts is desirable. If a taxable account is all that is available, then the taxation is starting to get beyond my pay grade in terms of funds vs. ladders. A municipal ladder might be relevant for this.
DeleteJust to add some additional complexity, you should get a higher nominal rate (sans inflation protection) with corporate ladders - this would force you to weigh the value of inflation protection (which you may be able to hedge elsewhere) against the loss in risk-adjusted return. The treasury/corporate spread is increasingly driven by perceptions of greater liquidity and security that may cost more than they should for an average retiree: http://faculty.haas.berkeley.edu/vissing/demandtreas_jan6.pdf
DeleteA better analysis would weigh the higher cost of using treasury debt, especially in tax-sheltered accounts, against the quantifiable benefits of inflation protection.
I read a paper written by a PhD at Vanguard some time ago. I'm going to try to track it down. The analysis showed that bond funds were preferable if there was no known date at which cash would be needed. In other words, if you're buying bonds for ballast, then funds will profit from higher reinvestment rates as they rise and offset principal losses. When a specific spending target was known, however, individual bonds were preferable. I don't like funds for providing a specific future year's spending requirements. I do use them when my asset allocation requires more bonds.
ReplyDeleteThough this may be a personal preference, I prefer TIPs ladders to SPIA's because there is no risk of losing principal if you die early. I've never been able to convince a client (or myself) to buy a life annuity. They all seem to have an aunt who bought one, died a year later, and left no inheritance. (Maybe they all had the same aunt?) I realize that TIPs ladders don't provide longevity protection at the extreme, but I'd prefer to handle that differently.
Bond ladders guarantee (as best can be) a certain amount of real income for a future year of retirement. You can't do that with dividends. If you can do that with bond funds, someone please show me how.
There is certainly sequence of returns risk with bonds unless you hold them to maturity. The risk comes from the uncertainty of future market prices at the intermediate transaction times. There is significantly less SOR risk with bonds, I would assume, because TIPs are far less volatile than stocks.
Regarding taxation, I believe I have also read that TIPs don't compensate for inflation (or might not) when held in a taxable account. Regardless, retirement accounts would seem to be the best place to hold them for several reasons.
I want a secure income floor for my retirement. TIPs are a safer floor than the best dividend stocks. SPIA's would provide secure income and longevity insurance, but I'd lose control of my capital.
I prefer a ladder to a fund because I can't match liabilities with a fund.
I do, however, prefer ladders shorter than 30 years. Sharpe ratios are much higher for long bonds (you don't get paid for the extra risk). Also, I might not be able to hold long bonds to maturity. I might die in 10 years instead of 30. I might need the principal to pay for medical or long term care expenses. If those things force me (or my heirs) to sell the bonds when rates are high instead of holding them to maturity, I've lost wealth.
Also, I don't want to tell someone I'm advising that although their net worth has declined because rates went up and their long bonds fell that they have no problem as long as they hold the bonds for thirty years.
There's my two cents as a financial planner who's been retired eight years. I'm certainly open to being shown a better way and I'm thoroughly enjoying the discussion.
Dirk Cotton writes, "They all seem to have an aunt who bought one, died a year later, and left no inheritance. (Maybe they all had the same aunt?)"
ReplyDeleteWhat am I missing here? -- There are annuities all over the place that have 5-year certain, 10-year certain, 15-year certain, 20-year certain, and perhaps other-year certain guarantees, in addition to return-of-premium guarantees, which in my universe seems to equate to 15-or-so year guarantees. And, these "N"-year certain annuities are not at all new.
I what universe do/did aunts have available to them only SPIA annuities with zero-years certain, when the death of the annuitant meant that the insurance company got to keep *all* the remaining cash?
This comment has been removed by the author.
DeleteWhat you're missing is that people hear about those options and still don't want to buy SPIA's.
DeleteTwo years ago, a prospective client's wife's first words to me were, "If you recommend an annuity, I'll walk out that door." Her sister bought an annuity and died two years later. I told her about the options for guarantees. She wasn't impressed.
I haven't looked at life annuity sales numbers in a long time, but my impression is that they didn't skyrocket when these options were added.
Don't shoot me. I'm the messenger.
Heavens! -- not shooting at you at all. On the contrary, thanks for taking the time to address my question, posed in wide-eyed innocence. I get what you're telling me.
DeleteMark, that was a "don't shoot me" with a smilie face.
DeleteI believe you're saying that people should buy annuities and I think most economists agree with you. There is an interesting article and paper in a recent Forbes about the annuity puzzle entitled "Why Don't Retirees Buy Annuities? They Get Something Most Economists Don't". (I won't leave a link here, you can Google it.)
They note complaints similar to ones I have about long bond ladders.
I might recommend annuities for some clients, but the data shows they probably won't buy them, even with those term-certain options.
Thanks (again) for this side conversation. In my two postings, I really was neither advocating people buying annuities nor advocating the opposite; it was a genuine puzzlement that led to my question.
Delete(Now that the subject is here, I will say that, as with many things in life, it depends on the individual situation. I do think annuities can have a substantive place in many people's retirement plans, but that issue can wait until an appropriate time in these conversations.)
Totally agree.
DeleteYes I realize folks want safety and believe the TIPS and inflation-indexed SPIA and bond ladders provide that to them. My contention is that a properly crafted dividend stock portfolio can generate over 4% in income while preserving principal. The other cost you principal. I view that portfolio as a safer investment because I get to keep the principal. I realize most will not agree with me.
ReplyDeleteThe reason why I won't agree with you is... why assume stock dividends keep pace with inflation? 1930-1950 they certainly did not, also not in the Seventies either. Dividends can be cut, omitted or suspended by the board of directors at their whim. If you can select companies for your "properly crafted dividend stock portfolio" where this is not a risk (in the future) then you have my admiration. Fred
DeleteThis discussion is long overdue and I thank Wade for starting it. Bond ladders for retirement income (or laddered “Income Portfolios”) are based on dedicated portfolio theory, which has a long history. It is based on the simple notion of buying bonds in the right quantities with the right maturities so that the annual coupons and redemptions match the income stream needed for whatever time horizon is desired (typically 5-10 years). By holding the bonds to maturity, the income stream is protected (immunized) against market risk from rate changes. Whatever money is not needed for this Income Portfolio can be allocated to equities or other, faster growing investments (the “Growth Portfolio”).
