I like hybrids. We bought my wife a Prius and we love it, so I bought a second, larger hybrid that better accommodates my height on long trips. We buy gas, like, once an eon now.
My retirement strategy is a hybrid. I hope to get a lot of mileage out of it, too.
Over the course of my last several blogs about retirement income strategies, I alluded to the fact that a retiree can combine parts of the four basic retirement income strategies to create a “hybrid” strategy customized to his or her needs. The posts were meant to point out the strengths and weaknesses of each class of strategy and the basic tools that are available to build a custom retirement strategy.
In How Many Rungs, I noted that I personally use a floor-and-upside strategy, but only out to ten years. Beyond ten years, I use stocks or intermediate bond funds to fund the secure account. Yes, I expose myself to market risk with stocks or interest rate risk with intermediate bonds, but if I didn't do it this way I would be exposing myself to the poor risk-adjusted returns and volatility of long bonds and the very real risk that I won't live long enough to hold many of the rungs to maturity.
We have to choose our risks.
The volatility of long bonds doesn't matter if you can hold them to maturity, but I might not live 30 more years, or I might have a financial crisis that forces me to sell the long bonds after an interest rate increase. Either my heirs (in the first case) or I (in the latter) might then have to sell the long bonds at a loss.
Ten years of spending in a TIPS bond ladder gives stocks a long time to recover. As Wade Pfau recently demonstrated, bond ladders longer than about 15 to 20 years don't add much more safety, anyway.
More importantly, my finances are such that I could maintain my current standard of living even if my stock portfolio fails, which is the broader objective of floor-and-upside strategies and one I recommend to all retirees.
Mine is a hybrid strategy based on floor-and-upside, substituting the time-segmentation approach of considering the best asset for a given investment horizon for longer TIPS ladder rungs, and tossing in the systematic withdrawals tactic of portfolio mean-variance optimization. I add the latter by ensuring that my ultimate portfolio, to the extent possible, has a bond allocation consistent with my overall portfolio risk tolerance.
Assume I am comfortable with a 60% bond allocation, which will suffer in all likelihood a portfolio loss of no more than 15% in a bear market. If my floor-and-upside strategy resulted in a portfolio bond allocation greater than 60%, I would be concerned about limiting upside spending potential. If my bond allocation were smaller than 60%, I wouldn't sleep well during a rough bear market. So, after allocating the bonds I would need to generate my floor income, I would try to adjust my overall portfolio allocation to around 60% bonds and 40% equities.
My other overall concern is that I not risk my current standard of living in the stock market, which is why I start out with a floor-and-upside strategy.
This combination of three strategies best meets my personal requirements. Fortunately, I am able to meet all of these goals, though that won't always be the case. Sometimes you have to make trade-offs. Because our financial situations vary widely, these are probably not the right tradeoffs for you.
There are lots of ways to create hybrid strategies. You can substitute bond ladders for life annuities, for example, and vice versa. You can substitute intermediate bond funds for long term bonds, increasing interest rate risk a bit, but lowering the risk that you will need to sell long bonds at a loss after interest rates rise. You can shorten or lengthen the bond ladder.
Another way to create a hybrid strategy is to alter your strategy over time. Recent work by Pfau and Michael Kitces, for example, suggests that it might be wise to dramatically lower equity exposure in early retirement and increase it as you age. This is a principle you might be able to apply to systematic withdrawal, time-segmentation and floor-and-upside strategies.
You might also plan in advance to change strategies over time. For example, you might decide to implement a systematic withdrawal strategy early in retirement and switch to a floor-and-upside strategy at age 70 or so, or switch to a life annuity strategy at 70 when annuity rates hit their sweet spot. You might decide to use a longevity annuity to fund retirement after age 85.
In my next few posts, I'll talk about how, why and when you might want to change strategies, and even plan those changes in advance.
Always enjoy your articles Dirk. Thanks for continuing to post. Brad
ReplyDeleteYour thinking resonates well with mine--this is all very helpful to me as I try to come up with an investment policy statement/philosophy. You have a gift for putting things into words in a way that crystallizes ideas in my head. I enjoyed the Prius analogy. (And a particularly apt reference in this post, since hybrid cars are a nice example of an investment that pays a tax-free real return since there is no tax on the future savings in gas expenses and you also insulate yourselves to a signficant degree against future increases in gas prices. Any kind of energy-saving consumer durable investment has similar properties.)
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