Proponents of bond ladders argue that they will significantly improve the security of financial plans. Others contend that the risk reduction benefits are merely a mirage. I side with the latter view and will explain why.
There is a lot of literature on bond ladders. Those who have written about the subject range from personal finance columnists to academic economists. Names include Suze Orman, Jane Bryant Quinn, Dirk Cotton, Harold Evensky, Michael Kitces, the Bogleheads, Michael Edesess, Wade Pfau and Moshe Milevsky. Stephen Huxley and J. Brent Burns, who developed the concept of asset dedication, are strong advocates for laddering and have written extensively on the subject. Many investment companies have also produced material on bond ladders.
In addition to these articles and books, online discussions with different points of view are particularly informative. This "Retirement Researcher" blog post from Wade Pfau early this year attracted 86 comments, and this later APViewpoint discussion drew 25 comments.
Types of bond ladders
Based on the literature, it is apparent that there are various structures and uses for bond ladders. All bond ladders are portfolios of individual bonds with maturities chosen to match the timing of future obligations. For example, one could construct a bond ladder to pay for the next seven years of estimated retirement expenses.
Discussions about bond ladders are complicated because they depend on particular structures and uses. I have attempted to clarify things by developing the following classification.
Rolling ladders
Tactical or non-tactical
Non-rolling ladders
Fixed term – short or long term
Lifetime
In a rolling ladder, new bonds are purchased for the back end of the ladder as bonds mature at the front end. In a non-tactical rolling ladder, the maturity of the longest bond and the overall ladder structure remain constant. A tactical ladder involves varying the maturity of the longest bond based on investment market conditions. For example, one tactical strategy is to not replenish the back end of the ladder when stocks perform poorly.
The non-rolling ladders are used to meet either fixed or lifetime obligations. For example, a short-term ladder might be used for an individual who retires at 65 and decides to defer Social Security until age 70. A ladder of bonds or CDs could be set up to fund five years of retirement expenses until Social Security begins. A long-term fixed ladder might be used by an individual who retires at 65 and has purchased a deferred-income annuity (DIA) that commences payments at age 85. Such an individual might use a TIPS ladder to provide inflation-adjusted income for the 20-year deferral period. A lifetime ladder might be used by an individual wishing to build a base of secure retirement income above that obtained from Social Security.
Evaluating non-rolling ladders
Bond ladders might seem ideal for meeting fixed-term obligations. Just set up a ladder and guarantee that bond maturities will match obligations regardless of changes in interest rates or investment market disruptions. However, there might be less costly, less complicated, or less risky ways to accomplish the same thing.
For Social Security delay, a better solution could be a product that doesn't yet exist. An individual who needs to fill the income gap until Social Security begins could go to an investment company or their company's 401(k) and invest in a custom product, paying an inflation-adjusted income that would seamlessly transition into their delayed Social Security. This type of arrangement could be implemented with TIPS purchased to fill the gap, but I'm describing a more integrated product. With Social Security optimization strategies gaining increased attention, the development of such a product would not be a surprise.
For the DIA example, one could compare how much one would need to purchase a TIPS ladder and a DIA versus buying an inflation-adjusted single-premium immediate annuity (SPIA). The TIPS/DIA combination would provide cash to heirs in the event of an early death. The most appropriate comparison would be with a SPIA with a cash refund provision that would guarantee recovery of at least the SPIA purchase price. There would be some differences in inflation protection and liquidity. A quick examination based on current market rates indicates that the prices of the two strategies are close. One would need to consider client and product particulars in deciding on the best strategy.
For the lifetime ladder, the natural comparison would be an inflation-adjusted SPIA. For a 65-year-old female a $100,000 purchase of an inflation-adjusted SPIA with a cash refund provision would pay $355.66 per month based on rates from Income Solutions®. Using the current yield on 20-year TIPS of 0.77%, if one wanted to be safe and do a TIPS ladder to age 100, the income generated would be $271.69 per month. The 30% income advantage for the SPIA makes it a potentially worthwhile alternative to the TIPS ladder.
Evaluating rolling ladders
Rolling ladders are typically used with retirement plans based on the "bucket" or "time-segmentation" approach. A bond ladder might be set up, for example, to fund seven years of retirement expenses and a longer-term bucket set up with all stocks or a stock/bond mix. Maturities from the bond ladder would be used to pay expenses, while funds to replenish the back end of the ladder would come from the longer-term bucket. With a non-tactical approach, the back end of the bond ladder would be replenished each year to keep the bucket maturity at seven years. With a tactical approach this decision would not be automatic but would depend on investment market performance.
