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Building a Safe Floor of Retirement Income — in Advance

A reader writes in, asking:

“I’ve been reading about the safety first school of retirement planning because I think that appeals to me more than the probability method of just spending from risky investments and assuming everything will ‘probably’ be okay. My question is how to start putting such a plan into action in advance.

With the old school probability method, I would just keep building my mutual fund holdings, possibly rebalancing to hold more bonds instead of stocks. The ‘safety first’ method focuses on delaying social security or buying an annuity. But I can’t delay social security until I’m 62. And I can’t, or shouldn’t, buy an annuity in my 50’s either. So what should I, as a safety first investor in my 50’s, be doing right now in the years leading up to retirement?”

As a bit of background for readers unfamiliar with the terms, there are two broad schools of thought with regard to retirement planning. The first school of thought plans to finance retirement spending primarily via liquidating a mutual fund portfolio (or a portfolio of individual stocks/bonds) over time. This approach relies heavily on historical studies and/or Monte Carlo simulations to calculate how safe a certain level of spending is, given various assumptions. This approach is sometimes referred to as the “probability” school of thought, because it focuses on metrics such as “probability of portfolio depletion.”

The second approach essentially says, “I don’t want to bet my retirement on the validity of such studies/assumptions. I’d rather lock in sufficient safe income (e.g., via annuities, pension, Social Security) to satisfy my needs and only use mutual funds to finance my discretionary spending.” This school of thought it sometimes referred to as the “safety first” or “safe floor” method of retirement planning.

The answer to the reader’s question about how to start implementing a “safety first” plan in advance is that you start building a TIPS ladder (or other bond ladder, or CD ladder) that you will use to fund your spending while you delay Social Security, or to fund your annuity purchase.

To plan in advance for delaying Social Security, you would allocate a portion of the portfolio to a bond ladder that will provide the necessary cash each year for 8 years. For example, if you’re passing up $1,500 per month ($18,000 per year) for 8 years, you could start building an 8-year bond ladder, with roughly $18,000 maturing each year.

If Social Security at age 70 still doesn’t give you a sufficient “safe floor” of income to meet your needs/satisfy your risk tolerance, then you should start thinking about a lifetime annuity.

To start planning in advance for an annuity purchase, you’d do something similar — build up bond holdings that you would eventually use to fund the purchase. What’s different about this, relative to delaying Social Security, is that you don’t know how much the annuity will cost. For example, if you anticipate buying a lifetime annuity at age 70 that pays $10,000 per year, there’s no way to know right now (in your 50s) how much that annuity will cost, because you don’t know how high or low interest rates will be when you turn 70.

The solution, rather than buying a bunch of bonds that mature when you turn 70, would be to work on building bond holdings that, when you turn 70, will still have a duration roughly equal to that of the annuity you expect to purchase. This way, the market value of your bonds will rise/fall along with the cost of such an annuity, helping to offset the interest rate risk that you face with the annuity purchase. (Here’s a great Bogleheads thread on that topic.)

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