The following are in response to Wade Pfau’s article, How to Use Bond Ladders in Retirement Portfolios, which appeared last week:
Dear Editor,
Dedicated portfolio theory is one of the most overlooked retirement income strategies in the advisory profession. This is perhaps due to the fact that modern portfolio theory – sadly – treats fixed-income allocations all the same, making no distinction between bond funds and individual bonds. Wade Pfau deserves full credit for applying his formidable research talent to investigate and highlight what it brings to the table in solving the retirement income problem. My comments here support his work and call for more research on this topic.
One of the questions I have asked advisors over the years is how many of their prospects understand that bonds held to maturity are guaranteed to return principal. The usual answer is less than half. The taboo word “guarantee” often raises the question of default probabilities for advisors. Only U.S. Treasury bonds are guaranteed, but that is because the Treasury has the right to print money and give it you. But some advisors are unaware of how close you get to zero percent default probability with investment-grade munis and corporates (.07% for muni and 2.78% for corporate defaults over the average 10-year span based on 1970-2012 data from Moody’s). How much anxiety relief would retirees feel if they understood that there is a way to (99.93% or 97.22%) guarantee their income stream without resorting to the high cost and other negatives associated with annuities?
When asked how many of their prospects understand the fact that bond funds will lose value permanently if rates rise to higher levels and remain there, the same answer shows up: less than half. This means advisors have a lot of education to do for clients to make them understand the difference between owning individual bonds and bond funds.
Regarding the Pfau’s analysis, several points deserve discussion. The assumption that the yield curve will remain stationary represents a soft spot in the analysis, as Pfau pointed out. This assumption means that the historically low yields right now will remain in place for the next 30-40 years – a depressing scenario that is fortunately unlikely. The result is worsened by using Treasury bonds rather than higher paying investment-grade bonds. It would be interesting to do a sensitivity analysis to see how much different the results would be if more normal yield curves and other bonds were used. In fact, sensitivity analysis for the assumptions regarding the mean return, inflation and withdrawals would also be interesting and worth additional research.
Another comment on the analysis is that Pfau’s model follows the traditional assumption that the investor (and/or the advisor) is completely oblivious to what is happening to the level of funds remaining in the portfolio each year and continues extending the ladder and maintaining the same spending rate. Part of the asset-dedication package is to monitor the level of the portfolio to make sure it is on or above the “critical path” it must follow to last 30 (or 40) years. If it falls below, the portion of the overall portfolio allocated to the bond ladder that generates the income (“Income Portfolio”) should not be extended. If it falls too far below, spending would have to be curtailed by forgoing the automatic inflation kicker or by a real reduction in spending. The goal is keep the probability of success at 80% (or whatever probability limit is chosen) or better.
One of the flaws of any Monte Carlo analysis, regardless of how trials are simulated, is its very rigid mathematical counting of failure rates. Even if a scenario fails by one penny, it is still counted when computing the probability of failure. Another avenue of research would be to estimate the probabilities of achieving 95% or 99% success as well as 100%.
But my points here are minor issues regarding another fine piece of work by Wade Pfau. Retirement income research – indeed, most personal financial planning research – continues to be shackled by the reliance on modern portfolio theory (MPT). MPT was originally designed for institutional investors, not personal investors. It is unfortunate that generations of planners have been led to believe it is the only approach to investing, even though it focuses on short-run returns rather than long-term success. Hopefully, as more advisors become aware of dedicated-portfolio theory, they will demand more research similar to this piece.
On our website, anyone can see how dedicated income portfolios are built under the Login “Demonstration Tool” link. It constructs the ladder using coupon bonds (governments, corporates or munis) for 3- to 10-year time horizons with zero to 6% annual inflation increases. It is for educational purposes and – most importantly – it is free!
Stephen J. Huxley, Ph.D.