ReplyDeleteIn normal times, one would expect that, as each year passes, the maturing bond will be replaced to maintain the time horizon over a lifetime – rolling the Income Portfolio forward. The money to replenish the Income Portfolio would come, as Wade says, by selling by investments out of the Growth Portfolio. In abnormal times, replenishment can be postponed because a person whose Income Portfolio is designed to immunize income for, say, 8 years, would not be forced to replace the maturing bonds for as long as 8 full years. That provides pretty good protection from even the nastiest bear market. The key point is buying the right bonds in the right quantities in the right maturities and holding them to maturity. Note that bond funds cannot be “held to maturity” – that is their fatal flaw.
To address some of the previous comments:
1) It is true that spending the money from a matured bond for income consumes principal. But most financial plans for retirement portfolios are designed for the distribution phase - to make the money last over 30 or 40 years, spending it down to zero or some legacy figure. It is not designed to grow. Happy beneficiaries if it does grow, of course, but its main job to support the retirees over their lifetimes.
2) Bond funds are fundamentally different financial instruments than individual bonds. Most bond funds have no obligation to hold bonds to maturity, pay off face value, or even distribute the coupon payments in a fixed amount. Bond funds are essentially used in most portfolios as sluggish stock funds to reduce volatility, not to provide income.
3) It is true that to build an Income Portfolio, whether in TIPS or any other bonds, you must have a target cash flow to match, usually the projected withdrawals that retirees need to replace their paychecks. But one of the fundamental purposes of financial planning is to help clients figure out how much they should spend to avoid spending too much or too little (i.e. leading lives of needless frugality). The plan must start with a specific set of assumptions and create projections, then make adjustments along the way as needed.
4) Dividends simply do not have the reliability of legally mandated coupon payments. During financial crises, firms can cut dividends. That is, precisely when security is needed, they may fail.
Again, I thank Wade for initiating the discussion and providing a clear example of how to use TIPS to build a 30-year Income Portfolio. It gets trickier mathematically when cash flows are lumpy, but his example fits a very common case. He has actually presented an argument for self-annuitization for those who might want 30 years of secure income. In the cases we work with, it is much more common to have shorter horizons and invest the rest for growth, but the idea is the same.
I sincerely hope his initiative leads the way to broader discussions and more research into dedicated portfolio theory. It is intuitive and ideal for many retirees seeking security – they understand it. As Wade says, it is an under- researched and under-appreciated answer to the retirement income problem. I invite those interested to read the book (Asset Dedication, McGraw Hill 2005) and visit our website (www.assetdedication.com) to read more on the dedication strategy.
There are now a number of targeted maturity bond funds in existence that hold bonds with defined maturity dates (after which the funds liquidate) and fairly predictable maturity values. For instance, in the taxable space, there are American Century’s zero coupon 2020 and 2025 funds. Among muni’s, there are Fidelity’s Defined Maturity Municipal Income funds with maturities ranging from 2015 to 2023. Among corporates, there are many Guggenheim Bulletshares ETF’s with maturities ranging from 2013-2022. And Guggenheim also has high yield corporate ETF’s that ‘mature’ in 2013-2020.
DeleteFor a hold-to-maturity bond investor, it would generally be better to hold low-risk (e.g., treasury or highly-rated corporates and muni’s) outright. For high yield bonds, the diversification achieved through a fund makes good sense. At any rate, the ongoing non-trivial management fees can be avoided by purchasing bonds outright.
Note that bond funds cannot be “held to maturity” – that is their fatal flaw.
DeleteWhat?...neither does that group of bonds in your latter. Who cares if you get your nominal dollars back at maturity.
Chris,
DeleteI don't understand your comment. If you hold individual bonds in your ladder, then each of these individual bonds can be held to maturity. And if your reason for buying those bonds was to be able to spend the principal at the maturity date, then you have removed interest rate risk for that bond.
My point is that if you are going to be continually rolling the latter the "fund" you created also does not have a maturity date.
DeleteI guess I don't understand the obsession with getting your principal back at maturity. Your 8 year latter will be affected by rising rates just like a similar bond fund. The only advantage I see is that if you choose to not pay attention to the daily prices of your bonds you may have a better chance of not panic selling if rates rise.
Chris,
DeleteThat's the idea. With retirement, the annual return on your portfolio is not a key criteria. It's supporting a sustainable income stream for life. This is the context with which households can evaluate the bond ladder. They can effectively ignore any paper gains and losses as interest rates fluctuate, because they will hold those bonds to maturity. And then they will spend that principal for that year's consumption as it matures. The bond ladder will be lengthened by using the growth portfolio, not the maturing bonds.
Thanks, Wade, for an excellent post, and thanks to everyone for a thought provoking discussion.
ReplyDeleteTo nitpick, I believe the TIPS prices quoted by the WSJ are in 32nds; for example, the accrued asking price for the bond maturing in 2043 is $786.77, not $783.74. If so, this will raise the total cost of the ladder and lower the effective withdrawal rate.
Rather than buying longer maturity TIPS to cover the missing years in the ladder, I wonder if it might be preferable to reduce interest rate risk by purchasing shorter maturity TIPS and investing the proceeds at maturity in individual short-term Treasuries?
In addition to those already stated, another point in favor of TIPS vs. SPIAs is the elimination of credit risk, which historically has an annoying habit of appearing at the most inopportune times. Has the insurance industry ever explored securing an FDIC-type insurance coverage from the federal government for an annuity product?
Keep in mind that a TIPS ladder does not represent perfect liability immunization as the (unknown) inflation adjustment is taxable. TIPS funds offer those investing from a taxable account some advantages in that regard - tax deferral and possible long-term capital gains treatment.
Let's also remember that purchasing individual TIPS allows one to eliminate the annual expense ratio of a fund, a non-trivial expense in the context of today's yields.
