Three fund portfolio for retirement

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bobcat2
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Three fund portfolio for retirement

Post by bobcat2 » Mon Nov 28, 2016 2:16 pm

There is a long running thread about the three fund portfolio here at Bogleheads. The three funds in the proposed portfolio are a US total stock market index fund, an international stock market index fund, and a nominal US bond market index fund. The claim is that this portfolio is both simple and well suited for the individual investor.

Given that the asset allocation of the above portfolio is mainly determined by the estimated risk preference of each investor, the portfolio is certainly both simple and flexible. But individual portfolios have purposes and for most individuals the primary purpose of their portfolio is to provide retirement income. Is the above portfolio the best three fund portfolio for reliable retirement income, or is there a better choice? I believe there is a better choice, and that choice is clear.

If the purpose of the portfolio is to provide reliable income throughout retirement, a better three fund portfolio would be to hold a global stock index fund, a LT TIPS bond fund, and a ST TIPS bond fund.

Long before retirement the portfolio consists of the global stock index fund with only a small proportion dedicated to the LT TIPS fund and nothing in the ST TIPS fund. When the investor is in their 20s or early 30s the portfolio is about 90% equity, shifting to roughly 65% - 70% equity when the investor is in their early 40s. If one wants to hold a third fund during this time, a nominal LT bond fund, either US or global, would be appropriate.

As the investor draws closer to retirement, the allocation first shifts slowly away from the stock fund to the LT TIPS fund and then, as the retirement date approaches, the AA shifts more rapidly to both the LT and ST TIPS funds. Once the investor is less than 15 years from retirement, the assets are moved aggressively to the TIPS funds. By the targeted retirement year, say about age 65, the portfolio would allocate about 75% to the two TIPS funds and the remaining 25% to the equity fund.

Beginning several years before retirement the weighted average duration of the two TIPS funds is matched to the duration of the targeted retirement income stream from the beginning of retirement to the age of average life expectancy - about age 85. (Some build in a few years fudge factor of five years or less beyond the average life expectancy.)

By duration matching real bond assets to the income stream, the retirement income stream is made much safer, because the duration matching immunizes that income against both the risk of changes in interest rates as well as inflation risk. This duration matching is equivalent to a TIPS ladder from the beginning of retirement to average life expectancy. Both the ladder and the two TIPS funds are accomplishing the same task of matching asset duration to targeted income duration. This is also the approximate duration of a real life annuity for every year in retirement up to life expectancy. Therefore the investor can use the TIPS to very safely purchase a life annuity for targeted very stable retirement income with longevity protection, or keep the TIPS for more flexible safe income but without longevity protection, or a combination of both annuitized real income combined with flexible real income from the TIPS.

The essential point of this three fund portfolio is to control retirement income volatility, and in turn retirement spending volatility, thru the duration matching of assets to income. For in retirement planning it is this risk of the volatility of retirement income, not the volatility of the investment portfolio that should concern us.

The amount of assets devoted to the TIPS determines how much reliable retirement income is provided by the portfolio. The TIPS assets used to purchase a life annuity, along with Social Security income and DB pension income, serve as a hedge in providing a stable floor of income throughout retirement, regardless of age of death. The amount of additional TIPS assets during retirement provides additional flexible safe retirement income above the floor thru to the age of life expectancy. The remaining portion of the portfolio devoted to equity provides additional assets that can be used to increase the levels of safe annuity and TIPS assets during retirement. The equity and TIPS assets also allow for the purchase of a longevity annuity beginning at age 85 to replace the income from the TIPS and provide additional stable income in late old age.

This three fund portfolio is an example of a liability driven investment (LDI) strategy. In this case the LDI strategy reduces the uncertainty of the retirement spending stream. This is particularly true when compared to a portfolio of stock and nominal bond funds that seek to match portfolio volatility to the investor’s estimated risk preference.

See the following articles by Wade Pfau and Robert Merton for more information on this three fund approach.

https://www.advisorperspectives.com/art ... come-funds

https://hbr.org/2014/07/the-crisis-in-r ... t-planning

https://www.nestpensions.org.uk/schemew ... cs,PDF.pdf


BTW, this three fund approach is the method DFA uses in all of its retirement target date funds. Click the following links for more information on the DFA’s target date retirement strategy.

https://us.dimensional.com/target-date- ... come-funds

At the following link click on the article "Liability-Driven Investing for Retirement Planning", which is located near the bottom of the page as an article in the Summer 2016 issue of DC Dimensions.
https://us.dimensional.com/defined-contributions

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

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Re: Three fund portfolio for retirement

Post by Taylor Larimore » Mon Nov 28, 2016 4:40 pm

BTW, this three fund approach is the method DFA uses in all of its retirement target date funds. Click the following links for more information on the DFA’s target date retirement strategy.

