Building bond ladders for retirement income is an important but understudied topic.
Especially since we are at a point in time when many are worried about future interest rate increases, bond mutual funds risk locking in capital losses when shares are sold to meet expenses, while a bond ladder will still provide the obligated cash flows, no matter what happens with interest rates.
Rather than purchasing bond mutual funds, an individual could build a ladder of bonds with some maturing each year to provide the income needed to cover annual expenses.
The Wall Street Journal’s Market Data Center provides information on all outstanding Treasury bonds, strips (zero-coupon bonds) and Treasury inflation-protected securities (TIPS).
Though creating an initial bond ladder with any of these asset sub-classes is relatively straightforward, coupon payments increase the complexity, especially when it is time to extend the bond ladder as time passes. For this reason, we will first focus on U.S. Treasury bond strips.
Treasury strips are zero-coupon bonds that only provide their face value on the maturity date. They sell for less than their face value, and the implied investment return from holding them to their maturity date can be calculated based on the pricing discount from their stated face value paid at maturity, as well as the length of time to maturity.
Using data from the Wall Street Journal for January 3, 2017, I’ve calculated the cost of building a ladder of Treasury strips for up to thirty years, using the bond that matures at the earliest date each year (2017-2046). For the first year, cash is held for expenses rather than purchasing a bond that will mature in a few weeks. The results are in Exhibit 1.
Yields range from 0.56% for bonds maturing in 2018, up to 3.12% for bonds maturing in 2046. The bond ladder is designed to provide $40,000 of income in the first year, with 2% annual growth to approximate inflation.
Without TIPS, built-in cost-of-living adjustments can only be applied in such a way. Future realized inflation could differ from the assumption used to build the ladder, leading the real value of the cash flows to fluctuate in unpredictable ways. Only TIPS can hedge unexpected inflation outside of what is assumed for the COLA.
The exhibit shows the cumulative cost (using wholesale prices without any potential markups in pricing for retail consumers) of building $40,000 with 2% growth for up to thirty years.
To get a clearer understanding of how the exhibit works, consider funding the income goal for 2027. With a 2% COLA, you seek to generate $48,760 that year. You want maturing bonds with this face value.
The yield on a strip maturing that year is 2.48%. Discounting the spending amount to the present, you must set aside $37,256 in the bond today with a 2.48% annual return to have $48,760 available from the maturing bond in 2027. The same process works for every date income is desired.
Over the full thirty years, the total ladder cost is $1.045 million. This implies an initial spending rate of 3.83% for the $40,000 initial spending goal, and an implied internal rate of return of 2.8% on the cash flows supported through the initial ladder cost.
In other words, 2.8% is the fixed investment return required for the initial $1.045 million payment to support the subsequent cash flows over the next thirty years. This is the maximum spending that can be supported by the Treasury strips’ yield curve in the current market environment.
Efforts to spend at a higher rate with risky investments like stocks will create risk that the goal cannot be met.
Exhibit 1
Constructing Retirement Income Bonds Ladders Using Treasury Strips on January 3, 2017 for an Annual Income of $40,000 with a 2% Annual Cost-of-Living Adjustment
Calculations made using data from the Wall Street Journal’s Data Center
The other important detail in the exhibit is the column showing the implied portfolio bond allocation needed to build a strips ladder of increasing length from a portfolio of $1 million.
The column reveals that every year of income from the ladder requires an allocation of about 4% of the portfolio, though this percentage declines at longer maturities where the yields are higher.
With a $1 million portfolio, the initial withdrawal rate to get $40,000 of spending is 4%. The full retirement ladder could only support a 4% initial spending rate (with the 2% COLA for spending) for twenty-eight years, as the portfolio would be fully depleted in year twenty-nine.
The ladder cost is scalable. If you want $100,000 of income, the cost is equal to the cost of $40,000 of income times the ratio of the new income goal: 100,000 / 40,000 = 2.5. Also, this exhibit works to show the cost for building a one-time bond ladder of any length up to thirty years.
The total cost for a shorter ladder is simply the cost shown at that point in the cumulative cost column.
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