Thank you for the feedback. #Cruncher at the Bogleheads Forum also corrected me on the pricing issue. When fixing that, the cost of the ladder increased by about $500.
DeleteAnd your point about buying at the shorter end rather than the longer end is well taken, thanks.
Wade..... I've been following your blog for the past two or three months and have found it extremely interesting and helpful. One of the first posts I read (and I can't find it now) was your post regarding a withdrawal rate of between 2.8% and 3.2% might be required to guarantee one's assets would last for 30 years.
ReplyDeleteA TIPS ladder as you propose here seems to totally refute the previous post. If one believes he should withdraw only 3% why wouldn't he build a TIPS ladder and enjoy 4%?
James,
Deletegood question!
Yes, I've been involved in a number of studies which suggest that using a 50/50 portfolio of stock and bond funds leads to a safe withdrawal rate much closer to 3% than to 4% over 30 years. The volatile portfolio has more upside potential, but also more downside risk.
With TIPS, you can lock in that 4% withdrawal rate, but you give up the upside potential for portfolio growth, and you do have to be aware of the fact that you need a plan if you live longer than 30 years.
This isn't a contradiction... it's just a matter that different strategies will safely support different amounts of income.
The classic 4% rule that you hear about assumes someone is investing aggressively with 50-75% stocks and the rest held in a bond fund.
I believe "A 4% Rule -- At What Price" (Sharpe, Scott) assumes a long term TIPs ROR of 2% and calculates a 4.46% withdrawal lasting 30 years (it's a simple present value of an annuity calculation). Of course, TIPs aren't yielding quite that right now, but probably will again.
DeleteWhy would you choose a stock portfolio to spend down at 3% or so, instead? Because you might end up WAY ahead with stocks. Then again, you might end up WAY behind. I wouldn't gamble the rent money, but a lot of people seem to be happy to do just that.
I'm still not convinced about the superiority of bond ladders over bond funds, even when using time segmentation. Let's say the time segment is the next 7 years of spending and one does a duration calculation on that spending and it equals 4 years. With a bond (or TIPS) ladder I assume that shorter bonds will roll out as they are used for spending and longer ones will roll in--keeping the duration at 4. Another option would be to purchase a TIPS fund of duration 4 (or say a mix of Vanguard's long term and short term TIPS funds to achieve a duration of 4). Now let's say interest rates shoot up from 0% real to 2% real. What happens--the fund suffers a market loss of 8% (2X4) of the fund value, but now the whole fund earns 2% real going forward. Assuming the bonds are not being marked to market, there is no loss to upset the investor, but most of the portfolio continues to earn 0% and not the new yield of 2%. With the two durations equal, it works out the same financially. This is a difference of book value versus market value accounting rather than a financial difference. The difference is also one between cash flow matching and duration matching. Insurance companies with large fixed income portfolios do duration matching; they don't bother with cash flow matching. If this were my own investment portfolio, I'd be looking at costs. If laddering was more costly than using funds, I wouldn't bother.
ReplyDeleteJoe, I agree with your point about cost but I disagree with the proposition that retirees should not care about the increased risk of bond losses at the long end of the ladder because holding to maturity will allow them to avoid realizing those losses.
DeleteFirst, people DO get upset about unrealized losses. The fallacy behind Dow 36,000 was that people don’t care about short-term volatility so it doesn’t matter if stocks are more volatile than bonds. People mentally “mark to market”.
Second, they SHOULD care, because holding 30-year bonds to maturity isn’t as simple as it might sound. Retirees who don’t live the full 30 years will realize those losses when they leave a smaller inheritance. Others may need to invade that principal for unexpected expenses like a health crisis or long term care and they will realize those losses when they do. In fact, the principal might not be there to invade.
Retirees who live to a very old age and avoid unexpected financial crises might, I agree, be able to shrug off the losses.
Dirk,
DeleteI seem to be on the wrong side of my own argument--I guess I need to make myself clearer. I'm not a fan of bond ladders. If your contention is correct that people "mentally mark to market," isn't that another reason not to bother with a bond ladder?
The expense question is critical. What is the all in cost to an investor for a bond ladder? How does this vary with portfolio size? We're up to nearly 30 posts and this is a good discussion, but it would be helpful if someone could enlighten us all with information about all in costs.
Dirk, I think your statement about mentally marking to market is overly broad.
DeleteFor instance, I have a muni bond ladder -- purchased years ago -- that will provide a predictable retirement income floor for each of the next 15 years. I don't mark to market and don't care about the ups and downs of market valuations; the income will be there when I have planned for it. I also draw income from a fixed lifetime annuity. I don't look over my shoulder wondering if I could have purchased a cheaper annuity and/or timed the purchase differently. I'm sure there are also many others who don't stress themselves marking to market unnecessarily.
Additionally, I have a long-term rolling bond ladder of US treasury zero's (12-25 year maturities), again purchased years ago. To me, rising long-term rates (in a positive sloping yield curve environment) are a blessing -- I can reinvest maturing bonds and/or earlier rungs (that have rolled down the yield curve) into longer maturity and even higher-yielding rungs. For emergencies, I have other funds. But if I had to sell bonds within the treasury ladder for large unexpected expenses, I would probably sell the earliest maturities (with the smallest potential losses) first.
In your example, if there’s a good chance you’ll need the principal before 30 years, then don’t buy such a long-term bond, or at least create a ladder with bonds also maturing significantly sooner. But suppose you did buy a 30-year Treasury zero at 4% YTM now (which would cost $308) and you needed to cash it out after 15 years, at which time 15-year rates were 6%. That bond would be worth $417, which is more than you paid for it and reflects a 2.04% annualized gain from purchase. The net return isn’t great, but it’s not a nominal loss, better than the current 5-year treasury rate, and certainly not worth getting bent out of shape over.
"In your example, if there’s a good chance you’ll need the principal before 30 years, then don’t buy such a long-term bond, or at least create a ladder with bonds also maturing significantly sooner."
DeleteYes. That's my point.
