Bonds can be incorporated directly into a retirement strategy in three broad ways:
- An assets-only approach to build a total returns investment portfolio,
- Matching the duration of bond funds to the duration of the retirement liability, and
- Holding individual bonds to maturity to generate the desired cash flows to fund expenses on an ongoing basis throughout retirement.
The two latter methods put the retirement liability (meeting an ongoing spending goal in retirement) at the forefront and try to choose bonds to best protect the spending plan from interest rate volatility.
(As an aside, another use for bonds—or, more likely, shorter-term cash instruments—with sufficiently low volatility is as a source of liquidity to provide for short-term and contingency expenses. My discussion here and in following posts will focus on using bonds specifically to meet budgeted retirement expenses.)
The first approach is the standard investing philosophy for accumulation that does not really consider how the nature of risk changes upon retirement. In short, it uses Modern Portfolio Theory to choose an asset allocation strategy that includes bonds as part of a total returns investment portfolio.
Bonds, with their lower expected returns and volatility, provide a way to reduce the portfolio’s overall volatility to an acceptable level while still maintaining a sufficient overall portfolio return. Asset allocation in this framework is generally determined in terms of assets-only considerations to build a diversified portfolio with the highest expected return for the accepted level of risk.
To the extent that retirement income needs were considered, it was generally to find an asset allocation that will minimize the probability of failure for the financial plan.
Looking back to William Bengen’s original work in the 1990s about sustainable spending rates, the best worst-case historical spending rates could be achieved with an overall bond allocation of 20 to 65%. He also found that intermediate-term U.S. government bonds provided a sweet spot in terms of return/volatility tradeoffs, keeping worst-case historical spending rates at the highest possible level.
The second and third methods take a more nuanced approach to incorporating bonds.
In the second, a bond fund (a mutual fund or an ETF) can be chosen specifically so that its ‘duration’ matches the duration of the retirement liability. I will explain this in greater detail in later posts.
The third route involves holding individual bonds to maturity to provide the desired income to fund annual expenses on an ongoing basis throughout retirement. In this method, maturing bonds and bond coupon payments provide a steady and known stream of contractually guaranteed income to meet planned expenditures.
Scholars and practitioners have numerous disagreements about the best way to incorporate bonds into a real-world retirement income plan. We will be delving into these controversies as well.
The discussion builds toward an eventual consideration of time segmentation—a hybrid strategy that invests differently for short-term and long-term expenses rather than use a total-returns approach. Time segmentation is often described as a way to help manage sequence of returns risk, though this point is controversial.
Though a myriad of strategies can be devised that would fall under the umbrella of time segmentation, the easiest way to approach this topic is to include a retirement income bond ladder as a tool for income planning. Sequence risk may be mitigated by holding individual bonds to maturity.
A retirement income bond ladder may be constructed to cover early retirement expenses, with a more aggressive portfolio of assets earmarked for longer-term expenses, so the risk of selling assets at a loss is reduced.
In my next post, I will go into greater detail to explain how bonds work.
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