Chief Investment Strategist
Asset Dedication, LLC
Mill Valley, CA
Dear Editor,
I have a lot of respect for Wade Pfau and the work that he does. I am not convinced by his argument in this article. He stated that rising rates hurt both bond fund and bond ladders, but for the latter (no pun intended) believes retired clients “need not be flustered.” He goes on to argue that capital losses are only relevant when an individual bond is sold, but the same argument can be made for funds: Capital losses need only be relevant if sold (although I disagree with both statements. I think capital losses are always relevant whether realized or not. Absolutely there is an economic cost in both scenarios). Investors can just as “happily ignore the fluctuating value” of funds as ladders, using Pfau’s argument. Why pay less attention when it’s a ladder than a fund? Isn’t a fund essentially a ladder but with many more bonds, more liquidity, better diversification and similar cost?
Your argument makes sense for the situation when there is an exact asset/liability match situation. However, most of our clients just roll their ladders – that is, every time a bond matures, it’s used to purchase the last rung on the ladder. Confusion arises because clients believe they have no interest rate risk and no economic concerns, but that is not true. If anything, unlike the introduction in your article, investors often have a bias to ladders over funds because of a misperception that the ladder cures their fears. It doesn’t in most cases. Funds are far more liquid, more diversified and often cheaper after expenses and trading costs.
Thank you,
Terri Spath, CFA
Vice President, Investments
Mercer Advisors
Santa Barbara, CA
Wade Pfau responds:
The issue here is that in the post-retirement period, I am assuming that the person is spending down from their bond holdings. With the ladder, they just spend the maturing bond and do not face any capital losses. With the bond fund, they are more exposed to sequence-of-returns risk. To spend a given amount from their bond funds, they have to spend a higher percentage of the remaining asset value, which digs a hole that makes their retirement less sustainable. In both cases, they are spending down assets, but with the ladder approach the capital losses do not affect them.
About the relevance of the capital losses: You are right in a sense that it's always unfortunate when someone faces paper losses. Had they waited, they could have bought their bonds for a lower price. But this gets at the point that for household investors in retirement, their objective is more aligned with having a sustainable income for life, which doesn't always match directly with trying to maximize wealth portfolio returns. This would apply more to households for which leaving a large legacy is not a primary objective, only ensuring a sustainable income for life.
I'm trying to make a distinction between a bond ladder as you describe it, and a "bond ladder for retirement income." The case I'm discussing is about when there is an asset/liability match.
Dear Editor,
I would be curious as to author's thoughts on using defined maturity ETFs in this way (or perhaps as a complement to this approach).
Charles G. DeNormandie III
Managing Director
North Point Wealth Management
Alpharetta, GA
Wade Pfau responds:
I understand that a number of companies are now offering ETFs with a collection of bonds that otherwise behaves like an individual bond with a clearly defined maturity date. As long as the costs are reasonable, this is an idea which has a lot of merit.
The following is in response to Joseph Stiglitz’ commentary, The Great Malaise Drags On, which was published on January 6:
Dear Sir,
I had the great privilege of assisting a conference by Professor Stiglitz in Mauritius some time ago. I found him articulate, coherent and full of good sense. Having said that, he and his fellow academic, Nouriel Roubini, are pessimists. The world, as both these men are intelligent enough to understand, is imperfect. Mauritius, and I have no doubt many other developing democratic countries, has made huge strides in the 45 years since its independence from Britain in 1968. Human beings have over the years demonstrated the ability to right what is wrong, and society generally moves forward.
What is important is whether you see the glass half full or half empty.
Regards,
René Leclézio
Managing Director
Promotion and Development, Limited
Port Louis, Mauritius
The following is in response to Mark Mobius’ commentary, Emerging Markets 2014 Outlook: Shaping the Next Decade, which was published on January 7:
Dear Editor,
I am a Brazilian financial advisor and follow you on Twitter.
Mobius' perspectives on Brazil are nicer than it is.
Mobius is correct about the positive impact of the World Cup and Summer Olympics. But he knows too little about our politicians and the Draconian laws in our country, which make good companies ashamed to be successful. Those companies are being destroyed by labor- and trade-protection laws, and by unexpected changes in governmental policy.
There have been problems with our electrical industries, telephone companies and miners. Our airlines will be the next to suffer.
I hope it will be different, but I am not optimistic.
Best Regards
Marcelo Castro
Financial Personal Advisor
São Paulo Brazil
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