Bob:

To my knowledge, DFA does not use the three total market index fund approach in their target funds. Their target fund Prospectus lists hundreds of individual securities in each fund. I believe their target funds are all managed funds. They are less than two years old.

It is important to understand that the financial industry seldom recommends total market index funds because they can make very little money from them.

These are experts who recommend the total-market, all indexed, low-cost Three-Fund Portfolio:

American Association of Individual Investors: "It should come as no surprise that behavioral finance research makes a strong case for buying and holding low-cost, broadly diversified index funds."

Mark Balasa, CPA, CFP: "That three-pronged approach is going to beat the vast majority of the individual stock and bond portfolio that most people have at brokerage firms. There is a certain elegance in the simplicity of it."

Christine Benz, Morningstar Director of Personal Finance: "It's hard to find fault with the "three-fund portfolio" espoused by many Bogleheads."

Bill Bernstein, author of The Four Pillars of Investing: "Does this (three fund) portfolio seem overly simplistic, even amateurish? Get over it. Over the next few decades, the overwhelming majority of all professional investors will not be able to beat it."

Jack Bogle, "The beauty of owning the market is that you eliminate individual stock risk, you eliminate market sector risk, and you eliminate manager risk. -- There may be better investment strategies than owning just three broad-based index funds but the number of strategies that are worse is infinite."

Warren Buffett, famed investor: “I’d rather be certain of a good return than hopeful of a great one. -- Most investors are better off putting their money in low-cost index funds."

Scott Burns, financial columnist: "The odd are really, really poor than any of us will do better than a low-cost broad index fund."

Jonathan Burton, MarketWatch: "There are plenty of ways to complicate investing, and plenty of people who stand to make money from you as a result. So just think of a three-fund strategy as something you won't have to think about too much."

Andrew Clarke, co-author of Wealth of Experience: "If your stock portfolio looks very different from the broad stock market, you're assuming additional risk that may, or may not, pay off."

Jonathan Clements, author and Wall Street Journal columnist: "Using broad-based index funds to match the market is, I believe, brilliant in its simplicity.

John Cochrane, President American Finance Association: "The market in aggregate always gets the allocation of capital right."

Consumer Reports Money Book: "Simply buy the market as a whole."

Laura Dugu, co-author of The Bogleheads' Guide to Retirement Planning: "With only these three funds in your investment portfolio you can benefit from low costs and broad diversification and still have a portfolio that is easy to manage."

Charles Ellis, author of Winning the Loser's Game: "The stock market is clearly too efficient for most of us to do better."

Nobel Laureate, Eugene Fama: "Whether you decide to tilt toward value depends on whether you are willing to bear the associated risk...The market portfolio is always efficient...For most people, the market portfolio is the most sensible decision."

Paul Farrell, author of The Lazy Person's Guide to Investing: "Where does Fama invest his retirement money? 'In index funds. Mostly the Wilshire 5000.' "

Rick Ferri, Forbes columnist and author of six investment books: "The older I get, the more I believe the 3-fund portfolio is an excellent choice for most people. It's simple, cheap, easy to maintain, and has no tracking error that would cause emotional abandonment to the strategy."

Graham/Zweig, authors of The Intelligent Investor: "The single best choice for a lifelong holding is a total stock-market index fund."

Alan Greenspan, former Chairman of the Federal Reserve: "Prices in the marketplace are by definition the right price."

Mark Hebner, author of Index Funds: “A diversified portfolio which captures the right blend of market indexes reaps the benefit of carrying the systematic risk of the entire market while minimizing exposure to the unsystematic and concentrated risk associated with individual stocks and bonds, countries, industries, or sectors.”

Hulbert Financial Digest: "Buying and holding a broad-market index fund remains the best course of action for most investors."

Sheldon Jacobs, author of No-Load Fund Investing: "The best index fund for almost everyone is the Total Stock Market Index Fund.--The fund can only go wrong if the market goes down and never comes back again, which is not going to happen."

