Late yesterday I became aware of a recent thread about investing in TIPS funds vs TIPS bonds where my name is involved, although I have not participated in the thread. I checked out the thread to see if I was accused of crimes I have not committed. I did not find any such accusations.Suppose your retirement date is 2045. Your retirement strategy is floor and upside. Let's say your goal is to have $1MM in cash in 2045 to purchase a SPIA for guaranteed income. What is needed to achieve this goal?
You only need two assets: an index stock fund and 2045 TIPS. Start off in 2015 investing in the stock index fund. As time goes by, and the stocks have appreciated, start moving from the stock fund to the 2045 TIPS. Over time, move more and more into 2045 TIPS until you have reached your goal. In 2045, the TIPS matures into $1MM cash, you purchase a SPIA which is the floor for your retirement spending. Leave the remaining in the stock fund, which is the upside.
Link to thread -viewtopic.php?f=1&t=174265
However, I came across the above quote in the thread, which I believe deserves its own thread. I’m not including the name of the poster, who is usually quite astute, but instead only the statement, which is a viewpoint that is widely held but wrongheaded.
The above quote is referring to a basic tenet of life-cycle finance (LCF), the economics based approach to financial planning. In that approach one has two financial retirement planning goals. The lower goal is a very safe retirement income floor. The other income goal is a higher aspirational level of retirement income that we try to reach relatively safely, but typically more risk is taken to attempt to reach this higher goal.
At Bogleheads the safe floor goal is often described as the liability matched portfolio (LMP). However, what the life-cycle approach is actually doing is somewhat different in setting both floor and aspirational income goals and using an overall liability driven investment (LDI) strategy, not simply forming a sub-portfolio. The distinction is important, not simply academic grammatical nit-picking. The LDI strategy is a much safer approach to obtaining targeted floor retirement income than the LMP approach.
Let me illustrate the difference between how the LDI strategy of life-cycle finance is implemented for meeting the retirement floor income goal as opposed to how the poster uses the LMP portfolio approach. A 63 year old male wants to retire in two years at age 65 and generate from his portfolio $64,000/year in safe retirement floor income in the form of a real life annuity.
Here is his strategy using the LMP approach. Real life annuities for an age 65 male are currently yielding 6.4% payouts. Ergo, I need $1,000,000 real in safe assets in two years using as safe assets TIPS maturing in 2 yrs, or near equivalents such as T-bills, MM funds, etc. Today my portfolio consists of $940,000 in such safe assets. Interest on the assets and my future contributions to the portfolio will get me to $1,000,000 in two years. I am in good shape. (Note that this example is similar to the example in the quote with both using the $1 million goal.)
Actually the LMP people don’t think of it quite that way, they instead think of it as in the above quote and set as the goal a level of portfolio wealth at retirement, which in this case is $1,000,000 real. Either way this approach is muddled finance.
Here is the LDI life-cycle approach for the same investor. He estimates accurately that the duration of the life annuity is 15 years and that currently a life annuity delayed two years producing the income floor of $64,000 costs $940,000 - the value of his safe assets today. He also knows that when the life annuity is purchased in two years it will be more costly because it will no longer be delayed. However, interest on the assets and future portfolio contributions should cover the additional cost of the delay going away.
Because the duration of the life annuity is 15 years, the safe LDI strategy is to invest in real income assets where the duration of the assets match the duration of the annuity (the liability). This means that the invested assets are not intended to be worth $1,000,000 in two years, but rather the invested assets will be duration matched with the duration of a life annuity that will pay out $64,000/year in real income, regardless of the price of that annuity in two years. Therefore, the safe assets are a portfolio of TIPS, bonds or funds, with a duration of 15 years, not 2 years or less. The duration of these TIPS holdings will be held constant over the next 2 years until the annuity is purchased from these holdings.
The above is an extremely important distinction because the price of real annuity income moves with LT real interest changes. In this example where the life annuity has duration of 15 years, a 1% move in LT real interest rates produces a 15% change in the price of the life annuity. If LT real interest rates move up 1.5% in two years the price of the annuity drops by 22.5%, but the value of the TIPS portfolio with duration of 15 years also falls by 22.5%. If, OTOH, real LT interest rates fall by 1.5%, the price of the annuity rises by 22.5%, but the value of the TIPS portfolio with duration of 15 years also rises by 22.5%. By using the LDI strategy the $64,000/year in floor retirement income is safely preserved, regardless of changes in interest rates in either direction.
If instead the investor uses the LMP approach and interest rates rise 1.5%, the value of his safe short duration assets falls slightly, but the price of the annuity will be much lower. The investor will be able to purchase significantly more annuitized income than $64,000/year. If, on the other hand, the investor uses the LMP approach and interest rates fall 1.5%, his wealth at retirement will be slightly higher, but the price of the annuity will be much higher. In this case his ‘safe’ assets will reduce his annuity income from $64,000/year to roughly $51,000 to $52,000 per year - a very significant shortfall from his floor income goal. The LMP approach was risky, not safe, and the risk materialized.
Such large swings in LT interest rates can happen over relatively short periods in the real world. In 2007 a 65 year old male could receive a 6.4% payout from a real life annuity. Two years later in 2009 LT real interest rates had fallen significantly and the payout had fallen to about 5.0%.
When using the LMP approach to attempt to obtain a safe retirement income floor, an investor makes two critical mistakes. One mistake is trying to fit a retirement income goal into a wealth target at retirement. The other is not matching the duration of the pre-retirement assets with the duration of the income goal – the duration of the annuity. The range of possible income per year outcomes in the LMP approach is so wide that the approach fails, in any meaningful sense, to provide a safe targeted retirement income floor. Instead what is produced is guaranteed retirement income where the level of that annual income is essentially, whatever.
If instead of purchasing an annuity at retirement the investor instead builds a TIPS ladder out of wealth at retirement the same analysis holds. For the targeted retirement income stream to be safely realized, the duration of the assets pre-retirement must be matched to the duration of the retirement TIPS ladder.
I am sympathetic to those who have not realized these problems when investing to reach a safe retirement income goal. For a long time I was unaware of these problems, which are extremely important, but subtle and non-intuitive.