Thursday, January 30, 2014

Untangling Retirement Strategies: Systematic Withdrawals

The large number of funding strategies available to someone planning retirement can be overwhelming. We've got sustainable withdrawal rates (“the 4% Rule”), floor-and-upside, bucket strategies, dividend strategies, cash reserve strategies and then there's the strategy economists love and consumers hate, purchasing life annuities.

No one says you have to limit yourself to one strategy, so you can combine these and others to generate an enormous range of hybrid strategies to fit your specific financial situation. Retirement planning isn't simple.

It sounds like a lot of choices, but I think of all of these as variations of four basic strategies. The rest are either combinations of these four strategies or variations on a theme:
  • Systematic withdrawal strategies
  • Floor-and-upside strategies
  • Time-segmentation or “bucket” strategies, and
  • The “purchasing life annuities” strategy
Let's compare these strategies using eight criteria. First, who are the biggest advocates of the strategy, economists or the financial services industry? I'm always skeptical that the latter has something to sell me (stocks), but some economists are employed by financial services companies and insurance companies, so there's reason to question credibility on both sides. A vital component of critical thinking is considering the source.

Each strategy has a spending plan that determines how much the retiree can withdraw annually. Each strategy also has its own investment strategy, another key consideration.

Liability-matching is identifying current financial resources that will be used to pay for a future expected amount of spending. We might set aside funds now to invest to pay for college in 15 years, or identify funds that will pay for each individual year of our future retirement. A liability we may have to pay off in twenty years may be one best funded by stocks, while a liability we will need to pay in the next couple of years might be better paid with funds invested in a money market account. Some retirement strategies match liabilities with available resources and others don't.

The greatest financial risk of retirement is longevity risk, the risk that we will live so long that we run out of money. Some retirement strategies provide better guarantees against longevity risk than others.

Some strategies provide for a secure minimum “floor” of annual income that you will be able to spend no matter how the market performs. Others have no floor.

Some strategies offer the possibility of improving our initial standard of living in retirement if our equity investments perform well, while other strategies offer no such “upside potential”. And lastly, most retirement strategies leave us in control of our own retirement savings, though life annuities do not.

Let's look at the four major strategies using these eight criteria starting with systematic withdrawal strategies.

The most popular systematic withdrawal strategy is the Safe Withdrawal Rates (SWR) strategy, sometimes referred to as the “4% Rule”. It is the most commonly recommended retirement funding strategy and, since it proposes the retiree invest heavily in stocks and bonds, it is quite popular with the financial services industry. Most economists believe it is deeply flawed (I agree with them).

The amount you can spend with SWR changes depending on how much longer you expect to live in retirement and your current portfolio balance. The studies show that the annual "safe" spending rate ranges from about 4.5% of your portfolio balance the first year of retirement to nearly 10% of your remaining portfolio balance when you expect about 10 more years in retirement.

The SWR studies are often purported to show that you can spend a constant dollar amount throughout retirement that is about 4.5% of your initial portfolio value, but this is an incorrect interpretation of the study results. If you continue to spend a constant dollar amount after your portfolio decreases significantly in value, you increase the risk of depleting your savings before you die. The reverse is true if your portfolio value increases.

In practice, financial advisers will advise you to spend more when your portfolio value increases and less when it falls. Hence, the amount you can spend annually using systematic withdrawal strategies varies with major moves of the stock market, up or down.

Recently, the 4.5% “safe” rate has been revised downward to about 4% by new studies and researchers like Wade Pfau now suggest that the rate may be closer to 3.5%. A reduction from 4.5% to 3.5% may not sound like a lot at first glance, but in actuality it is a 22% decrease in the amount of money you can spend. The former provides spending of $4,500 annually from a $100,000 portfolio, compared to $3,500 a year for the latter rate.

Looked at differently, if you can safely spend 4.5% of your initial savings annually and want to spend $10,000 a year in retirement, you would need to save $222,222. If you can only spend 3.5% in retirement, you need to save $285,714. You would have to save 29% more. That 1% in question is actually a huge difference.

Even these low spending rates result in a predicted 5% to 10% portfolio failure rate. The longevity risk mitigation mechanism for these strategies is to trust back-testing that shows had you lived in 90% to 95% of rolling 30-years periods of stock market history you wouldn't have gone broke.