Kiplinger's Retirement Report: "You'll beat most investors with just three funds that cover the vast majority of global stock and bond markets: Vanguard Total Stock Market; Vanguard Total International Stock Index and Vanguard Total Bond Market Index."

Lawrence Kudlow, CNBC: "I like the concept of the Wilshire 5000, which essentially gives you a piece of the rock of all actively traded companies."

Prof. Burton Malkiel, author of Random Walk Down Wall Street: "I recommend a total-maket index fund--one that follows the entire U.S. stock market. And I recommend the same approach for the U.S. bond market and international stocks."

Harry Markowitz, Nobel Laureate: "A foolish attempt to beat the market and get rich quickly will make one's broker rich and oneself much less so."

Bill Miller, famed fund manager: "With the market beating 91% of surviving managers since the beginning of 1982, it looks pretty efficient to me."

Money 101: "If you don’t want to leave your stock and bond allocations up to someone else, you can build a low cost portfolio that own most of the global market with just three funds. A “total stock market” index fund will hold over 3000 stocks, ranging from small companies to established corporate giants. Round that out with an international index fund to cover foreign holdings, and bond index fund."

E.F.Moody, author of No Nonsense Finance: "I am increasingly convinced that the best investment advice for both individual and institutional equity investors is to buy a low-cost broad-based index fund that holds all the stocks comprising the market portfolio."

Motley Fools: "Invest your long-term moolah in index mutual funds that are designed to track the performance of a broad market index."

John Norstad, academic: "For total-market investors, the three disciplines of history, arithmetic, and reason all say that they will succeed in the end."

Suzy Orman: "One of my favorite index funds, Vanguard Total Stock Market (VTSAX), has a total expense ratio of 0.06%"

Anna Pryor Wall Street Journal writer: "A simple portfolio of 3 funds. It may sound counter-intuitive, but for the average individual investor, less is actually more."

Jane Bryant Quinn, syndicated columnist and author of Making the Most of Your Money: "The dependable great investment returns come from index funds which invest in the stock market as a whole."

Pat Regnier, former Morningstar Analyst: "We should just forget about choosing fund managers and settle for index funds to mimic the market."

Ron Ross, author of The Unbeatable Market: "Giving up the futile pursuit of beating the market is the surest way to increase your investment efficiency and enhance your financial peace of mind."

Allan Roth, CPA, CFP, adviser and author of "How a Second Grader Beat Wall Street": "The beauty of a 3-fund portfolio is that it automatically builds the global portfolio without having to worry about standard deviations, correlations, Sharpe ratios, and the like."

Paul Samuelson, Nobel Laureate: "The most efficient way to diversify a stock portfolio is with a low-fee index fund. Statistically, a broadly based stock index fund will outperform most actively managed equity portfolios."

Gus Sauter, former Vanguard Chief Investment Officer: "I think a very good way to gain exposure to the stock market is through the Total Stock Market Portfolio on the domestic side."

Bill Schultheis, author of The Coffee House Investor: "You don't need to have eight funds. You can do it with two or three and have a great portfolio."

Charles Schwab: "Only about one out of every four equity funds outperforms the stock market. That's why I'm a firm believer in the power of indexing."

Chandan Sengupta, author of The Only Proven Road to Investment Success: "Use a low-cost, broad-based index fund to passively invest in a little bit of a large number of stocks."

Prof. Jeremy Siegel, author of Stocks For The Long Run: "For most of us, trying to beat the market leads to disastrous results."

Dan Solin, author of The Smartest Portfolio You'll Ever Own: "You can get as simple or as complicated as you'd like. You can keep it very simple by owning just three mutual funds that invests in domestic stocks, foreign stocks, and bonds. That's precisely what I recommend in my model portfolios."

William Spitz, author of Get Rich Slowly: "Few are able to beat a simple strategy of buying and holding the securities that comprise the market."

Prof. Meir Statman, author of What Investors Really Want: "It makes sense to have those three funds. What makes it hard is that it seems too simple to actually be a winner."

Stein & DeMuth, authors of The Affluent Investor: "Buying and holding a few broad market index funds is perhaps the most important move ordinary investors can make to supercharge their portfolios."

"Robert Stovall, investment manager: It's just not true that you can't beat the market. Every year about one-third do it. Of course, each year it is a different group."

