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Are Inflation-Protected Bonds Unnecessary in Mostly-Stock Portfolios?

A reader writes in, asking:

“I was recently reading an article on Investopedia, about using Vanguard ETF to build a commission free portfolio.

What was interesting to me is this author based his article on Vanguard Target Date Funds. One of the conclusions he suggested is that a portfolio that has a stock allocation of 65% and above doesn’t need inflation protected bonds in it at all. This seems to be validated by Vanguard when you check the Target Date Funds they offer, anything with an allocation of 65% stocks indeed has no inflation protected bonds. However Vanguard’s Life Strategy Funds have no allocation to inflation protected bonds no matter the stock allocation. Was just curious about your thoughts on this.”

The purpose of Treasury Inflation-Protected Securities (TIPS) is to provide a specific, predictable after-inflation return. And they are very effective at doing this, provided that you hold them to maturity.

This makes them a super neat tool for funding a specific expense in the future, or for funding a series of expenses over time (e.g., everyday living expenses in retirement, funded via a TIPS ladder). For this purpose, they’re pretty clearly preferable to regular nominal Treasury bonds.

As a part of a portfolio, they’re perfectly fine, but not nearly so powerful. That is, they still reduce the inflation risk to which you’re exposed, but they can’t provide your overall portfolio with a predictable after-inflation return if they’re only a small part of your portfolio.

Imagine, for example, that I have a 70/30 stock/bond allocation, and 15% of the portfolio (i.e., half of the bonds) is in TIPS. Sure, that 15% of the portfolio has a predictable after-inflation return. But who really cares? I’m concerned about the return on my entire portfolio, and the uncertainty that comes from the 70% stock allocation will absolutely dwarf the uncertainty (or lack thereof) that comes from switching 15% of the portfolio between TIPS or nominal bonds.

I often think it’s instructive to look at mutual fund return charts from Morningstar — not for showing which funds are better than others, but for showing how similar or different various funds are.

The following chart plots:

  • Vanguard Inflation-Protected Securities Fund (in blue),
  • Vanguard Intermediate-Term Treasury Fund (in orange), and
  • Vanguard Total Stock Market Index Fund (in yellow)…

…since the TIPS fund was first created in June of 2000.

Morningstar Performance Chart

Sure, you could make a case for picking one of the bonds funds over the other. But if the portfolio primarily consists of that stock fund, it wouldn’t have made a heck of a lot of difference which of the bond funds was used.

In other words, I don’t think it’s a bad idea at all to include TIPS (rather than just nominal bonds) in a mostly-stock portfolio. Rather, I just don’t think it’s likely to make that much of a difference.

This is markedly different from a situation in which the portfolio is mostly (or entirely) bonds. A nominal Treasury ladder and a TIPS ladder provide two very different levels of certainty in terms of the spending they can support.

Is Your Retirement Portfolio Less Liquid Than You Think?

While reading Wade Pfau’s recent paper “Retirement Income Showdown: Risk Pooling Versus Risk Premium,” I came across a topic I wanted to share with you. (For reference, this is not the main point of the paper but rather one of a handful of points discussed in a comparison of partially-annuitized portfolios to regular “investments-only” portfolios.)

I think the concept is best explained with an example.

Imagine that you retire at age 65, and you decide on the date of your retirement to use all of your retirement savings to purchase a Treasury bond ladder extending 30 years into the future. That is, you plan to have Treasury bonds maturing each year for the next 30 years, and you plan to use those bonds to fund your retirement spending.

In this example, how liquid is your portfolio?

In one sense, it’s super liquid, given that Treasury bonds are one of the most liquid assets in the world. At any given moment, there are countless parties who would be willing to buy your Treasury bonds.

But from the perspective of your own personal retirement, your portfolio is not nearly so liquid. For example, in Year 1 of retirement, you can really only afford to spend the money from Year 1’s Treasury bonds. If you find yourself liquidating Year 2’s bonds and spending that money prior to Year 2, you have a problem.

Pfau explains it this way (while referencing another article by Curtis Cloke):

“In a sense, an investment portfolio is a liquid asset, but some of its liquidity may be only an illusion. Assets must be matched to liabilities. Some, or even all, of the investment portfolio may be earmarked to meet future lifestyle spending goals. In Cloke’s language, the portfolio is held ‘hostage to income needs.’ A retiree is free to reallocate her assets in any way she wishes, but the assets are not truly liquid because they must be preserved to meet the spending goal. While a retiree could decide to use these assets for another purpose, doing so would jeopardize the ability to fund future spending.

This is different from ‘true liquidity,’ in which assets could be spent in any desired way because they are not earmarked to cover other liabilities. True liquidity emerges when excess assets remain after specifically accounting for ongoing lifestyle spending goals. This distinction is important because there could be cases when tying up part of one’s assets in something illiquid, such as an income annuity, may allow for the spending goal to be covered more cheaply than could be done when all assets are positioned in an investment portfolio.”

