March 24, 2009
Implementation Concerns
Because investors must construct a diversified municipal bond portfolio with half their assets, this approach requires a minimum portfolio size of at least $2 million. For smaller portfolios, the investor must either sacrifice diversification or use an all-TIPS allocation.
The safe withdrawal rates from this portfolio are highly sensitive to current market conditions (specifically yields on municipal bonds). Yields on municipals are at an extraordinary level relative to Treasury bonds, but they are at an average absolute level, as shown below:
Since 1982, the average yield on AAA-rated municipals has been 6.32%, and in the past decade the average rate was 4.98%, exactly equal to current rates. Analogous to Kitces’ research, investors can assume higher withdrawal rates when municipal bond rates are higher.
Instead of municipals, investors could construct a portfolio of investment grade “bullet” corporate bonds. The primary advantage is that these bonds are not callable, but that consideration is not relevant in an environment of increasing inflation. At today’s rates, an investment grade portfolio consisting of issuers such as Verizon, AT&T, Boeing, and IBM will yield approximately 6.00%, roughly the same as the taxable equivalent yield on AAA-rated munis, but with a greater risk of default.
As with previous studies, this analysis is conducted on a pre-tax basis. The use of TIPS introduces the issue of the “phantom tax” on the accrued principal value, which is taxed at ordinary income rates. For this reason, TIPS should be located in a pension account or similarly sheltered vehicle. The phantom tax issue arises in an inflationary environment, when the TIPS principal is accruing and the municipal bond values are declining. If a sheltered account is not used, up to $3,000 per year of the phantom tax could be offset against capital losses on the municipal bonds.
Only individual bonds should be purchased. Bond funds are not constructed to a fixed 30-year maturity, as is necessary in this approach. The expense ratio of a typical bond fund would impose a costly drag on the projected cash flows. For actively managed bond funds, the manager’s incentives are not aligned with those of the investor. The investor seeks highly predictable cash flows over a 30 year period, whereas the bond manager is measured based on performance relative to a benchmark, usually over short time frames.
In practice, advisors may wish to construct a laddered maturity portfolio to reduce overall volatility. This would reduce the withdrawal rates I cite, assuming a rising yield curve. Depending on the interest rate environment, however, a portfolio could be constructed to support a fixed (e.g., 4%) withdrawal rate using only 20- and 30-year instruments.
Bengen and all subsequent researchers allow for the depletion of principal over the course of the 30-year period. But advisors must consider the psychological effect on retirees of watching their balance approach zero as they age. Advisors must also consider mortality risk and the possibility an investor may outlive his or her assets. For this reason, I show the safe withdrawal rates without the depletion of principal.
Some retirees may require (or desire) unrealistically high withdrawal rates. Under the equity-centric approach, planners could increase the equity allocation to 100% or, if that isn’t enough, advise the client to take a trip to Las Vegas. Under the all-bond approach, planners can use increasingly risky bonds. Planners must then consider the risk of default and the introduction of excessive volatility. But these risks are quantifiable, making the approach far more preferable to the near-certain loss of principal from gambling one’s savings in a casino.
Statistically, retirees are slightly more vulnerable to inflation than the rest of the population. Since 1982, the government has tracked a separate CPI index (the CPI-E) to measure the inflation that the elderly face. Over the last quarter century, the CPI-E has been 3.3%, versus 3.1% for the broad-based CPI-U (which is used for the TIPS calculation). But for wealthier retirees (i.e., those meeting the $2 million minimum portfolio criterion), inflation concerns diminish. Wealthier retirees have more options to cut back on expenses (e.g., by taking fewer vacations or buying fewer luxury goods). Overall, for less-wealthy retirees, a retirement strategy with an increased emphasis on hedging against unchecked inflation may be necessary.
If I were to retire today, this is the portfolio I would choose.
The author wishes to thank Michael Kitces for his extremely valuable contributions to this article.
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