Larry Swedroe, author of 17 financial books: "Over the last 75-years, investors who simply invested passively in the total U.S. stock Market would have doubled their investment approximately every seven years."

Peter D. Teresa, Morningstar Sr. Analyst: My recommendation: "A fund that indexes the entire market, such as Vanguard Total Stock Market Index."

Kent Thune, CFP, editor of The Financial Philosopher: "In keeping with the virtues of passive investing, combined with Bogle’s haystack philosophy, we can capture the entire market of securities with Vanguard index funds, investing in just three broad categories: U.S. stocks, foreign stocks and bonds."

Walter Updegrave, author and senior editor of Money magazine: "Simply invest in the following three funds (or their ETF equivalents): a total U.S. stock market fund, a total international stock market fund and a total U.S bond market fund. Do that, and you'll gain exposure to virtually every type of publicly traded stock in the world (large and small, growth and value, domestic and foreign, all industries and sectors), as well as the entire U.S. investment-grade taxable bond market (short- to long-term maturities, corporates, Treasuries and mortgage-backed issues)."

Wilshire Research: "The market portfolio offers the best ratio of return to risk."

John Woerth, Vanguard Director of Public Relations: "We would agree that this three-fund approach offers most investors a prudent, well-balanced, diversified portfolio at a low cost."

Jason Zweig, Wall Street Journal columnist and author of Your Money and Your Brain: "I think a total stock market index fund is not only the simplest, but the very best core investment for most people."
Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Three fund portfolio for retirement

Post by bertilak » Mon Nov 28, 2016 5:03 pm

bobcat2 wrote:The essential point of this three fund portfolio is to control retirement income volatility, and in turn retirement spending volatility, thru the duration matching of assets to income. For in retirement planning it is this risk of the volatility of retirement income, not the volatility of the investment portfolio that should concern us.
Bob, how does that change if one's Pension plus SS cover 100% of one's income needs?. Over time, as inflation slowly eats away at the pension, the portfolio will gradually need to pick up the slack. In the six years since retirement I can already see this approaching.

Does someone in this situation look at one's portfolio more like a pre-retirement portfolio, where the "standard" three-fund portfolio is more appropriate? This is right where I am with the pension being 65% of my income. I am invested in a "standard" three-fund portfolio at 60/40. With some international as part of that 60%.
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Re: Three fund portfolio for retirement

Post by Quark » Mon Nov 28, 2016 5:36 pm

A typical argument is that (1) stocks are likely to perform better than bonds, therefore one can take the risk and (2) TIPS don't have a high enough return to sustain spending. The average investor can't afford the luxury of a guaranteed income stream.
bobcat2 wrote:As the investor draws closer to retirement, the allocation first shifts slowly away from the stock fund to the LT TIPS fund and then, as the retirement date approaches, the AA shifts more rapidly to both the LT and ST TIPS funds. Once the investor is less than 15 years from retirement, the assets are moved aggressively to the TIPS funds. By the targeted retirement year, say about age 65, the portfolio would allocate about 75% to the two TIPS funds and the remaining 25% to the equity fund.

Beginning several years before retirement the weighted average duration of the two TIPS funds is matched to the duration of the targeted retirement income stream from the beginning of retirement to the age of average life expectancy - about age 85. (Some build in a few years fudge factor of five years or less beyond the average life expectancy.)
Vanguard's LT TIPS fund has an average duration of about 8 years. If we're duration matching to life expectancy, nothing would be in TIPS until about age 77.

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Re: Three fund portfolio for retirement

Post by bobcat2 » Mon Nov 28, 2016 5:46 pm

LT TIPS funds

I believe DFA has a LT TIPS fund and there are LT TIPS ETFs. In fact I own one offered by PIMCO. The last time I checked the PIMCO LT TIPS fund had a duration of just under 22 years. The PIMCO LT TIPS ETF has the ticker symbol LTPZ.

BobK
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Re: Three fund portfolio for retirement

Post by bobcat2 » Mon Nov 28, 2016 5:55 pm

bertilak wrote: Bob, how does that change if one's Pension plus SS cover 100% of one's income needs?. Over time, as inflation slowly eats away at the pension, the portfolio will gradually need to pick up the slack. In the six years since retirement I can already see this approaching.