In other words, a typical “investments-only” portfolio of stocks/bonds/mutual funds is liquid in the sense that you can sell your holdings at any time. But if the portfolio is just barely large enough to be expected to satisfy your lifetime spending, it’s illiquid in the sense that you have no flexibility in terms of how much you can safely spend per year. You can’t really afford to spend a higher-than-planned amount in a particular year.

Conversely, if you took part of the portfolio and used it to purchase a lifetime annuity, your remaining portfolio would be smaller, but because of the relatively high payout on such annuities, you would have more flexibility with your remaining portfolio — more “true liquidity” in Pfau’s terms.

How About an Example?

For those of us here in the U.S., the best deal we can find on an annuity purchase is from delaying Social Security.

Imagine you have a retirement portfolio of $800,000, and you estimate your annual expenses to be $50,000. With regard to Social Security, you have a full retirement age of 67, and your primary insurance amount (i.e., your Social Security benefit at full retirement age) is $2,000 per month, meaning that you would get:

  • $1,400 per month ($16,800 per year) if you file ASAP at age 62, or
  • $2,480 per month ($29,760 per year) if you wait until age 70.

If you file at age 62 your portfolio will have to satisfy $33,200 of expenses per year (that is, $50,000 of total expenses minus $16,800 of Social Security income). With an $800,000 portfolio, that’s a 4.15% initial withdrawal rate — putting you squarely in the “probably fine, but who really knows?” zone. (That is, you’re in the zone where you likely can’t afford to have a big spending shock, especially not in early retirement.)

Conversely, if the plan is to wait until age 70, the portfolio can be split into two sub-portfolios:

  1. One portfolio that will have to satisfy $20,240 of annual expenses every year, starting at age 62, and
  2. One portfolio that will have to satisfy the remaining $29,760 of annual expenses from 62 until 70 (at which point Social Security will kick in).

The second portfolio will have to be $238,080 (i.e., $29,760 per year for 8 years), and it should be put in something very safe (e.g., money market account, an 8-year CD ladder, etc.). That leaves $561,920 for the first part of the portfolio, resulting in a spending rate of 3.6%.

In other words, the portion of the portfolio that is intended to last throughout retirement now has a spending rate of 3.6% rather than 4.15%, meaning that there’s more flexibility to handle unexpected spending shocks.

To be clear, this is a simplified example, in that it ignores investment returns, taxes, and the complexity that arises with regard to Social Security benefits for married couples. But even when you build out a more detailed analysis, the same overall concept holds true. Delaying Social Security means you’ll have a smaller portfolio, but you will have greater flexibility in terms of what you can do with that portfolio — more “true liquidity.”

The same concept holds true with purchasing lifetime annuities from insurance companies, though the effect is not as powerful, given that the payout per dollar spent on premiums is not as high as the payout per dollar spent to delay Social Security.

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Spending from a Portfolio in Retirement

I was recently asked to share my thoughts on how to spend from a portfolio in retirement. In my view (without getting into the topic of whether part of the portfolio should be annuitized) there are three broad questions you have to answer:

  1. Which account(s) to spend from each year (i.e., Roth, tax-deferred, taxable),
  2. Which assets to spend from (i.e., stocks first, bonds first, or both at the same time), and
  3. How much to spend per year.

Which Account(s) to Spend From?

While tax planning is very case-by-case, there is broad consensus on the strategy that most often makes sense. (See this paper or this article from Colleen Jaconetti and Maria Bruno of Vanguard, or my book Can I Retire, for a more thorough discussion of this topic.)

Most often, the overall strategy is to spend in the following order:

  1. Spend RMDs,
  2. Spend from taxable accounts,
  3. Spend from Roth accounts if your current marginal tax rate exceeds the marginal tax rate you expect to face in the future, or spend from tax-deferred accounts if your current marginal tax rate is lower than the marginal tax rate you expect to face in the future.

Of note, #3 isn’t just about tax brackets. It’s about marginal tax rates, which include the effect of various tax breaks phasing out over specific income levels or various taxes kicking in at specific income levels. Also, it’s a dollar-by-dollar decision. For example, in a given year it may make sense to spend from tax-deferred up to a certain point, then switch to Roth spending once, for example, you reach the point where additional income would be taxed at a higher rate (e.g., because you’ve hit the top of your tax bracket).

A tax professional can be very helpful here. Alternatively, if you’re doing the analysis yourself, software such as TurboTax can be useful for running “what if” scenarios (e.g., how much would my overall tax bill go up if I took out an additional $1,000 from my traditional IRA this year?).

Which Assets to Spend From?

With regard to which assets to spend from first, there’s still ongoing debate on the topic.

Most target-date fund providers assume that stock allocation should decline in early retirement, then stay level for the rest of retirement (i.e., spend first from stocks, then spend from both stocks and bonds).

But Michael Kitces and Wade Pfau made an interesting case a few years back that retirees’ stock allocation should actually be lowest in the years immediately before and after retiring, when their finances are most exposed to years of bad returns. That is, your bond allocation should be at its highest point when you retire, and you should be reducing your allocation to bonds gradually from there.

