How to Create Reliable Income Sources with Bond Ladders, SPIA’s and DIA’s
“You know…it is a lot different when you are actually retired.”
The above quote from a recently retired client points to the challenges of retirement. The change from working and saving to not working and spending from your portfolio is daunting. Layered on top of these “normal” concerns are today’s troubling headlines. This “headline risk” has contributed to recent market volatility. While we understand that this volatility can cause one to be nervous, our view is that no matter the market, one can always be worried about it. Sometimes, even when everything is going great, some get worried that “it is too good to last!”
So, what should you be doing now or in the future if you have these concerns? Our answer depends on your time horizon and risk tolerance. If you have a long-term investment time horizon, our view is that while “headline risk” is disconcerting, the alarming headlines will pass. And it is a fool’s errand to try to time the market. For example, if you missed the 25 best trading days from 1990-2018, the return on the S&P 500 is halved, from 9.29% to 4.18%. We challenge anyone to determine the 25 best trading days over the next 20 years. Simply put, market timing is tough.
However, if you are like many of our retired or soon to be retired clients, the answer is not easy. One way to deal with these retirement fears and “headline risk” is to create reliable income streams that aren’t subject to the whims of the markets. Below we will cover the benefits of reliable income streams and how they can complement your current stock and bond approach.
Why is Retirement Different?
Before getting to the benefits of creating reliable income streams, it is essential to drill down on why retirement makes people feel so vulnerable. Often, we’re anxious about retirement because there is little room for error, and you only get one bite at the apple. At 30 or 40, you can take a chance of investing in Bob’s “sure-thing” commodity fund, or a friend’s start-up business. If they fail, time, and your human capital (your ability to earn a salary) will generally mitigate these mistakes. However, when you are at or near retirement, your human capital is in short supply, and time is not your friend. To employ a sports analogy, you do not have the “makeup speed” you once had.
Benefits of Reliable Income in Retirement
A vital benefit of a reliable income source is that you will feel more secure and happy. And, after all, isn’t this a critical retirement goal? A prominent study on happiness in retirement conducted by Towers Watson, linked retirement happiness with reliable income streams. They looked at folks with comparable asset levels and age and found those with steady income streams tended to be happier than those without steady income streams.
Beyond potentially making you more content, reliable income sources allow you to be more effective in other parts of your investments and planning. Most notably, they help you maintain investment discipline and keep you invested in a down market. If you know you have enough reliable income to cover your essential expenses, you will be less likely to sell out of stocks during a weak market. In some cases, people even feel comfortable enough to increase their stock exposure once they have guaranteed income sources.
Reliable income sources also can help your overall portfolio tax efficiency by avoiding selling low-cost basis stocks and, instead, allow for a step-up in basis of these assets at your death. For example, we have many retired clients with significant gains in their taxable accounts. And rather than selling these stocks to fund income goals, our clients can convert a portion of their bonds to an income annuity. The “extra” income from the annuity will then diminish the pressure to sell stocks, possibly allowing a step up in basis at death. This means your children will not have gains associated with these stocks when they are inherited. Also, this strategy can be synced with your Required Minimum Distributions (RMD’s) at age 70 ½. To do this, you buy an annuity that approximates your RMD, and the income from the annuity will satisfy RMD requirements.
How Do You Create Guaranteed Income Streams?
Beyond Social Security and pensions, the two most common ways to create an income stream are Bond Ladders and Annuities.
How you employ bond ladders in retirement is different than how you may have used them while you were working. Before retirement, bond ladders are mainly used to help manage interest rate risk and dampen portfolio risk. You buy bonds that mature in a series of future years and reinvest the proceeds (both principal and interest) when the bonds mature.
In contrast, retirement ladders are used to fund your essential expenses. You can think of them as “consumption” bond ladders. There are two main strategies to consider. The first is to buy enough bonds that the income generated from them meet your expenses. This strategy works well if you have sufficient assets, and interest rates are high enough to meet your non-discretionary expenses. Another retirement bond ladder strategy is to match your expected yearly expenses with both the principal and interest from the bonds that mature each year. In this case, rather than living off the interest, you consume both the interest and principal. This “flooring approach” works well during your first years in retirement and can help mitigate a 2008 and 2009 type of market. In addition, this “flooring strategy” also enables you to bridge to higher social security payments at age 70 because you will not need to begin social security as early.