Does someone in this situation look at one's portfolio more like a pre-retirement portfolio, where the "standard" three-fund portfolio is more appropriate? This is right where I am with the pension being 65% of my income. I am invested in a "standard" three-fund portfolio at 60/40. With some international as part of that 60%.
Set up a TIPS ladder or the equivalent two TIPS fund weighted duration TIPS fund where the "ladder" of inflation-indexed TIPS "rungs" of real income increase over time instead of remaining constant in real terms over time. Alternatively, purchase small real life annuities over time to compensate for the real income losses incurred by the nominal pension income. Personally I would also consider doing a little of both.

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

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Re: Three fund portfolio for retirement

Post by bobcat2 » Mon Nov 28, 2016 6:09 pm

The DFA target date funds use a global stock index fund and two TIPS funds. The DFA TDFs use a global nominal bond fund in lieu of the ST TIPS fund until the investor gets within a few years of their target retirement year.

Here is a quote from the Wade Pfau article on DFAs target date funds, which I linked to in my initial post in this thread, that discusses the composition of these TDFs.
This is where DFA’s Target-Date Retirement Income Funds enter the scene as an alternative to traditional TDFs. These funds share the same philosophy as TDFs pre-retirement in terms of accounting for the relative size of human capital and financial capital over time and reducing the stock allocation as human capital decreases with age. A globally diversified portfolio of stocks and bonds is designed to grow the portfolio and the sustainable income base. But rather than transitioning from stocks into duration mismatched nominal bonds as the target date approaches, DFA’s funds transition into a portfolio of TIPS with the same duration as a 25-year real spending objective beginning at the target date. This allows the investments to better lock-in an inflation-adjusted income stream for retirement. It provides a more effective way to achieve the actual objectives of the typical TDF investor to support their retirement spending by managing the risks related to inflation and interest rate fluctuations while still leaving some assets to focus on growth.
Here again is the link to the Wade Pfau article.
https://www.advisorperspectives.com/art ... come-funds

BobK
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Re: Three fund portfolio for retirement

Post by Erwin » Mon Nov 28, 2016 8:27 pm

How can one build the DFA portfolio with ETFs?
Erwin

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Re: Three fund portfolio for retirement

Post by Lieutenant.Columbo » Mon Nov 28, 2016 9:57 pm

bobcat2 wrote: If the purpose of the portfolio is to provide reliable income throughout retirement, a better three fund portfolio would be to hold a global stock index fund, a LT TIPS bond fund, and a ST TIPS bond fund.

Long before retirement the portfolio consists of the global stock index fund with only a small proportion dedicated to the LT TIPS fund and nothing in the ST TIPS fund. When the investor is in their 20s or early 30s the portfolio is about 90% equity, shifting to roughly 65% - 70% equity when the investor is in their early 40s. If one wants to hold a third fund during this time, a nominal LT bond fund, either US or global, would be appropriate.

As the investor draws closer to retirement, the allocation first shifts slowly away from the stock fund to the LT TIPS fund and then, as the retirement date approaches, the AA shifts more rapidly to both the LT and ST TIPS funds. Once the investor is less than 15 years from retirement, the assets are moved aggressively to the TIPS funds. By the targeted retirement year, say about age 65, the portfolio would allocate about 75% to the two TIPS funds and the remaining 25% to the equity fund.

Beginning several years before retirement the weighted average duration of the two TIPS funds is matched to the duration of the targeted retirement income stream from the beginning of retirement to the age of average life expectancy - about age 85. (Some build in a few years fudge factor of five years or less beyond the average life expectancy.)

By duration matching real bond assets to the income stream, the retirement income stream is made much safer, because the duration matching immunizes that income against both the risk of changes in interest rates as well as inflation risk. This duration matching is equivalent to a TIPS ladder from the beginning of retirement to average life expectancy. Both the ladder and the two TIPS funds are accomplishing the same task of matching asset duration to targeted income duration. This is also the approximate duration of a real life annuity for every year in retirement up to life expectancy. Therefore the investor can use the TIPS to very safely purchase a life annuity for targeted very stable retirement income with longevity protection, or keep the TIPS for more flexible safe income but without longevity protection, or a combination of both annuitized real income combined with flexible real income from the TIPS.

The essential point of this three fund portfolio is to control retirement income volatility, and in turn retirement spending volatility, thru the duration matching of assets to income. For in retirement planning it is this risk of the volatility of retirement income, not the volatility of the investment portfolio that should concern us.