DeleteThanks everyone,
Joe, I think I'm following your example and would agree with you on the accumulation phase. But I'm still not seeing it for someone in retirement. If their fund had an 8% drop and they are spending from, then this will have a negative impact on their sustainable spending rate.
This brings us up to your very valuable question of how much does this all cost? What are the all-in costs of a ladder vs. a fund. As we are approaching the holidays, I'm not getting much opportunity to work, but here are a few holdovers to consider:
1) It's been a couple months since I read "Explore TIPS," so I can't precisely quote it, but he did actually run some tests about brokerage prices for TIPS vs. wholesale prices, and I came away with the impression that a 1.5% markup was a reasonable assumption. Again, I'm not completely confident that I remember this right.
2) I received this information in a reader email: "I noticed you used wholesale bond quotes for your TIPS analysis. You can get RETAIL quotes on TIPS & STRIPS from Fidelity.com w/o logging in or being a customer of theirs. Simply go to Fidelity.com, click on Research and then Fixed Income and Bonds and then Find Bonds and CD's. You can even download quote tables to Excel."
3) As this is becoming a comprehensive thread, for someone looking to buy a bond ladder, it is also worthwhile to check the price of an immediate annuity with no life component but only a guaranteed payout for a set number of dates. That was what I used in an example about delaying Social Security for 8 years when I wrote about that a couple of months ago. I can get the retail prices for those. I'm not sure if they are available with CPI-adjustments or not though. I'll look into this some more. The fixed-term annuity should pay higher because it will also use some corporate bonds, but it does have the counterparty risk that would make it less secure that government issues.
Wade, In the retirement phase I think the key distinction is whether one is using the ladder to pay off an obligation (e.g., the last 10 years of a mortgage) or using the ladder to pay the next X years of expenses and refreshing it each year. In the former case one would first want to see if it made sense just to pay off the obligation immediately, and that one would be complicated to handle with bond funds because one would need to shorten duration each year. For the case where one is refreshing the fund I think bond funds and ladders produce the same financial result for a retiree if the durations are the same. Perhaps I need to do a spreadsheet on that. If they do produce equivalent (or nearly equivalent) results, then cost and effort differences become important.
DeleteThe fixed term immediate annuity is an interesting one to look at. I believe Income Solutions offers them via Vanguard.
Hi Joe
DeleteNot necessarily a superiority argument, but the bond ladder has one advantage over a fund in being able to delay action if the market is not favourable. As Wade and Dirk mention the direct holdings can reduce the sequence of returns risk.
If a retiree operates a bond ladder on auto-pilot, always extending the ladder by a year every year, the result will be much like a bond fund. However, if rates are low the retiree will have an option to delay the extension of the ladder until the rates improve (that is they can allow their invested duration to fall if rates are low). They also have the option to extend the duration if they think rates are high.
There is a related issue with the role of the growth section of the portfolio. Extending the ladder involves selling more of the growth portfolio. Assuming that this growth in invested in stocks, it should be noted that there is a correlation between poor stock returns and low yields. Aside from inflation spikes, falling stock prices tend to occur with falling bond yields. If the retiree has the ability to defer buying the next 7-year bond they can avoid selling stocks at the low and locking in the low yields. Potentially they can by a 5-year, a 6-year and a 7-year bond in a couple of years. It is hard to do this with a bond fund.
Obviously the cost of this more active management strategy is going to be higher.
Aaron,
DeleteThanks for the comments. I agree with you about the issue that falling stock prices tend to coincide with lower interest rates. This matter came up when I was evaluating an income guarantee rider whose payout rate is related to the 10-year Treasury yields. It turns out that this is not an attractive feature from the perspective of downside risk protection because the payout rate ends up being lower at times that the stock market is underperforming.
Joe, I don't think fear of unrealized gains is a reason to not buy a bond ladder; I think it's a reason to not buy a long bond ladder. I'd build a 10-year ladder and forego the poor Sharpe ratio of longer bonds. I (personally) would keep the longer stuff in stocks, but I don't know that I'd recommend that for everyone.
ReplyDeleteI don't know the answer to your cost question, but Schwab SCHP has a 0.07% fee and Barclay's TIPS 0.18%. You can buy individual TIPs bonds for no fee, so I'm guessing we're not talking about much cost in either case.
I was under the impression that there were investment managers offering ladders and charging quite a bit for the management. I have a vague recollection of some kind of PIMCO offering, but maybe that was something else. If I were looking at this as a DIY investor, I'd be putting a value on my own time, and I would think I'd need to spend quite a bit more time buying and maintaining a TIPS portfolio than just buying an intermediate term bond fund.
DeleteI guess they way I look at this overall is that retirement involves quite a bit of uncertainty and the need to make adjustments along the way--expenses cannot be predicted with certainty and, if one owns stocks, those returns are hardly predictable. So building bond ladders seems to me like trying for precision in one part of an overall environment filled with uncertainty.
The analogy is--retirement is like crossing the ocean with 20-foot waves, and building a bond ladder is akin to arranging the deck chairs.
Joe,
DeleteThere would definitely be some study time involved to get the bond ladder set up, but for extending it, the additional work wouldn't need to be much more than what is otherwise involved with rebalancing one's portfolio. Treasury Direct is fairly easy to use, as I've finally gotten around to using it for I-Bond purchases.
At any rate, building a bond ladder is not going to be an option for a DIY investor with no financial sophistication. It's either got to be a strategy for people working with advisors, or for Bogleheads-style DIY folks. With advisors, I'm not convinced that fees will otherwise be that much higher. But I agree this deserves a closer look.
Wade, This article by Michael E. caused me some concern when I read it a few years ago. http://advisorperspectives.com/newsletters11/pdfs/A_Close_Look_at_the_PIMCO-Met_Life_Retirement_Strategy.pdf
DeleteThis is from a Morningstar posting on costs for the PIMCO offerings.
"Launched in the fourth quarter of 2009, the funds are still small and expenses are not cheap. The retail D shares cost 0.79%, and the institutional shares charge a more modest 0.39%. At fund supermarkets, the institutional shares can be tapped for a $100,000 minimum and a $75 fee."