How Much to Spend Each Year?

As far as how much to spend per year, that’s also a topic where there’s a lot of discussion/debate. It mostly centers around whether or not the “4% rule” — in which you spend 4% of your portfolio in the first year of retirement, then increase that level of spending each year in keeping with inflation, regardless of how your portfolio performs — is actually safe.

For instance, Wade Pfau took a look at how a 4% inflation-adjusted withdrawal rate would have worked if used in other countries, and the answer is that it would have been quite risky. That is, it may just be a historical fluke that such a strategy happened to be pretty safe in the U.S. in the 20th century.

In addition, the low interest rates we face today strongly suggest that a 4% withdrawal rate is riskier today than it would have been in the past (in the U.S.), because we can be pretty confident that the bond portion of the portfolio will provide less total return than in most historical cases in the U.S.

A counterpoint, however, is that if you are flexible with how much you spend (i.e., you could easily cut spending if your portfolio experiences poor returns early in retirement), you can start with a higher withdrawal rate. (For a good discussion of this topic, see the second video in this article in which financial planner Jonathan Guyton explains his applicable research.)

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Re-evaluating Betterment After Their Price and Service Change

Most readers of this blog are passive investors of some form or another, whether via Target Retirement/LifeStrategy funds, robo-advisors, or just simple index-fund/ETF portfolios.

A few readers have asked for my thoughts on the changes that robo-advisor Betterment recently made to their fees and offerings.

Previously, Betterment’s cost was 0.35% pear year for accounts up to $10,000, 0.25% for accounts from $10,000-$100,000, and 0.15% per year for portfolios of at least $100,000. And for that price, the customer received automated portfolio management, including tax-loss harvesting for taxable accounts.

Now, they will be offering three different levels of service, two of which include ongoing human advice along with the portfolio management:

  • For 0.25% per year you get the same portfolio management service as before.
  • For 0.40% per year you get portfolio management, plus an annual call with their CFP team.
  • For 0.50% per year you get portfolio management, plus unlimited calls with their CFP team.

In other words, it’s a price increase for people who have at least $100,000 with Betterment, and a price decrease for people who have less than $10,000 invested with them. And now there are two additional options to choose from (for people who meet the applicable minimum account sizes).

The price change makes Betterment’s portfolio management price nearly identical to that of their closest competitor, Wealthfront, which also charges a flat 0.25% per year for portfolio management (with the exception of the fact that Wealthfront will manage the first $10,000 of assets for free).

Compared to Target Date Funds

I’ve always found it instructive to compare robo-advisors to an alternative hands-off portfolio solution: all-in-one funds, such as target-date funds, balanced funds, or LifeStrategy funds.

In my view, relative to all-in-one funds, the primary advantage of Betterment’s portfolio management service has been the fact that it is more tax-efficient when there’s a taxable account in the mix, because it includes tax-loss harvesting, offers asset location planning, and uses muni bonds rather than taxable bonds when appropriate.

As a result, the situation in which Betterment always seemed most appealing to me was for investors who:

  • Have at least $100,000 to invest (such that they’d qualify for the lowest cost),
  • Want a hands-off portfolio management solution, and
  • Have a large part of their assets in taxable accounts (such that the improved tax-efficiency would provide significant value).

I think the same holds true today, except for the fact that there’s no longer a need to hit the $100,000 threshold for lower pricing. (Of course, for people who do have more than $100,000 to invest, the price just went up by 0.1%, thereby meaning that the value of the tax-efficiency must overcome an additional 0.1% annual hurdle in order to provide a net benefit to the customer.)

Compared to other Human/Robo-Advisors

Vanguard’s Personal Advisor Services costs 0.30% per year. For that cost you get portfolio management, plus phone/email/Skype contact with a Vanguard advisor whenever you want. The service does not, however, include tax-loss harvesting.

Similarly, Schwab recently announced that they’ll be launching a human/robo service later this year. The cost for that service is supposed to be 0.28% per year (with an annual maximum of $3,600). And what you get for that cost looks very similar to Vanguard’s service — portfolio management, plus as-needed contact with a Schwab advisor. One noteworthy difference: for accounts of at least $50,000, they will also provide automated tax-loss harvesting.

Schwab’s upcoming service and Vanguard’s Personal Advisor Services seem most comparable to Betterment’s 0.5% service level, because they each include unlimited access to human advisors.

The Betterment platform would be preferable to the Vanguard platform if you think that tax-loss harvesting will be worth at least 0.2% per year (in order to justify the additional cost). But I’m not really sure how it would be better in any way than Schwab’s new service once that is released, as the Schwab service appears to offer all of the same things, at a lower cost (0.28% annually rather than 0.5%).

(Of course, it’s possible that the Schwab service will have some “catch” that we have yet to learn about. Presumably we’ll get more information when the service is actually released and people try it out and report back on their experiences.)

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