The amount of assets devoted to the TIPS determines how much reliable retirement income is provided by the portfolio. The TIPS assets used to purchase a life annuity, along with Social Security income and DB pension income, serve as a hedge in providing a stable floor of income throughout retirement, regardless of age of death. The amount of additional TIPS assets during retirement provides additional flexible safe retirement income above the floor thru to the age of life expectancy. The remaining portion of the portfolio devoted to equity provides additional assets that can be used to increase the levels of safe annuity and TIPS assets during retirement. The equity and TIPS assets also allow for the purchase of a longevity annuity beginning at age 85 to replace the income from the TIPS and provide additional stable income in late old age.

This three fund portfolio is an example of a liability driven investment (LDI) strategy. In this case the LDI strategy reduces the uncertainty of the retirement spending stream. This is particularly true when compared to a portfolio of stock and nominal bond funds that seek to match portfolio volatility to the investor’s estimated risk preference...
bobcat2,
1. Will one have to wait longer before retiring if using the portfolio you recommend, compared to using a no-TIPS portfolio?
2. what is a second-best asset that you think could be used in this portfolio if one didn't want to use TiPS?
3. do you happen to know what Larry Swedroe's opinion on this portfolio is?
Thank you.
Lt. Columbo: Well, what do you know. Here I am talking with some of the smartest people in the world, and I didn't even notice!

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Re: Three fund portfolio for retirement

Post by bobcat2 » Mon Nov 28, 2016 10:58 pm

Erwin wrote:How can one build the DFA portfolio with ETFs?
You would need a global stock index ETF, a ST TIPS ETF, and a LT TIPS ETF at a minimum. Early on in lieu of the TIPS ETFs, you could add a nominal global bond ETF or a US bond ETF or both. I would want these ETFs to have a minimum duration of at least five years, because you are never intending to spend out of them.

You might also want to become bold :) and go to a four ETF portfolio where the global stock index ETF is replaced by a US total stock index ETF and an international stock index ETF.

The hard part of this isn't picking the ETFs, but rather getting the duration matching of the TIPS to retirement income done appropriately. Also using this method you are focused on how much income you will have in retirement and how close you are to being on track. (A simple way to do this is the funded ratio.) If you are falling behind your retirement income goal, which is easier to see with this LDI portfolio strategy, you have to decide whether to save more per year, work more years, allocate more to equities and widen both high and low possible income outcomes, when to take Social Security, whether or when to annuitize assets, and whether or when to use a reverse mortgage.

At a recent roundtable discussion of retirement issues by leading financial economists, Jeremy Siegal made the following points.
That TIAA-CREF example reinforces the need for goal- or liability-driven investing. Forget about strategies. What is the risk-free rate for investors? You cannot know what risk is until you know the time frame of the investors.

Regarding the TIAA-CREF example, it is important to decide whether the pot is a savings account or a retirement account. It is hard to have
two different goals because they conflict. One calls for having principal stability, which is a Treasury bill. The other calls for standard-of-living and income stability, which is a long-term bond. You cannot have both.

If you get clients to focus on rates of return and asset mixes, it is likely to be the wrong approach. You should get people to determine their goals instead of asking them how much they want to put in real estate.

Everyone in this room knows what people want for retirement. It is an income. Social security gives an income. DB plans give an income. In DC
plans, for some reason, we do not show people the funded ratio. We are showing them the wrong thing, and then we are saying they are making the wrong decisions. We are telling people that risk is the value of their fund, when risk is really how much income they can sustain for retirement. We must get that straight, and by “we” I am including the US Department of Labor and the SEC so that they do not force us to give people the wrong numbers.
Link to Roundtable discussion - http://robertcmerton.com/wp-content/upl ... Future.pdf

If you are not familiar with the funded ratio it is a simple concept and here is a link to a straightforward explanation.
https://www.ifa.com/articles/funded_rat ... _spending/

BobK
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Re: Three fund portfolio for retirement

Post by sandramjet » Tue Nov 29, 2016 10:23 am

bobcat2 wrote:
The hard part of this isn't picking the ETFs, but rather getting the duration matching of the TIPS to retirement income done appropriately. Also using this method you are focused on how much income you will have in retirement and how close you are to being on track.