The spending plan for systematic withdrawal strategies is to spend an unpredictable (market-determined) 3.5% to 4.5% of current portfolio value annually with a 5% to 10% chance of going broke in old age. Reducing the spending rate improves portfolio survival chances.

Note that this spending plan is also used, at least in part, by some of the other three retirement strategies.

The investment strategy for systematic withdrawal strategies is sometimes referred to as a “total return strategy”. Rather than allocate portions of the portfolio to match various future liabilities, the strategy attempts to create a single pool of wealth, typically using modern portfolio theory's mean-variance optimization. In other words, it seeks a portfolio stock/bond allocation on the efficient frontier appropriate for the retiree's attitudes toward risk, hoping to achieve the highest possible portfolio return available for a given amount of portfolio volatility (risk).

To oversimplify, the systematic withdrawal strategies assume that if you can create a large enough single pile of capital, your other financial problems longevity risk, a spending floor, liability matching will take care of themselves. Systematic withdrawal strategies map all future liabilities to a single portfolio.

You always maintain control of your investment capital with systematic withdrawal strategies and there is a possibility that your investment results will be so good that you will be able to increase your standard of living in the future. Along with that comes the possibility that your investments will perform poorly and that your future standard of living will decline.

So, to sum up systematic withdrawal strategies, invest all your savings in a portfolio of stocks and bonds with an asset allocation based on how much volatility you can stand. Forty or fifty percent stocks would be about right for many people.

Spend 4.5% of the remaining portfolio value each year, which is an unpredictable dollar amount. (Maybe it's only 3.5%, though.) Increase the percentage gradually to about 10% when you're 85 or 90, though your portfolio balance will likely be declining as the withdrawal percentage increases.

Your future standard of living might improve or worsen, depending on your investment results. People who sell stocks and bonds will love you and you will always have control of whatever's left of your savings.

Who would be attracted to a pure systematic withdrawal strategy?

Someone who is comfortable with a 5% to 10% chance of running out of money in retirement. Someone who believes the stock market will always go back up if we wait long enough and who isn't panicked by large swings in his net worth. And someone who doesn't need guaranteed consistent annual income or a floor beneath which her spending will not drop. Perhaps someone whose income floor is adequately provide by Social Security retirement benefits and other pensions.

Some people like a dividend strategy. They buy stocks that yield high dividends and plan to spend only those dividends. They hope their stock prices will preserve their principal.

This is a variation of the systematic withdrawal strategy theme with no bond allocation and not much equity diversification, either. Due to this lack of diversification, it is riskier than the run-of-the-mill systematic withdrawal strategy but otherwise shares the same characteristics.

I'll talk about the life annuities strategy in my next post.

Monday, January 27, 2014


If you build a ten-year TIPS ladder to secure retirement income instead of a 30-year ladder, why would you invest the funds for years 11 through 30 in stocks instead of short term Treasuries?

That's the question a reader posted after my last blog, How Many Rungs?, and it's a great question. I like it because it gives me an opportunity to talk about risk. Risk is as important as return, but it seems to me it gets far less ink (or fewer pixels, as the case may be).

My last post suggested that instead of investing in a 30-year bond ladder, a retiree might build a ten-year ladder and invest the funds for future years in a bond fund or stocks. A reader asked why it wouldn't be safer to invest that money in 2- or 3-year TIPS instead of stocks.
The answer depends on which risks you're trying to avoid.

And here's a key point. No financial strategy is without risk.

Some strategies have downsides that are more likely than others and some have downsides that are more devastating than others, but all have risks. Even deciding not to invest at all has risks. You have to choose which risks you want to accept and which risks to avoid or mitigate.

Long TIPS ladders are a component of the floor-and-upside retirement income strategy, the one I prefer. This strategy recommends that we first make sure our critical income needs are provided safely before investing any remaining capital in a risky portfolio. If the market is kind to us in retirement, we improve our standard of living. If the market fails us, at least we still have lunch money.

Another strategy, referred to as time-segmentation or the "bucket strategy" and preferred by about a fourth of advisers, recommends allocating capital to different time periods of retirement (buckets) and investing the retiree's portfolio in assets appropriate for each time period.