Michael mentioned not only the fees but also the need to use linear programming because all maturities are not available--sounded complicated.
I guess this discussion points up a general challenge for average investors--how does one get good advice and invest in fixed income in a low interest rate environment and still earn a decent return after fees?
Joe,
DeleteI think the "linear programming" is more or less what I was explaining about having to work backward and having to keep track of all the coupon income coming in each year when figuring out how much maturing bonds to get for each year. The missing maturities is an issue, but I explained some basic work-arounds.
This comment has been removed by the author.
ReplyDeleteWade, the only open issue for me is whether and to what extent bond funds sacrifice inflation protection by not holding bonds to maturity.
ReplyDeleteOne additional note. I made a lot of money in TIPS bond funds the last few years (a surprise). That means you can lose a lot in a short time, too.
And thanks for starting an enjoyable discussion.
Does anyone know how many years advance of retiring one should build the TIPS bond ladder? Do you do it the year you retire, or sooner? And does one build the ladder all-at-once, or incrementally over time?
ReplyDeleteI believe there is general agreement that you should reduce your stock exposure about a decade before retirement. You wouldn't need to build a ladder at that point, though you could. But, I'd go with bond funds then.
DeleteThe object of the bond ladder as we're discussing it is to provide income in retirement. You could build the ladder with the first rung maturing the first year of retirement and you'd need to do that before retiring. I personally don't think that's necessary.
I don't see much interest rate or inflation risk over a period of a couple of years or so, so I recommend you keep the first two or three years of your "ladder" in cash and short bond funds and build the next seven years' rungs from individual TIPs.
If you do it that way, you can wait until you retire to build the ladder and live off the funds while you do. I'd recommend building a 10-year ladder and extend it each year. Long bonds don't pay for their additional risk.
Sorry for the long answer. Does that help?
Matthew,
DeleteThis is a good question. I don't think there is any one right answer for it. Though certainly if you are still at least a few years in retirement, it seem like a good idea to me to start building the ladder in advance. Then you are less vulnerable to whatever interest rates happen to be precisely at your retirement date, and you can also buy more of the higher-yielding longer term bonds: such as buying a 10-year bond 7 years before retiring to get income in retirement year 3, rather than buying a 3-year bond at retirement.
In Michael Zwecher's book "Retirement Portfolios" he discusses the idea about how the transition from pre-retirement to post-retirement involves shifting one's bonds from funds to ladders as an incremental process.
Lots of things to comment on here – really enjoying this discussion! Here are some of my comments:
ReplyDelete1. Funds that hold bonds to maturity: Yes, we use Guggenheim’s Bulletshares for corporate and Ishares for munis, which have maturities every year through 2022 and 2018 respectively. These funds hold bonds to maturity and distribute the coupon interest along the way. The disadvantages are that they are not as precise as individual bonds (you get your YTM but the principal redemption value will vary a bit depending on the price at which you bought it). They also carry management fees (24 bps and 30 bps respectively). The primary advantage for the end-client is diversity - they hold about 100 bonds all maturing within about 3 months of the termination date of the fund. Their primary advantage for the advisor is their ease of purchase – just click the “buy” button like stocks. But, even with their shortcomings, these ETFs get the job done.
2. Inflation protection: Only TIPS can handle inflation automatically. To account for it with bond ladders held for income (“Income Ladders”), you have to guess at what inflation will be over time-horizon for the ladder and build it into the desired cash flow stream. Our demonstration tool at www.assetdedication.com allows for inflation protection of 0 to 6 percent (click directly on the word “Login” to get to the tool - if you click the popup link, you clicked the wrong one).
3. Bond fund durations: Attempting to buy bond funds with equivalent duration is messy and only approximates the match needed to fund a specific cash flow. An income ladder matches the duration perfectly, directly, and intuitively for the client, meaning they will be more likely to stick with it. So it seems difficult to claim individual bonds and bond funds are equivalent.
4. Dynamic Income Ladders: Setting up the initial income ladder is not too difficult for a smooth income stream. Our demonstration tool mentioned above does this. But knowing whether or not to roll it forward as each year passes – the dynamic problem - is more complex. I agree that most people endure random shocks to the system – divorces, health, accidents, etc. – but that hardly seems like an argument against setting up something solid and predictable such as a specific cash flow stream. Decreasing any of the factors contributing to a random environment ought to be welcomed, not disdained.
5. Smooth vs. lumpy withdrawal streams: Smooth streams are not too difficult, as Wade has shown. But lumpy cash flow streams can become mathematically complex and require non-linear programming, something best left to those who have the requisite expertise.
6. When to start an Income Ladder: No good answer to this. I personally like the gradual rather than “plunge” approach. I would let the time horizon dictate when to start. If a person is following the sustainable withdrawal rule (initial withdrawal of 4% or 5% then that dollar amount plus the prior year’s inflation thereafter), each year of income will cost about 5% of the portfolio assuming 3% inflation. So someone wanting an 8-year income ladder will allocate about 40% of their portfolio to fixed income in the form of individual bonds. They would thus buy an 8-year bond when they think they are 8 years from retirement. The next year, they buy another 8-year bond, and repeat this each year. When they reach the date when they thought they would retire, they will have 8 years of income lined up, ready to fire. All the rest of their funds can be devoted to equities or other growth investments. The plunge approach would buy immediately all 8 years of income (bonds maturing in 8, 9,…15 years) but at today’s low yields, the gradual approach seems better to me. An Income Ladder can be set up at any time, of course, and if a person is already retired, it still offers all the advantages that dedicated portfolios offer.
On the question on costs: we charge 35 bps to set up and monitor dynamic Income Ladders. We work only through advisors.
"The plunge approach would buy immediately all 8 years of income (bonds maturing in 8, 9,…15 years) but at today’s low yields, the gradual approach seems better to me."
DeleteAgree! If I were doing it today, I'd go slowly. I'm selling TIPs right now, not buying. Other than that, I don't see a real advantage to either timing.
Prof. Huxley,
DeleteThank you very much for sharing all of your expertise on this topic!