With the non-tactical approach, a rolling ladder is analogous to a mutual fund with a limited number of bond investments and a duration and maturity structure that doesn’t change. It is natural to ask, "Why bother with a bond ladder? Why not just invest in a bond mutual fund with the same duration?"
To sort out this issue, we need to focus on the precise meaning of duration. The technical definition is: the dollar-weighted time to maturity for a series of cash flows, with the cash flows adjusted to present values based on an interest rate reflecting the riskiness of the cash flows. This posting provides a full explanation with examples. Duration not only provides a measure of time to maturity, but also—and more usefully--provides an approximate measure of price or market value sensitivity to changes in interest rates. If a bond has a duration of three, a 1% increase in interest rates will decrease the market value (or price) of the bond by approximately 3%.
The cash flows associated with a stream of expenses will have a duration as will the maturities from a bond ladder. If a bond ladder is set up so the maturities exactly match a stream of expenses, the durations will be the same because the cash flows are the same. The bond ladder will pay off the expense stream regardless of any changes in interest rates. However, in the case of a rolling bond ladder, one could achieve this immunization against changes in interest rates by investing in a bond mutual fund with the same duration as the cash flows, or more practically, in a mix of mutual funds with a weighted duration equal to duration of the cash flows.
It's best to avoid bond mutual funds where the manager exercises a lot of discretion over duration and credit risk. In an August 2014 Advisor Perspectives article on fixed income strategies, I advocated mutual funds following passive strategies and investing in Treasury bonds or TIPS. Such mutual funds would also provide the best fit as alternatives to bond ladders.
But aren't ladders still safer?
In discussion postings, some express concern that using mutual funds in the manner I've described would be risky; an increase in interest rates, they fear, will cause the fund to lose value and reduce the sustainable withdrawal rate. However, if the fund and payment stream durations are the same, the decline in fund value will match the decline in the present value of the payment stream. The immunization will therefore still hold. In other words, the reduced-value fund will now earn a higher interest rate, which will offset the market value reduction and still support the payment stream.
Proponents of the bond ladders and the bucket approach also argue that having a block of immunized bonds in front of the longer-term bucket devoted to riskier investments insulates the overall portfolio from sequence-of-returns risk. Response to this concern differs depending on whether the bucket approach is non-tactical or tactical.
For the non-tactical case, a steady stream of sales from the longer-term bucket replenishes the back end of the bond ladder. In terms of sequence risk, this presents the same situation as a regular systematic withdrawal plan where investments are being sold on a regular basis to pay for retirement expenses. Using a bond ladder under this structure does not reduce the sequence-of-returns risk. Also, there is no difference in sequence risk depending on whether a ladder or mutual fund is used for the bond bucket.
The argument for the tactical case is that sequence-of-return risk can be mitigated by holding stocks and not replenishing the back end of the bond ladder when stocks perform poorly. In effect, this approach is akin to a regular systematic withdrawal plan where the stock allocation is increased when stocks perform badly. In this paper, Moshe Milevsky ran simulations comparing outcomes for this type of tactical bucket strategy versus a standard systematic withdrawal approach with periodic rebalancing to maintain a level asset allocation. He found that in scenarios with bad sequences of returns (losses in the early years), the tactical bucket strategy did worse than systematic withdrawals with rebalancing. He characterized the tactical bucket strategy as "an optical illusion at best, creating a potential for grave disappointment at worst."
Conclusion
The risk-reduction advantages of bond ladders have been overstated. In some cases there may be other products, such as annuities, that can perform the same function and also provide longevity protection. In other instances, mutual funds may work just as well as bond ladders. The comparison may come down to which approach is the simplest and least expensive. Bond ladders may provide psychological comfort for clients, but advisors need to recognize the difference between psychological effects and real financial benefits.
Joe Tomlinson, an actuary and financial planner, is managing director of Tomlinson Financial Planning, LLC in Greenville, Maine. His practice focuses on retirement planning. He also does research and writing on financial planning and investment topics. He very much appreciates input from Wade Pfau and Dirk Cotton on bond ladders, but notes that the opinions expressed in the article are his own.
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