For instance, retirement savings might be invested in cash to provide income for the nearest five years of retirement, bonds for 6 to 10 years in the future, and stocks for the 11- to 30-year bucket. The theory here, based on the length of time those three asset classes have historically needed to recover from losses, is that five years isn't long enough for bonds or stocks to recover from a downturn, and ten to fifteen years is long enough for bonds to recover before you need to sell them, but possibly not long enough for stocks.

Building a shorter TIPS ladder and investing the capital for the more distant future in bond funds or stocks is a hybrid of these two strategies that provides a compromise among the risks of the two.

Let's consider this in light of the reader's question.

The amount of capital required to fund years 11 through 30 of your retirement is probably quite large. Short term TIPS are basically cash investments and won't provide much more return or risk than a money market fund. My first question would be whether I wanted to tie up a large portion of my portfolio in low-yielding cash investments for a long time. The bucket strategy theorizes that bonds or stocks would be more appropriate assets for that time period than cash.

My next question would be what holding this much cash would do to my overall portfolio allocation. Holding a lot of cash would lower the portfolio's expected return and reduce its risk. Is this the portfolio allocation that fits the rest of my retirement plan?

I noted the risks of a 30-year bond ladder in my last post: the possibility (probability, actually, when you consider mortality) of not being able to hold those bonds to maturity, the poor risk-adjusted return of long bonds, and the possibility of locking in low returns. Wade Pfau pointed out that we don't lower risk much by building the ladder beyond 20 years.

What are my risks if I build a 10-year TIPS ladder and put the money for years 11 through 30 in short TIPS/cash? Primarily, there is the opportunity risk of investing in a low-return asset for ten years. There is also a risk that my overall portfolio will have less than optimal equity exposure if I hold this much cash.

The retiree could also invest that money in intermediate TIPS bond funds. (If you're wondering why I would prefer bond funds to simply extending the bond ladder, see my previous post, Funds and Ladders.) What are the risks of that approach?

Again, there is a risk of opportunity lost by not investing in higher-returning equities, though the expected return of intermediate TIPS bond funds would be higher than that of short TIPS. There is a risk that interest rates will rise significantly and the bond funds will lose value. Bond fund volatility is similar to stock fund volatility. If I invest this money in either type of fund, there is a risk that fund will lose value and I will need to sell shares at a loss.

And finally, what are the risks of investing that money in equities? Obviously, there is a risk that the equities will decline in value. That's a problem if we have to sell them after a downturn but before the market recovers, but we don't have to sell stocks for a long time with this strategy because we have the next decade of income secured by the TIPS ladder.

The reader also asked if my approach using equities would introduce sequence of returns (SOR) risk.

Absolutely. Any time your strategy involves selling stocks at some point in the future there is SOR risk. That's what SOR risk is: variance of future stock prices when those future sales occur. That risk is mitigated, again, by the fact that I don't have to sell stocks for up to 10 years, thanks to my  bond ladder. For example, I wouldn't have sold stocks in 2008 to replace a rung of the ladder. The risk is there, though.

Normally, I wouldn't recommend equities for the secure "flooring" portion of a retiree's portfolio, and I'm not really doing that now. I'm holding the funds in equities that I will use to buy secure flooring at some future date.  By having the next ten years of my spending secured by the TIPS ladder, I am personally more willing to accept that market risk and wait out a downturn.

You might not be.

Your overall portfolio allocation also comes into play, because investing that much money in bonds or cash might limit your equity or bond allocations. I needed the additional equity exposure, which factored into my decision to invest in stocks. Had my portfolio needed less equity exposure, I would have invested that money in intermediate TIPS bond funds.

Still, as the reader pointed out, there is a possibility that money I have designated to secure future guaranteed income flooring is at risk when invested in stocks if the market falls and won't recover for a very long time. There is a similar risk of interest rates rising and not recovering if I invest in a bond fund.

If you want to ensure 30 years of inflation-protected retirement income, the safest way to guarantee that income is to build a 30-year TIPS ladder.

