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Building a Super-Safe Retirement Portfolio

A reader writes in asking,

“I was laid off 20 months ago at age 61 and have been unable to find another job. I think at this point it’s time to start calling myself retired. I had planned to work until 65 at least, so my savings aren’t what I’d hoped they’d be.

My question is about asset allocation. I don’t care about getting rich. I don’t feel the need to go on cruises or travel the world. I just don’t want to run out of money.

I just want to know what is the safest allocation I can use. I know that bonds are safer than stocks, but with no stocks, how does one keep up with inflation? On the other hand, I understand that it’s problematic to be caught by a bear market at the beginning of retirement if you have too much in stocks.”

Inflation-Adjusted Fixed Income

The idea that bonds expose you to a great deal of inflation risk is left over from a time prior to the existence of inflation-adjusted bonds. These days, there are fixed income investments that provide inflation-adjusted income:

  1. Treasury Inflation-Protected Security (TIPS), and
  2. Inflation-adjusted lifetime annuities.

TIPS are Treasury bonds that promise a specific after-inflation (“real”) interest rate, as opposed to a before-inflation (“nominal”) interest rate. And a lifetime inflation-adjusted annuity is essentially a pension that you can buy from an insurance company, that will be adjusted upward with inflation.

If your goal is to come as close as possible to eliminating the risk of running out of money, these are the tools for the job. Of course, the drawback is that using your entire portfolio to buy TIPS and inflation-adjusted lifetime annuities will completely eliminate any possibility of a happy surprise — the sort of thing that at least could happen with stocks.

In addition, it’s important to recognize that neither TIPS nor inflation-adjusted lifetime annuities are risk-free. (Nothing is risk-free.)

Risks with a TIPS Ladder

A bond ladder is a portfolio of individual bonds, designed so that some bonds mature each year, thereby freeing up money to spend. If you create a ladder of TIPS, your two primary sources of risk would be reinvestment risk and longevity risk.

Reinvestment risk is the risk that, when your bonds mature, you’ll have to reinvest the money at a lower rate of interest than you had anticipated. This risk arises because it’s not always possible to find TIPS with the exact maturity dates you need. For example, the longest-term TIPS mature 30 years from now. If you wanted to build a 35-year TIPS ladder, there’s no way to know right now — while you’re doing your planning — what interest rates you’d get in years 31-35.

Longevity risk is the risk that you’ll live longer than you had planned. For example, if you design a TIPS ladder to be liquidated over 25 years, but then you end up living 30 years, you have a financial problem.

Risks with a TIPS Mutual Fund

If you hold an individual TIPS until it matures, you know exactly what return you’ll get over the life of the bond. If you sell the bond prior to maturity, however, there’s no way to know with certainty what return you’ll earn, due to the fact that TIPS’ market prices fluctuate with changes in market interest rates (specifically, real interest rates).

With a TIPS mutual fund, each time you sell shares to pay living expenses, you’re effectively selling a smattering of TIPS of different maturities, all before their maturity date. As a result, if you’re using a TIPS mutual fund (as opposed to a TIPS ladder), you’ll have an additional source of risk: interest rate risk.

Risks with Inflation-Adjusted Lifetime Annuities

Because inflation-adjusted lifetime annuities promise a certain (inflation-adjusted) level of income for your entire life, they do not expose you to longevity risk or interest rate risk.

They do, however, expose you to more credit risk than TIPS because they’re backed by an insurance company rather than by the federal government.

Overall, however, the degree of credit risk is quite low given that:

  1. Insurance companies tend to be financially healthy, and
  2. There’s a second level of credit protection provided by the state guarantee associations.

(It’s worth noting, however, that those guarantees have limits, which vary by state, and it’s not the state itself that provides the guarantee. Rather, the association is funded by the insurance companies doing business in the state.)

TIPS or Inflation-Adjusted Annuities?

Given that TIPS and inflation-adjusted annuities expose you to different types of risk, the safest overall plan, naturally, is to use some of each.