Excellent article, and excellent discussion. I just wish my spreadsheet skills were sufficient to rebuild your spreadsheet so that I could apply it to my personal situation. Is the spreadsheet available to be downloaded.
ReplyDeleteIn my case, I am doing the calculations in a program called Matlab, and then I just copied some output over to Excel to make the nice looking table. So I'm sorry that I don't currently have a spreadsheet. A fellow at the Bogleheads Forum named #Cruncher has made a spreadsheet about building a TIPS ladder though.
DeleteYou can read about it and download it at this thread:
http://www.bogleheads.org/forum/viewtopic.php?p=1350991
Regarding costs--here's a rough idea of what I'm hearing so far. Cost of the underlying investments (0 to 35 basis points), charge for laddering service (35 basis). If I add typical advisor charges of 50 to 100 basis points, that's 85 to 170 basis points annually.
ReplyDeleteIf one were seeking the lowest-cost alternative to a similar strategy, something like a 15% allocation to VAIPX and an 85% allocation to VTAPX (Vanguard's inflation protected securities and short term inflation protected securities respectively) to roughly match a 7-year ladder would cost 10 basis points. If one could find a competent hourly-fee planner to provide assistance, the all-in cost could probably be held to less than 20 basis points.
To get an idea of what it takes to buy TIPS directly and hold them to maturity, I checked out quotes on Fidelity.com. The bid-ask spread for the adjusted prices (which account for inflation adjustments to date and any accrued interest since the last coupon payment) is 0.85% for the 2043 maturity issue, 0.48% for the 2028 issue, and 0.29% for the 2021 issue. So the total one-time markup at purchase would be about half of these figures – quite small for something held for years. And there would be no other commissions/concessions for buying them and no fees for holding them in a brokerage account there. Of course, mutual funds also incur some costs to buy/sell/swap their bond holdings, but they are not transparent nor reflected in the published expense ratios.
DeleteIn my opinion, many people are quite capable of creating their own ladders in a discount brokerage account without a laddering service or ongoing advisor charges; this is especially important at a time when interest rates are so low and every basis point of fees really matters. Once a ladder of high quality bonds (e.g., TIPS) is created, very little maintenance is needed.
I agree. I set up a muni ladder at Fidelity a few years back. I called their bond desk, told them what I wanted, and over the next few days they called me with candidate bonds they had found. There was no charge for the service and we were done in about three days. Once the ladder is built, you do one transaction a year.
DeleteThanks Anonymous,
DeleteLooking at the bid-ask spread at services like Fidelity is a great way to understand what the underlying costs will be. Of course those spreads will be larger than what the WSJ reports for the wholesale market. But that way you can see the additional cost.
And you are right to emphasize that these are one-time costs, not annually compounded percentage fees connected to mutual funds.
I'm wondering why I'd want to build a short, eg. 8 year, vs. a 30 year TIPS ladder if all what I'm trying to accomplish is to match my future liabilities on an inflation adjusted basis for a 30 year glide path.
ReplyDeleteAssuming I have enough right now to fully fund my expected retirement liabilities for 30 years, ie. available funds >= yearly expenses * 30 years, it seems to me I have won the game and would want to minimize risks such as investment bad sequential returns and not keeping up with inflation.
By going with a short ladder, would I be trading off the additional liquidity and less exposure to raising interest rates against the risk of not being able to keep rolling over the ladder if the remaining investments do not at least keep up with inflation?
Your analysis is correct. The issue really comes down to personal preferences about upside potential vs. downside protection. Building the 30-year ladder is more secure, but the incremental security from going out that far may be rather minimal compared to a ladder of another length. In this case, a lot of upside potential may be given up for a small gain in downside protection. Do keep in mind that there is a possibility that one will live even longer than 30 years as well.
DeleteI think you should keep liquidity in the issues mix with upside potential and downside protection.
DeleteIf you actually live 30 years or so (most won't) and don't have a financial emergency, a long ladder makes perfect sense.
The problem with long bonds is that you are not well-compensated for the additional risk. That's not a problem if you hold them to maturity. But that assumes you will actually live 30 years or so and will not need the money for a health emergency, long term care or other crisis.
Since long bonds are much more volatile, there is a risk that you will need the principal for an emergency after bond prices have significantly declined and have to sell at a loss. There is also an excellent chance that you will not live 30 years and your heirs will not hold the bonds to maturity, so the losses will be realized.
These are similar to the problems many people have with life annuities.
Do you agree, Wade?
Dirk,
DeleteI agree with you that these are downsides to having a longer bond ladder.
I agree and am glad this conversation is continuing. Anonymous, you are asking a good question and I think the replies provide valid answers. As Wade says, this portfolio would last 30 years in real terms and in that sense you have won the game. But the game you have one is the simple game, the one mathematicians would call the “deterministic” game where future cash flows are known for sure – no unexpected emergencies, no change in standard of living, no deviation from the plan, etc. There would also be no legacy for heirs or charities, as Wade points out. In other words, you have won the static game (checkers) but life is a dynamic game (chess). The real world is full of random events that befall all but a few of us.
ReplyDeleteI can add some numbers to flesh out these responses. Shorter horizons release funds to be invested in equities. I ran some tests using Wade’s numbers. I assumed a person wanted $10,000 per year increasing at 5.4% per year, the highest rate it has ever been for all 30 year periods back to 1928 (the highest was 1965-95). The total amount to invest would be Wade’s $247,388.14 with time horizons of 5 and 10 years. The cost of the “Income Portfolios” using CD’s and agency bonds would be $44,756.73 and $104,105.89 for 5- and 10-year portfolios respectively. This would leave $202,631.41 and $143,482.25 respectively to invest in a Growth Portfolio.
If the Growth Portfolio consisted of equity index funds, how much would it earn? This depends on the equity funds selected. If our 7-15 year equity model had been selected, it earned an average of 14.2% and 14.6% over all 5- and 10-year spans back to 1928.
If we apply our dedicated portfolio and Critical Path strategies and continued to withdraw $10,000 per year increasing by 5.4% each year, the median value remaining in the overall portfolio after 30 years would be $2,704,930 and $1,252,618 for 5 and 10 year horizons respectively. The chances the portfolio would last 30 years would be based on the historical record back to 1928 are 78.2% and 67.3% respectively. (Both probabilities are above 90% if data since 1947 is used.)