You will need to accept the risk that you might be forced to sell long bonds at a loss after a rise in interest rates (because you have a financial emergency or because most people won't live 30 years after retiring). You will need to accept the opportunity risk that you might have profited more from stocks, to accept the risk that you are locking in low interest rates for the next three decades, and you will have to accept the risk of the increased volatility of longer bond prices. You will need to accept a poor risk-adjusted return on your long bonds, and perhaps to accept the risk that your portfolio will have suboptimal equity exposure.

But your income will be as safe as it can be for as long as you live, up to 30 years.

It comes down to which risks you want to avoid, because you're going to have some risks not matter which strategy you choose.

Friday, January 24, 2014

Bonds Now?

After my last few columns on TIPS bonds, beginning with Why Bonds?, several people have asked what I would recommend they do to implement a bond portfolio for retirement income today. One reader asked if I could recommend funds.

(That reader posted a comment while I was on vacation and I somehow lost the post. I apologize. I try to respond to every reasonable comment.) 

I don’t generally recommend specific products. I am a firm believer in index funds, so I look for mutual funds and exchange-traded funds with low cost. However, I have read that iShares Barclays TIPS Bond Fund (symbol TIP) and Vanguard Inflation-Protected Securities fund (symbol VIPSX), together hold half of all TIPS dollars invested through fund companies. I have owned both at one time or another. Charles Schwab also offers Schwab Treasury Inflation Protected Securities Index Fund (symbol SWRSX).

I would head to Treasury Direct for TIPS bonds to be held in a taxable account with no purchase fee, though that is often the worst place to hold them because of their tax problems. To hold TIPS in a retirement account, you need to buy them on the secondary market though a brokerage that offers retirement accounts. Treasury Direct does not.

You can find a list of all outstanding Treasury bonds, strips (zero-coupon bonds) and Treasury inflation-protected securities (TIPS) at The Wall Street Journal’s Market Data Center. That doesn't mean all of those bonds are available to purchase, however. Check with your brokerage's bond desk for available issues. (The Fidelity and Vanguard bond desks have been extremely helpful in answering questions and helping find the kind of bonds I want.)

So, what would I do about securing future income with bonds today?

I'd wait.

Interest rates are at historical lows today. They have been held down artificially by Federal Reserve Board actions responding to the 2007 global financial crisis. While I don’t believe anyone can predict future interest rates, it would seem that there’s is a lot more room for rates to go up than further down at this point. The Fed has announced it’s intentions to let rates rise in the near future.

Buying bonds today would lock in historically low interest rates. Wade Pfau recently provided an analysis showing that rates are currently so low that a retiree can only buy about 27 years of income today with a 4% annual withdrawal rate.

Purchasing future guaranteed income is historically expensive today and if I were you, I would wait until it is cheaper. (I wonder if the Fed realizes how badly their actions have impacted older Americans.)

Furthermore, as rates rise, bond values will sink. Although I prefer TIPS ladders to funds, funds would likely be the better bet if you insist on purchasing them today because they will take better advantage of rising interest rates than a ladder will.

I recommend you stay in short term, high quality bond funds (which, themselves, provide inflation protection) and cash until rates move up closer to the historical 2% real return for TIPS.

Monday, January 20, 2014

How Many Rungs?

You could build a bond ladder that lasts as long as you think you might live, say 35 years. But, should you?

You could buy TIPS bonds, for example, that mature in 2015, 2016 and so on out to 2049. Each year when bonds matured you would spend that principal. That’s a 35-year ladder.
If TIPS returns match their long-term real average of 2%, you could spend 3.9% of the initial value of your total investments in the bond ladder each year and your bond ladder should last exactly 35 years, at which time you would have spent all the interest and all the principal. A 30-year ladder under the same circumstances would have an annual payout of 4.46%1.

In comparison, systematic withdrawal strategies estimate a payout of about 4%, though you might end up with some capital to leave to heirs, and an inflation-protected single-payment fixed annuity currently offers a 65-year old couple with 100% survivor benefits about 4%.

(TIPS bond yields are significantly lower than 2% right now, as the graph below shows, so you can’t do that today. I’m guessing you will be able to again within the next few years as the Fed stops holding rates down. As a matter of fact, purchasing secure future retirement income, or "flooring", either with bonds or annuities, is extremely expensive right now.)

You could also build a rolling ladder of any shorter length. For example, you could build a 10-year ladder with bonds that matured in 2015 through 2024. You could set aside capital to fund living expenses after age 74 in a stock index mutual fund. 

