How to use laddered inflation-indexed bonds (i.e., TIPS), CDs, fixed annuities, and fixed index annuities to meet retirement living expenses while worrying less about running out of money.
Topics covered include:
- How individuals can use liability-driven investment strategies
- Why now is the best opportunity to buy Treasury Inflation Protection Securities in 15 years
- How to use bond ladders
- How deferred fixed and deferred variable annuities work
- How to analyze fixed index annuities
Show Notes
Worry-Free Investing by Zvi Bodie and Michael J. Clowes
New 5-year TIPS auctions with a real yield of 1.732%, highest in 15 years—TIPSwatch
Complete List of Multi-Year Guaranteed Annuities (MYGAs), October 26, 2022—ImmediateAnnuities.com
Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement by Wade Pfau
A Complete Guide to Investing in TIPS and I Bonds—Money for the Rest of Us
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Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today’s episode, 407. It’s titled “Worry-Free Retirement Investing.”
Two weeks ago, in episode 405 we discussed how many UK pension plans were using liability-driven investment strategies. These plans got into trouble because they went beyond trying to match their assets with the liabilities but instead used implicit leverage, debt that is baked into derivative contracts in order to try to grow their assets.
When these derivative contracts fell in price as interest rates rose, these UK pension plans were forced to sell bonds, which caused those bond prices to plummet, and the yields or interest rates to spike.
Interest rates got so out of hand that the Bank of England had to step in and purchase bonds in order to calm markets.
Liability-driven Investment
Liability-driven investment in its simplest form is a sound concept. It is at the heart of what insurance companies do. They estimate what their payout is for claims, such as in the case for life insurance, or annuities, where they promise an ongoing payment to annuitants.
They estimate what those cash flows will be each year, and then develop an investment strategy which mostly consists of bonds, so that the cash flow from their investments and premiums are sufficient each year to meet the expected claims and cash flow needs, including covering expenses, and so there’s enough so that there’s a profit for the insurance company.
Bond Ladders and TIPS
In 2003 I read a book by finance professor Zvi Bodie, titled Worry-free Investing. He proposed a liability-driven investment strategy for retirees that made a lot of sense to me. It used what at the time was a relatively new investment vehicle—Treasury Inflation Protection Securities, or TIPS. TIPS are U.S. government inflation index bonds.
Bodie recommended structuring what is known as a bond ladder using TIPS. A bond ladder is a series of bonds that mature, and the proceeds from that bond maturity is then used to cover the cashflow that the retiree has that year. At the time the book was issued, the real yield on tenure TIPS was around 2%. That meant an investor would earn 2% plus the rate of inflation on those bonds.
A retiree could buy a series of TIPS that would mature each year for the next 20 years, and those bonds would be used to fund the investor’s spending for that year. And since the bonds had an interest rate of 2% before inflation, the retiree would benefit from compounding to meet those future expenses. That intuitively makes a lot of sense to me, and it did when I read the book. However, the ability to implement it basically went away.
Since 2007, the yield on tenure TIPS has been less than 2%, except for a period of market dislocation in 2008 when the yield on TIPS spiked to 4%. Believe me, I bought TIPS then; it was the opportunity of a lifetime to buy TIPS. And then I sold it once rates fell, and I got the capital appreciation.
But that foray into TIPS wasn’t an asset-liability matching approach, and it’s been difficult to match those assets with projected cash flows, because the yields on TIPS have generally been less than 1% for most of the past decade, and there have been extended periods of time when the yield has been negative, which means a TIPS investment actually didn’t keep up with inflation because the real yield or the yield net of inflation was negative. It’s costing money on a real basis to hold those TIPS.
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