Of course, that means there is some risk that it would not last 30 years, whereas Wade’s is guaranteed to last 30 years (hopefully, they will not be among the 1% or so who live beyond age 100) with a guaranteed zero balance remaining. But, on balance, I believe all but the most risk-averse retirees would opt for the shorter horizons.
Stephen-- Given William Bernstein's wisdom about stopping the game playing if you've already won (and I'm referring to your dynamic chess metaphor above, not the simplistic 30-year asset depletion or checker models), at what point of asset accumulation relative to projected expenses do you or can you advise retirees to skip equities and skip growth as an objective? Not everybody shares your unabashed confidence in "stocks for the long run" -- despite your elaborate back testing and front-end bond flooring approach -- and not everybody wants nor even needs to take the risks associated with growth or equities components.
ReplyDeleteStephen and Anonymous,
DeleteI think we need a bit more context about what it takes to "win the game." As I certainly agree with the idea of de-risking if one has already won the game.
But what comes out here is that a 30-year TIPS ladder supports a 4% withdrawal rate. If you spending goal in retirement is 4%, then you'd have to actually put all of your financial assets into TIPS, allowing yourself to "win" in terms of funding that "deterministic" spending goal.
But in reality, lots of the risks of retirement involve unexpected expenses which require having liquid financial assets available. As Dirk is discussing, the long-term TIPS in the bond ladder many not really be all that "liquid" in the sense that they may have to be sold for much less if needed for an emergency at a time that interest rates have risen. Harold Evensky makes the distinction here between "marketability" and "liquidity" as people tend to naturally assume that something is liquid if it can be sold with the original investment returned. But that's not the case. So really, someone wanting to fund a 4% spending goal can't really do it with just TIPS, since it would require putting everything into the TIPS ladder and then facing risk in the dynamic game of unexpected future expenses. As more of a reserve is created for the unexpected, the sustainable withdrawal rate starts dropping below 4%.
Now, if someone's deterministic spending goal in retirement represents a 2% withdrawal rate, then they could use half of their assets to build a 30-year TIPS ladder, and this would fit well into the context of the "safety-first" retirement. It's a viable option.
Anonymous, I do share your concern that time segmentation approaches have only been tested on US data since 1926, and I've written a lot how that period may not be fully reflective of what may happen in the future.
These comments are really getting at the heart of the issue that divides the "probability-based" retirement income approaches and the "safety-first" retirement income approaches. Prof. Huxley's Asset Dedication approach is part of the "probability-based" family. He had a great quote in a discussion included in the American College's RICP curriculum which I now include in presentations, as I think it effectively summarizes his point so well. So, quoting the professor:
“It would be great if everyone had over their lifetime saved enough money so that they could in fact buy 30 years worth of TIPS to protect themselves. That would be terrific. Unfortunately, most of us haven’t done that, and so consequently you have to assume some level of risk and then go with the flow and hope that things work out and make adjustments along the way if you have to.”
Another good question - when does one stop accumulating? As each year passes, the probability of needing 30 years of income decreases and thus the risk of running out of money declines so long as nothing unusual happens. But the unpredictability of life never ends: a car accident to yourself or a loved one, your child goes through divorce and needs help, etc., can change life in an instant. Holding laddered TIPS to maturity can avoid market and inflation risks but not all the other risks associated with being a human being.
DeleteSo is it unclear to me that a prudent person can or should ever skip growth entirely as an objective. Indeed, it could argued philosophically that, even if satisfied with one’s own personal and family situation, so long as there remains one starving child in the world, planning should include leaving as large a legacy as possible to a charity feeding that child.
From the standpoint of a dedicated portfolio strategy, the question evolves to asking at what point does one stop extending the ladder? If one had a 15 year ladder at age 90, would he or she extend it out the next year? I doubt it. As the probability of the money lasting until one’s death rises to 98%, 99%, etc., I suspect attention would turn to building as large a legacy for one’s children (or grandchildren) as possible. If heirs are deemed sufficiently endowed, feeding that starving child or similar good works would like become the focus. The bottom line is that it seems wasteful and against human nature to ignore growth. I believe this is what economists refer to as one of the fundamental axioms of economics: the “non-satiety” axiom, meaning someone, somewhere, can always use more money.
Regarding back testing, it is true that the span back to 1926 may not be indicative of the future. Wade has shown elsewhere that the 4% rule does not work so well in other countries, so who can know? Like most other situations, all one can do is take actions that appear reasonable based on due diligence and existing circumstances and be ready to make changes depending on what happens. It is another argument in favor of probabilistic models. In a sense, it is similar to Maslow’s hierarchy of needs theory - as one wins one game, a new one takes its place. I suspect that the transition from one game to the next is fuzzy and always subject to the dynamics of the situation. So how best to calculate a strict cut-off point to stop extending the ladder in advance appears to be an unanswerable question. It will be determined by unknown circumstances in the future.
Yes. It is difficult to manage and follow the economical plans. Financial status plays crucial role in secured life. Invest in stock market to balance financial status.
ReplyDeleteRetirement Income Planner
Coming late to the party? TIPS and I savings bonds were yielding 3.5-4 percent over inflation fourteen years ago and you could purchase up to $30,000 annually of the savings bonds if taxation were an issue. Of course back then no one seemed to want any.
ReplyDeleteProbably nobody wanted them because in the late 1990's the Great Bull Run was at full strength with equities returning 20% and better! The internet, end of the Cold War, etc. created a frothy optimism. The tech crash of 2000 followed by 9/11/2001 soured the economy and we are still digging out of it. The best laid plans....