When the 2015 bonds mature, you would spend the principal and interest and purchase 2025 bonds with funds from your stock portfolio, keeping the ladder length at ten years.
The next year, you would spend the interest and principal from the matured 2015 bond and purchase a bond maturing in 2025 with funds from the stock account.

Why build a ladder shorter than the length of life you might live?

Because long bonds are very sensitive to interest rates and behave more like stocks than bonds of shorter maturity and because stocks have a better risk-adjusted return than long bonds.

Let’s look at the short end of the ladder first. You probably want a couple of years of expense money, three at the most, in cash or short term bonds. Inflation isn’t my greatest concern; persistent inflation is. The money I keep in cash or short term bond funds will compensate for inflation in the short term. So, I prefer cash and bond funds for the first three years of the ladder. Individual bonds aren’t as liquid and, frankly, aren't worth the effort.

Now, let’s look at the long end of the ladder.  Long bonds suck. Their return doesn’t reward their extra risk.

A 4% return earned from a small cap growth stock isn't the same as a 4% return from a blue chip stock because you took much more risk to earn the former. We can measure risk-adjusted return with the Sharpe ratio. The higher the Sharpe ratio, the better the investment's returns are relative to the amount of risk taken. Vanguard Small Cap Growth Index has a Sharpe ratio of 1.0, while the S&P 500's is 1.3.

Vanguard Intermediate-Term Bond Index Fund Investor Shares has a Sharpe ratio of 1.24, and Vanguard Short-Term Bond Index Fund Investor Shares sports a Sharpe ratio of 1.64. But, the Sharpe ratio for Vanguard Long Term Bond Index Fund is a measly 0.7. You get a tiny bit more return from long bonds but you take a lot more risk.
As you can see from the table above, the volatility of long-term bonds, as measured by standard deviation of returns, is much closer to the volatility of an S&P 500 stock dividend index fund than to that of an intermediate-term bond fund2.

As the chart below from a recent Wade Pfau paper entitled, "How Do I Build a TIPS Bond Ladder for Retirement Income?" demonstrates, interest rates rise quite rapidly with bond maturity up to about ten years. The return curve flattens out from 10 to 20 years, before becoming quite flat at 20 years. As you can see, the return for a 30-year bond isn’t much higher than that of a 20-year bond.

As Wade points out from his analysis, "One conclusion which does emerge is that there is relatively little additional safety to be gained from extending the bond ladder beyond about 20 years."

The sweet spot appears to be the intermediate range of bonds with maturities longer than 3 years but less than 7 to 10 years. Stocks, on the other hand, rarely lose money if you hold them 10 years or more. I’d prefer to hold my “secure floor capital” in stocks for floors beyond 10 years (though I would also be OK with holding that capital in an intermediate-term bond fund if I needed to do so to maintain my overall portfolio allocation).

As my ladder rolls forward, I will spend the maturing bonds and add an additional rung at the top of the ladder with funds from this stock allocation. 

As I have discussed in recent blogs, TIPS bond ladders are relatively free of interest rate risk if we hold individual bonds to maturity. The problem with this strategy is that we might be forced to sell bonds from the ladder before they mature. If interest rates rise, the value of our bond ladder will decline. Should a medical emergency or the need for long term care, for example, force us to sell bonds we intended to hold to maturity after rates have risen, we might take a loss on the bonds sold.

We have to plan for a long retirement because the results of planning for an average life span and then living a long time could be disastrous. Still, most people won’t live into their nineties and those with long bond ladders who don't live a long life won’t be around to hold those bonds to maturity.

Long bonds are much more sensitive to interest rates than intermediate or short bonds. A long bond might have a duration of 16 years, while an intermediate bond has a duration of 6.7 years and a short bond 2.7 years. That means a 1% increase in overall interest rates might result in a 2.7% decline in the price of a short bond, a 6.7% drop in the price of an intermediate fund and a decline of 16% in the value of a long bond.

The greatest bond risk, then, is at the long end of the ladder and that is also the end that has the lowest risk-adjusted return. The longer your bond ladder, the worse its risk-adjusted return and price volatility, and the greater likelihood that you will be forced to sell long bonds before they mature.

