TIPS and RISK

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.