DeleteWell when I calculated what the IRR of a portfolio that allowed me to withdraw 4% real for thirty years was (about 1.25% I believe) and realized that I could get the same income from the TIPS I was astounded. All those stocks, bonds, REITs, small-cap stocks, foreign stocks.... All to achieve a mean rate of return of 1.25% real? Plus at the end of thirty years you would still have your original (real) capital with the TIPS. Seemed like a once in a lifetime opportunity, and perhaps it was at that. Fred
DeleteFred,
DeleteAre you talking about the situation in the late 90s? Yes, back then, being able to lock in a 3.5-4% real return over 30 years probably was a once in a lifetime opportunity. If I could get a real return of 4% today, I'd probably move everything to that. In my own planning spreadsheet I assume a compounded real return of 2%.
Well even if we assume a real net yield of zero, after taxes and inflation, that equates to an annual real withdrawal rate of 3.33% for thirty years. After which you are broke of course, but after watching the stock market average negative inflation-adjusted returns for ten years (2000-2009) I'm inclined towards caution myself. Fred
DeleteThanks for the insights on TIPS ladders. I'm just a retired individual investor who uses TIPS in my portfolio, but I think you could build a better inflation protected ladder to provide modest amounts of future real income ($20-30K/year) by replacing the TIPS in your example ladder with series i bonds for the 1 to 6 year in the future rungs of the ladder. First the series i's have a positive real income (as opposed to the negative real YTM of the short term TIPS). Second, if you do need the principal sooner than you expected, you don't have interest rate risk with the series i. Conversely, if you don't need the income as soon as you thought, you can let the i bonds continue without the interest rate risk that accompanies the need to reinvest funds from matured TIPS. Finally there is no bid-ask spread on series i. What's not to like about these??? In the past two years I've sold as many of my 3% or so YTM 20 year TIPS as the government allows me to reinvest in series I and done that. The only downside I see is you can't buy very much.
ReplyDeleteThanks. Right, they are such a good deal that the government limits how much we can buy. I purchased my first I-bonds in 2013 and plan to continue doing so in the future. The only downside I can see relates to holding them as a long-term investment. If you buy and I-bond today and hold it for 30 years, your real return is 0.2%. This compares to 1.5% for a 30-year TIPS, if you could hold that TIPS in a tax-deferred or tax-free account. But at the shorter end of the maturity spectrum, you are right!
DeleteHI All,
ReplyDeleteFidelity bond ladder tool helps you build a staggered fixed-income portfolio that provides a consistent income stream. It is easy to build a ladder of short or medium term savings.
Thanks for this informative post theretirementgroup
I am recently retired and want to secure a floor of income with a TIPS ladder but I'm not smart enough to figure it out. Surely many others retirees would like to do the same. The problem for many of us is the difficulty that comes with building ladders. Will there ever be financial products that make might make it easy? Hopefully in the near future there will be something akin to target date funds but for bonds ladders or ready made TIPS ladders of varying lengths. I am fortunate that retirement allows me the time to read and follow the research of many of you, otherwise I would not be aware of lifecycle investing or income flooring. Thank you all for your research.
ReplyDeleteDear Anonymous -
ReplyDeleteI don’t wish to use this forum for marketing, but it is our business to build dedicated portfolios similar to the one Wade built. We wrote a book on the application of dedicated portfolio theory and how it can be applied to personal financial planning (Asset Dedication, McGraw Hill, 2005).
Unfortunately, these Income Ladders, as we like to call them, usually have to be custom-built. You can buy defined maturity funds through Guggenheim's BulletShares with corporate bonds and iShare with muni bonds, but I am not aware of any that offer TIPS. In fact, even with the defined maturity funds, they will not tell you how much to buy in order to match the stream of future liabilities that income withdrawals represent. Hope this helps and will not be construed as a sales pitch.
To implement a dedicated portfolio, whether funded by TIPS or otherwise, you will need to have a comprehensive plan in place that includes a projection of your desired cash flows over whatever time horizon you choose, lifetime or otherwise, before the dedication strategy can be implemented. If you are already working with an advisor, you can have him or her contact us or we can provide you with a list of recommended advisors familiar with our dedicated strategy. You can visit our website (www.assetdedication.com) or contact me directly at huxleys@assetdedication.com if you would like to get more information.
Dear Dr. Huxley,
DeleteThank you for helping to answer the questions. I don't view it as marketing, since Asset Dedication is the only company I'm aware of that is addressing these issues in an educational type of way (not a salespitch-y way) on a widespread basis.
About building a TIPS ladder, one of the mysteries for me is what to do when it comes time to extend the ladder with coupon bonds.
I mean, initially, you can plan the ladder out to get the precise income you desire for each year of the ladder by combining coupons and principal in the way I outlined above.
But next year, when it comes time to extend the ladder, if you use a coupon bond to do that, you are then suddenly getting too much income from the coupons in all of the previous years. Are you planning for this in advance by leaving some of the income needs unfulfilled initially in anticipate that you will then fill those when extending the ladder in the future?
There is certainly no need to answer this, but I just thought I'd throw the question out there, as this explains why I switched to using Treasury Strips when writing at Advisor Perspectives. It's not an issue if there are no coupons.
Best wishes, Wade
Dear Wade -
DeleteSorry - I missed this very good question earlier. It is good because it takes the discussion to a deeper level. Most people looking at dedicated portfolios think only about the initial portfolio. Those don't comprehend the dynamic element that must be faced as time passes and bonds in the initial portfolio begin to mature and do their job. This is why I wish more researchers would begin to investigate dedicated portfolio theory instead of minor nuances of MPT.
There are at least two ways to handle the problem you mention, neither of which is perfect.
The first you have already discovered - add a zero bond with no coupons. This leaves the original stream untouched. The only problem with this is that it will ultimately lead to a portfolio that consists entirely of zeros. There may be nothing wrong with that except zeros may behave differently than coupon bonds. Presumably, they would be more volatile. This should not matter if held to maturity but clients may get nervous.
The second, easier solution, is to tell the client to reinvest the extra cash that flows in over and above the planned income. This would require discipline from a behavior aspect but solves the problem. Of course, extra income can arrive from any other investment approach, so this problem is not unique to the dedication strategy. It is that a dedicated portfolio draws attention to it so that it cannot be ignored.
I really appreciate the thought and work you have put into this area, Wade. I wish more researchers had the the same amount of intellectual curiosity that you do!
Hi,
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