One last idea you might consider. We often have discussions about whether annuities or bond ladders are better, but they aren't mutually exclusive. If fixed annuities interest you, the sweet spot for purchasing them is around age 70 to 72, when mortality credits are higher, making the payouts larger. You could build a TIPS bond ladder to cover your income to age 70 or so and then purchase a fixed annuity.

I like a 10-year ladder with the capital for future rungs held in stocks until needed. That way I avoid the worst interest rate risk and lower risk-adjusted return of long bonds and add some upside potential from the stocks. I keep cash to cover the first year of the ladder and use high-quality, short-term bond funds for years 2 and 3.

There are any number of ways to create a rolling bond ladder, or a single long ladder, or a combination of a ladder and fixed annuity, depending on your resources and your attitude toward risk.

But this is how I roll.

1The present value of a 35-year annuity paying $1.02 a year and discounted at 2% is $25.49. A $1.02 annual payout on a $25.49 investment is 3.9%. A 30-year ladder under the same circumstances would have a payout of 4.46%.

2This doesn't mean you should replace the long bonds in your portfolio with stocks. While long-term bonds may have volatility similar to stocks and a worse risk-adjusted return, bonds have a relatively low correlation to stock returns, which means bonds are still vital to reduce the volatility of your portfolio. My point is that intermediate-term bonds are probably a better bet for maintaining your portfolio allocation than long-term bonds.

Monday, January 13, 2014

Funds and Ladders

Retirees who decide they want to fund at least some of their retirement income with Treasury Inflation-Protected Securities, or TIPS bonds, have a choice between investing in a ladder of individual bonds or a fund of TIPS bonds. Wade Pfau recently asked at his blog which retirees should prefer.

I first tried to answer the question “Why Bonds?” and then the question “Why TIPS bonds?” before mulling the choice between individual bonds or a fund of bonds. The most important thing to know about these two investments is that an individual bond (or a ladder of individual bonds) is in many ways a very different animal than a bond fund.

The second most important thing to understand is that neither is a better tool than the other in every application. For some purposes, individual bonds will be better and for others a fund will be more suitable.

The topic of bond funds versus ladders has been discussed at length at the Bogleheads website, with the general conclusion that bond funds are no worse than ladders and probably better. When interest rates rise, the fund's value will decline, but the fund will reinvest in bonds that pay higher interest and in the long run, all will be well.

On the other hand, William Bernstein has a well-known dislike for TIPS bond funds because they can't be held to maturity like an individual bond. Their net asset value fluctuates over time so bond funds behave a lot like stock funds. Bernstein believes that our risk-free portfolios should be totally risk-free, so he prefers ladders for retirement income and other known future liabilities.

How do we rationalize two distinctly different views of people who really know what they're talking about? By recognizing that they're talking about two different uses of bonds.

Individual bonds (and ladders of individual bonds) have the unique ability to provide a risk-free, inflation-protected amount of capital at some future date if they are held to maturity. Funds can't do that. That makes bonds an ideal way to fund a future liability, such as a year of retirement income.

Bond funds, on the other hand, do a better job of reinvesting interest without you having to buy an entire $1,000 bond and of rolling into higher return bonds when interest rates rise. That makes funds a great alternative if your goal is to reduce portfolio volatility.

Using a bond ladder to diversify with no targeted future liability, you would purchase a new bond each year with the proceeds of a maturing bond. You would find reinvesting the interest challenging.

Using a ladder to fund retirement, you would spend the interest and spend the principal from matured bonds, so reinvestment isn't an issue. New bonds would be purchased at the long end of the ladder with funds from your stock portfolio.

They're two very different scenarios. I agree with Bernstein when we're talking about generating retirement income (use a ladder) and the Bogleheads when we don't have a specific target date (go with a fund).

Let's look at how each tactic compares in some critical ways.

Holding to Maturity. A bond has a single maturity date when you can be assured that your principal will be returned in full, and TIPS bond principal will be increased at maturity to compensate for the inflation you have experienced. A fund has many bonds with many maturity dates that may or may not be held to maturity by the fund's managers.

