Laddering with Individual Bonds
Duration matching is not straightforward for bond funds when shares of the bond fund must be sold to meet ongoing retirement expenses. If rates have risen, shares of the bond fund may need to be sold at a loss, with more shares sold to meet a given spending objective. This triggers sequence risk and locks in losses. Immunization only works if interest payments can be reinvested at a new higher interest rate to compensate for capital losses. But not all the funds are fully reinvested when a spending goal is met, so reinvestment risk and interest rate risk do not get neutralized. The return on remaining assets would need to be even higher to keep the retirement liability funded. Immunization is harder when there is also a spending goal to support.
A more practical approach is to use individual bonds in a retirement income plan. A retirement income bond ladder can be structured so the cash flows provided through coupons and maturing face values will provide a steady and known stream of contractually protected cash flows for the ongoing expenditure needs in retirement. Cash flows from the bonds are matched to fund desired expenses at desired dates. Interest rate risk can be ignored for the retirement expenses that have been matched with these dedicated assets. Sequence risk is reduced because there is less risk of assets being sold at a loss. Rebalancing may be required in terms of extending the length of the bond ladder as time passes to cover future expenses, but the complexities involved in an ongoing effort to match durations can be better avoided.
Retirement income bond ladders generally take the form of Treasury bonds to minimize the possibility of default risk. For a household retiree, maximizing investment returns is not the goal; the goal is to meet expenses. Paper losses on individual bonds do not have to be realized if the bond is held to maturity. While the retiree misses out on the opportunity to buy the bond at a lower price later, this cannot be known in advance. It is always unfortunate to buy bonds and then see the price drop due to rising rates. But if the initial purchase allows the retiree to meet his or her retirement objective, then it is a successful purchase, no matter what interest rates subsequently do.
Retirees who realize that it is nearly impossible to predict interest rate fluctuations can take comfort in knowing that individual bonds allow them to enjoy retirement and ignore subsequent interest rate fluctuations. Ignoring interest rate fluctuations is not possible with a bond fund strategy that has to make frequent adjustments to the portfolio’s duration in order to immunize against interest rate risk.
The difference between a traditional bond ladder as an accumulation tool and a retirement income bond ladder is that with a traditional ladder, the cash flows received as coupons and face value are reinvested to purchase new replacement bonds at prevailing prices that extend the ladder and keep its length relatively constant over time. With a retirement income bond ladder, the cash flows received are spent on planned retirement expenses. A retirement income ladder will naturally wind down if other assets from outside the ladder are not used to extend it further as time passes.
As we have discussed, changing interest rates lead, in turn, to capital gains or losses for investors. For professional bond traders, rising interest rates would be a serious problem for someone who had just purchased a long-term bond. Most traders have no intention of holding bonds to maturity and will realize capital losses on the subsequent sale. Interest rate increases might also force retirees owning bond funds into a position of selling shares at a loss in order to meet retirement expenses. For a bond portfolio that is not fully immunized, this triggering of sequence-of-returns risk can create irreparable harm for retirees.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.