The beautiful thing about these bond ladder strategies is their flexibility. You can always sell the bond and decide on a new course of action if circumstances warrant. Whether bond ladders are the right fit for you depends on your overall asset level and your required income.
An annuity is a contract between you and an insurance company. The insurance company promises to pay a certain amount to you (and your spouse) for your life in exchange for a premium. Each state guarantees the insurance company’s payments to a certain level, usually around $250,000 per contract. Even with this state guarantee, it is still crucial that you do your homework to make sure each insurance company is sound, as you will rely on their ability to pay for decades into the future. There are several different types of annuities of varying levels of complexity and value to investors.
We focus on Single Premium Immediate Annuities (SPIAs) and Deferred Income Annuities (DIA’s) because they have lower costs, are less complicated, and are easier to employ with a stock and bond approach. You can think of both SPIA’s and DIA’s as a way to “pensionize” your portfolio. There are other types of more complicated annuities like Fixed Index Annuities (FIA’s) and Variable Annuities with an income rider, that are used in specific situations but are beyond the scope of this article. Generally, the more complex a product becomes, the warier you should be. We plan a future article to go into when these types of annuities can make sense.
Beyond providing reliable income, SPIA’s and DIA’s are attractive because of an insurance company’s ability to provide more income than what the bond market can offer. Insurance companies are not doing anything special to generate this” extra” income. There are no double top-secret trading strategies. Instead, insurance companies use something called “Mortality Credits” to provide a higher payout than bonds. Because insurance companies work with large pools of people, those who die early fund the pool for those that live longer. This “mortality funding “allows the insurance company to pay out more to those that live longer.
While there are many positives to an annuity, there are a few downside characteristics to consider. The main downsides are lack of flexibility and fees. Unlike a bond ladder, you are locked into an annuity for the most part. You can’t sell them, and there can be surrender charges. Fees can be high in certain annuities too. SPIA’s and DIA’s though, are the least expensive annuities.
Another downside often mentioned by detractors is that while SPIA’s and DIA’s may help solve the retirement cash flow problem, your legacy assets suffer from an annuity. Wade Pfau, our Director of Financial Planning, has done research that refutes this notion. Wade has shown that adding an SPIA to a stock and bond portfolio improves both the retirement cash flow along with the legacy assets. Wade refers to this combination of bonds, stocks, and annuities as the efficient frontier.
While there are pros and cons to consider with an SPIA and DIA, they can certainly be a foundation for your retirement plan.
Bond Ladders/Annuities and Your Existing Portfolio
If you decide that an income annuity or a bond ladder makes sense, several questions should be asked to determine how best to incorporate either into your existing stock and bond portfolio. The first and more strategic question is to determine how the addition of an income annuity may impact your risk tolerance, meaning your overall stock and bond allocation. Like creating an emergency fund for unexpected expenses, a reliable income stream may make you feel more confident in either staying at your current stock allocation or even increasing it. There is no right or wrong answer here. Instead, the point is you should revaluate your overall risk profile with the addition of the annuity or bond ladder.
Once you have reassessed your risk profile in light of adding an income annuity or bond ladder, then there are several tactical questions to consider. Where should I source the funds to purchase the annuity? Should funds come from stocks or bonds, and which account (taxable or tax-deferred) makes the most sense? The answers to these questions depend on your unique circumstances. You will need to take into account your tax situation, other income streams like social security, your current stock-bond allocation, and your current cash position to make the best decision.
Once you have sourced the funds for the annuity or bond ladder, you should review how the addition of the reliable income stream impacts your overall retirement plan. Does the combination of reliable income streams, bonds, and stocks pass the smell test? For example, if you purchased a SPIA without an inflation rider, does your portfolio have enough inflation protection? A straightforward answer is that the annuity has allowed you more stock exposure, and stocks are an excellent inflation hedge. Or you could look to add more Treasury Inflation-Protected (TIPS) bonds to the remaining portfolio to manage the inflation risk.
Yes, retirement can be scary, and like one of my clients recently said: “retirement is the time to put on your big girl pants!” Nevertheless, you can develop plans that not only make you feel more secure but improve financial outcomes. Don’t get stuck in one way of solving the retirement cash flow riddle. Stocks and bonds are not always 100% the right solution, nor are annuities or bond ladders automatically the right solution. The goal is to focus on the “brilliance of the and” to find the right combination.
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