Like funds, the value of your bond ladder will rise and fall opposite of interest rates over time, but you have the option of holding bonds to maturity and knowing their values at that future date. The value of a bond fund at any specific date in the future will be unknown. It might be higher or lower than an individual bond would have been.

For example, let's assume I can choose between a $1,000 TIPS bond that pays 2% real interest and matures in ten years on January 15th, 2024 and a TIPS bond fund that holds similar bonds. On January 15th, 2024, the TIPS bond will be worth $1,000 in 2014 dollars. I would be able to sell the fund on that date at its net asset value, which might be more or less than $1,000 in 2014 dollars, depending on interest rates between now and then.

Reinvestment Risk. The interest paid by an individual bond ladder may be difficult to reinvest optimally because it won't typically be enough to buy another $1,000 bond. The interest will probably end up in a low-return cash fund.

Bond funds reinvest easily. Bond funds are a better solution to reinvestment risk if your bonds are intended to mitigate portfolio volatility. Interest from bonds purchased to provide retirement income, however, will be spent, not reinvested.

Minimum Investment. TIPS bonds are issued with $1,000 face value. Investors with small amounts to invest will find a fund easier to deal with.

Capital Gains. Jane Quinn argues that if you buy and hold a bond ladder to maturity, you can't take advantage of capital gains if interest rates decline, while a managed fund could. True as stated, but no one says you must hold individual bonds to maturity and that you can't change your mind.

I purchased TIPS two years ago and was amazed to see the tremendous price increase in such a short time for a risk-less investment. I purchased the bonds to hold, but sold when I realized I had probably benefited from a relatively temporary run-up of prices.

(For the opposite side of the Quinn arguments, see Larry Swedroe's response.)

Maintenance. Of course, it's easier to buy a fund and let someone else do the work if you're OK with the disadvantages of a fund, but I don't find maintenance of a TIPS ladder onerous. A Fidelity representative helped me set up a ladder several years ago and did most of the legwork for free. He called me occasionally with a few choices and we had it set up in about three days. Since then, major brokerages, including Fidelity, have provided online tools that simplify the process. After the ladder is set up, you buy one more rung every year.

Diversification. Owning diverse securities is usually a huge benefit of mutual funds. TIPS, however, have no credit risk, so diversification is not an issue as it would be for municipal and corporate bonds.

Cost. TIPS are a cheap asset to purchase in any form. You can buy individual bonds for free online at Treasury Direct. Several large brokerages sell them with no fee. Of course, you will pay half the bid-ask spread when you purchase them on the secondary market, but that is a one-time cost.

You could pay an advisor to set up a ladder for you. I recently read about a service that charges 35 basis points to do so.

iShares TIP fund (symbol TIP) has a net expense ratio of 0.20%, but that is a recurring annual expense. It's also 10% of the expected real return (2%) of the fund. Compare that to SPY (S&P 500) with a net expense ratio of 0.09% and a possible average return of say, 6%, and it looks expensive. SPY expenses are maybe 1.5% of expected returns, not 10%.

If you're willing to do the work yourself, ladders look cheaper. Even if you pay an advisor 0.35% for the initial purchase, you still come out ahead.

Inflation Protection. Individual TIPS bonds will return additional principal at maturity to compensate for increases in the CPI. Funds make no such promise. Interestingly, Morningstar reports that iShares TIP fund returns are not highly correlated with inflation. Isn't that the point?

TIPS fund prices may outperform inflation and they may not. They should compensate for inflation that exceeds market expectations, however.

Taxes. TIPS have a “phantom income” tax problem whether you buy individual bonds or a fund. You have to report accrued principal annually and interest payments are subject to Federal income tax, but not state tax. Hold them in a Roth account and these problems go away.1

(Interest from TIPS and other Treasuries is taxable as federal income but exempt from state tax when held in a taxable account. Hold them in a traditional tax-advantaged account and you convert them to taxable (state and federal) ordinary income when funds are withdrawn. So, if you have low Federal taxes but very high state taxes, beware.)

Many complaints about bond ladders are legitimate if you're investing in bonds to reduce portfolio volatility, or investing in bonds with credit risk, or not spending the income and matured principal. But, most of them just don't apply to a retirement income ladder.

If you're investing in bonds to improve your portfolio allocation, funds may be just the ticket. I would also recommend a fund if you're unwilling to do the initial setup. After that, it's a little more work once a year.

