When it comes to retirement income bond ladders, Joe Tomlinson created a taxonomy of different types in his 2014 Advisor Perspectives column, “Why the Risk Reduction Benefits of Bond Ladders Have Been Overstated.” His list inspired me to create a more extended version in Exhibit 1.
Taxonomy of Retirement Income Bond Ladders
|Types of Bond Ladders||Potential Use|
|Fixed Short Term||Build a Social Security delay bridge|
|Fixed Medium Term||Twenty-year bond ladder followed by deferred-income annuity to cover remainder of lifetime|
|Fixed Long Term||Thirty-year bond ladder as source of “lifetime” retirement income|
|Automatic||Each year purchase a new bond to extend the horizon by one more year as bond matures, keeping ladder length constant over time|
|Market-Based||Allow ladder length to fluctuate based on market performance. For example, extend ladder by more when the stock market has performed well or market valuations are high, but let ladder length decrease without extension after poor market performance or low market valuations|
|Personalized||Conduct a capital needs analysis for how much wealth should remain in each year of retirement to meet goals. Extend ladder when actual wealth exceeds the requirement. Let ladder length decrease when actual wealth is falling short.|
Retirement income bond ladders are divided between one-time ladders and rolling ladders. “One-time ladders” are divided into three types differentiated by the length of the ladder.
The shared characteristic between all types of one-time ladders is that they can be spent down over time. The bond ladder is not extended as bonds mature, gradually reducing the length of the bond ladder as time passes.
A short-term bond ladder might be used for something like building a Social Security delay bridge for someone looking to temporarily generate more retirement income for the period of time that they wait before collecting Social Security benefits.
As a part of delaying benefits to age seventy, a sixty-two-year old might build an eight-year bond ladder that generates income equivalent to the reduced age sixty-two Social Security benefit level.
This extra income is not needed after Social Security benefits begin, so the ladder is allowed to wind down naturally.
For a medium-term one time bond ladder, the classic example is to combine a bond-ladder with longevity insurance through a deferred-income annuity. Bond ladders expose retirees to longevity risk if you live past the ladder’s end date.
To account for this, S. Gowri Shankar developed an alternative of combining a twenty-year TIPS ladder with a deferred immediate annuity (DIA) that begins payments twenty years after the retirement date in his 2009 article, “A New Strategy to Guarantee Retirement Income Using TIPS and Longevity Insurance.”
He did this to provide longevity protection with a smaller amount of annuitized assets. With this strategy, the bond ladder is again allowed to wind down, because the deferred-income annuity replaces the lost income precisely when the bond ladder terminates.
Finally, a full thirty-year bond ladder could be created with the idea of generating “lifetime” income. A thirty-year bond ladder is as long as can be constructed with available bonds (it does not truly provide lifetime income).
The bond ladder would be spent down entirely by year thirty, creating a problem for someone still alive in year thirty-one. For this reason, not all assets should be used to construct such a ladder.
It is important to set something aside for unplanned contingencies and the prospect of living longer than thirty years. For unplanned expenses, while the bond ladder is liquid, selling portions of it to meet unexpected expenses directly means sacrificing some of the assets earmarked for later retirement spending.
Also, retirees selling individual bonds prior to their maturity dates face interest rate risk, as a rise in interest rates would force capital losses to be realized in these cases.
For someone considering a thirty-year retirement income bond ladder, it is important to also take a serious look at income annuities as a cheaper and more secure way to generate lifetime income.
The next category of bond ladders consists of different ways to build bond ladders extended over time to keep the length relatively constant as time passes. Rolling bond ladders are not meant to be fully wound down.
As bonds mature with the proceeds spent, new bonds are purchased with other financial assets to extend the ladder length. Rolling ladders provide the basis for time segmentation strategies.
Possibilities for designing rolling ladders include to automatically extend the ladder length by one additional year as each year passes (automatic), or to develop a strategy to only extend the ladder when certain conditions are met (market-based).
Possible decision criteria for extending a rolling ladder could be stock market valuations, current interest rates, recent market performance, or the individual’s personal situation with respect to being adequately funded as determined by a capital needs analysis (personalized).
We will discuss different strategies in more detail when we get to the topic of time segmentation. Next time, we will consider how to construct an actual retirement income bond ladder.