As far as choosing how to allocate between the two, it’s largely a question of whether you care more about:

  1. Spending more during your lifetime, or
  2. Leaving more to your heirs.

Because lifetime annuities provide a meaningfully higher level of income than TIPS, they allow you to spend more per year. But the money disappears when you die, whereas a not-entirely-liquidated portfolio of TIPS would be left to your heirs.

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  1. Mike, good advice as this is the best one can hope for in these circumstances when wanting to play it safe..

    A couple other related ideas… make sure to maintain an emergency fund. If all wealth goes into either the TIPS ladder or the annuity, then there is no flexibility if some surprise expenses show up.

    Another possibility, though it doesn’t fully protect from inflation, is to build a TIPS ladder for 20 years or so, and then also buy a deferred immediate annuity that will begin payments in 20 years. This would allow for keeping more control over one’s assets while still benefitting from the longevity protection of annuities.

  2. Good suggestions, Wade. Your emergency fund point is especially important for people who end up leaning heavily toward annuities.

    By way of explanation for other readers: For people with a TIPS ladder, future years’ TIPS can be sold ahead of time (undesirable obviously, but possible). With a lifetime annuity, there’s no such liquidity.

  3. Mike, do you not think this reader would benefit from holding a small percentage (say 20-25%) for the long term in a stock fund?

  4. Larry,

    Possibly. Or rather, given the nature of stocks and their expected returns, yes, he would probably benefit. But he might not.

    As far as deciding whether or not that would be a good idea, I think it depends primarily on how much income the investor wants to be sure of having per year, and how the size of the portfolio compares to that amount.

    For example, if the investor feels that he’d just barely squeak by on the income he’d get from annuitizing nearly the entire portfolio, then there’s probably not much room for anything else (that is, anything with more risk). But with a larger portfolio (and the same level of desired income), there’s more room to take on some risk in order to have a decent shot at a higher level of income.

    Edited to add: I’m working on a follow-up post on this topic.

  5. Mike,
    Since the person is only 61 he could also consider delaying social security as a way to annuitize his portfolio:

    If it were me I would try to find some kind of work, even if it is part time work to minimize the drain on the portfolio. The less he takes from the portfolio today the better he will be in the future.

    -Rick Francis

  6. I just watched Consuelo Mack’s WealthTrack (on-line). Her guest was Robert Kessler who advocates buying Treasuries, especially for one’s retirement portfolio. I didn’t follow his explanation of expected returns. Rates are now at 3%, he expects them to go to 2%, which gives a yield of 25-30%. How is that return arrived at? (Worst case scenario, you have the 3% return.) I’ve never grasped how bond returns work. If anyone could help that would be appreciated. And how is it relevant if you’re buying a bond fund i.e. VG Total Bond Fund, and not individual bonds? Kessler recommeneded Treasury STRIPS. Thanks.

  7. Hi Nancy.

    This article explains how bond prices move in relation to interest rates. In short, if rates go down, bond prices go up. The longer the duration of the bond in question, the more the price will move for a given change in interest rates.

    A good approximation is that the change in price will be approximately equal to the duration of the bond, times the change in interest rates. For example, a bond with a 10-year duration (or a bond fund with an average duration of 10 years) would increase in price by 10% if interest rates fell by 1%.

    Or, if you had a bond (or bond fund) with a duration in the 12-15 year range, a 1% decrease in market interest rates would result in a 25-30% increase in price. (Though this is a one-time effect. It would not mean that you’d earn that return over the life of the bond.)

    STRIPS are explained here. In short, a zero coupon security (such as a STRIPS) will have a longer duration than a regular bond with the same maturity — thereby resulting in a greater sensitivity to changes in interest rates.

    Personally, I think guessing at future changes in interest rates is a fool’s errand.

  8. Good advice. Although both are boring, these really are about as close to “safe” as you’re going to get. In general, do you feel as though one could obtain a better net rate of return from the annuity versus the TIPS?

  9. MyMoneyDesign,

    It’s just not an apples to apples comparison. Annuities definitely provide for a higher level of spending than TIPS do. But that’s because you give up the money when you die. (See here for more on that.)

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