But, if you're investing for certain annual income, want the lowest cost, prefer to know exactly how much money you will have to spend at a future time and want to be certain you will outpace inflation, I prefer a ladder of individual TIPS bonds held in a retirement account, and preferably a Roth.

How should you set up a TIPS ladder? Please check out my next post, How Many Rungs?

1You can't purchase bonds from Treasury Direct from a retirement account to take advantage of their no-fee feature. Treasury Direct will only work with taxable accounts. You can, however, purchase TIPS bonds on the secondary market from a tax deferred retirement account.

Thursday, January 9, 2014

Why TIPS Bonds?

William Bernstein is a fan of TIPs bonds as a retirement income investment.

TIPS, or Treasury Inflation-Protected Securities, are U.S. Treasury bonds that compensate for inflation. The U.S. Treasury is considered the safest bond issuer in the world and many consider TIPS the safest of the safe, because unlike all other Treasuries, TIPs also protect against inflation.

TIPS bonds pay their coupon rate of interest semi-annually. At maturity, the Treasury increases the amount of principal you are repaid to compensate for inflation over the life of the bond.

My last post discussed why retiree's might want to own bonds, but bonds come in many different flavors. They are issued by financially sound governments, developing nation governments, government agencies, blue chip corporations and risky, small companies (junk bonds). They are also issued by cities (muni's) and many other entities. The more financially sound the issuer, the safer the bond and the lower the interest rate paid.

When interest rates go up, bond prices go down, and vice versa. Bonds that will mature soon are safer than bonds that won't pay back their principal for a long time. A change in interest rates will have a much greater impact on the price of long bonds than it will on short or intermediate maturity bonds. Longer bonds can be quite risky.

Bonds can be exempt from Federal income taxes (municipal bonds) or exempt from state taxes (U.S. Treasury bonds).

What would constitute a perfect bond for retirement income?

That bond would be nearly risk-free. As Bernstein says, the riskless portion of your portfolio should be totally riskless. Long bonds and junk bonds are examples of bonds with considerable risk. TIPS, particularly short and intermediate maturity TIPS, are the safest bonds available.

The perfect bond would be available in a wide range of maturities, as TIPS currently are, from short term to 30 years.

Since retirement may last a long time, the perfect bond would compensate for inflation. While perhaps imperfect in this respect, depending on how well you believe the CPI tracks actual inflation, TIPS compensate for inflation better than any other fixed-income security.

Long term investments with relatively low returns also need to have low transaction costs. Even a small recurring cost can be a significant percentage of the stingy total real return of a TIPS bond. You can buy TIPS bonds directly from the U.S. government at Treasury Direct for no fee. Several large brokerages will also sell them for no fee.

So, lowest risk, inflation protection, wide range of maturity dates and low cost. Why aren't TIPS the perfect retirement income investment?

TIPS have a tax problem, "phantom income", resulting from having to pay taxes on accrued principal as you go. The solution to this problem may be to hold them in a retirement account like an IRA or 401(k).

(TIPS are not subject to state income tax and if you hold them in a tax-deferred account, you will lose that feature. Withdrawals will be treated as ordinary income for tax purposes. So, if you have low Federal taxes but high state taxes, beware.)

TIPS are safe and that typically means low volatility, but TIPS have a strange volatility characteristic. TIPs can be volatile in the short term during an economic crisis because of liquidity issues, though they exhibit low volatility over the long run. This isn't a problem, of course, unless you are forced to sell them in a crisis. If you can hold them, the volatility problem will subside.

TIPS bonds may not be available in every maturity you desire. For example, there are no TIPS currently maturing in 2024, 2030-31, or 2033-2039.  This problem can be mitigated by buying twice as many bonds maturing in 2025, for example, but I would prefer to buy half of my allocation to replace 2024 bonds in 2023 bonds and half in 2025 bonds to get the average duration and return.

TIPS aren't a perfect solution for secure income in retirement, but they are clearly the best alternative in my opinion, and apparently in William Bernstein's opinion.

You can decide which endorsement means more to you, but I'm personally going with Bill's.

Now, on to the original question: should you buy individual TIPs bonds or invest in a TIPS bond fund?