BobK
[/quote]

Actually, it always seems to me the hard part of this is in fact predicting what income you need in retirement AND when. It is a function of inflation (not the "usual" CPI, but your "personal" inflation for your expenses), your prediction of when you will need money (when will I require LTC ... this year or next or ??, when will that tree fall on my house/car?, etc), how much things might cost, and how long you will live, etc.

I realize that whether you do a liability match or not, you still have to face those problems ... but as I look forward to planning, and see just how many times my parent's predictions were wrong, all I can say is that it seems a good thing that my parents had enough equities (and enough luck) that the market growth exceeded expectations....

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Re: Three fund portfolio for retirement

Post by bertilak » Tue Nov 29, 2016 10:44 am

sandramjet wrote:
bobcat2 wrote:
The hard part of this isn't picking the ETFs, but rather getting the duration matching of the TIPS to retirement income done appropriately. Also using this method you are focused on how much income you will have in retirement and how close you are to being on track.

BobK
Actually, it always seems to me the hard part of this is in fact predicting what income you need in retirement AND when.
It gets easier as you approach retirement. Early on one needs to rely more on rules of thumb and other loose estimates, all boiling down to "save as much as you can as early as you can (but at least some $X number)." The exact portfolio breakdown is almost meaningless at first. As retirement approaches one knows with much more accuracy and precision what one's expenses are going to be and can therefore plan more precisely how to reliably produce that income with the resources one has.

BobK has some well thought out advice on how to do that.

In retirement, it is income that matters. Whatever you have left after producing that income can be handled/invested with a legacy in mind. I say, don't confuse the two (income and legacy). It is best to get used to thinking in these terms well before retirement.

ADDENDUM:
The bigger one's nest egg the more latitude one has for planning or, to put it another way, making mistakes! I think this touches on the concept of "funded ratio" mentioned by BobK above. I would add (but I think BobK may disagree in that I am not being optimal) one can essentially "self insure" some income with a high enough funded ratio, reducing the need for inflation protection with, for example, TIPS ladders.
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Re: Three fund portfolio for retirement

Post by sandramjet » Tue Nov 29, 2016 11:13 am

bertilak wrote:It gets easier as you approach retirement.
I would hope that to be the case, but at least in my situation I doubt it. Even at retirement age, I may have some kids in college, be supporting others with special needs, and possibly having to assist with grandkids. Life does not always work out as simply as one would like.

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Re: Three fund portfolio for retirement

Post by pkcrafter » Tue Nov 29, 2016 11:46 am

sandramjet wrote:
bertilak wrote:It gets easier as you approach retirement.
I would hope that to be the case, but at least in my situation I doubt it. Even at retirement age, I may have some kids in college, be supporting others with special needs, and possibly having to assist with grandkids. Life does not always work out as simply as one would like.
Correct. Life is what happens when you're making other plans. :happy

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Re: Three fund portfolio for retirement

Post by bertilak » Tue Nov 29, 2016 11:46 am

sandramjet wrote:
bertilak wrote:It gets easier as you approach retirement.
I would hope that to be the case, but at least in my situation I doubt it. Even at retirement age, I may have some kids in college, be supporting others with special needs, and possibly having to assist with grandkids. Life does not always work out as simply as one would like.
By easier I meant easier to predict, not easier to pay for! :beer

My point is, you will KNOW all those things at the time so can put them on your list of actual expenses for which actual income needs to be generated.
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Medical costs

Post by Taylor Larimore » Tue Nov 29, 2016 12:01 pm

Bogleheads:

The big unknown costs in retirement are medical costs which can often exceed $100,000 (I already know).

The average lifetime retirement health care premium costs for a 65-year-old healthy couple retiring this year and covered by Medicare Parts B, D, and a supplemental insurance policy will be $266,589.

https://www.hvsfinancial.com/PublicFile ... elease.pdf

Best wishes
Taylor
Last edited by Taylor Larimore on Tue Nov 29, 2016 1:04 pm, edited 1 time in total.
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Re: Three fund portfolio for retirement

Post by azanon » Tue Nov 29, 2016 12:17 pm

Ideally, you're characterizing your medical costs in terms of sum total of the costs of your health plan(s) over and above medicare (plus deductibles). Much less than ideally, you roll the dice with inadequate coverage, and hope you don't have a 100K bill! Yikes!

I plan to continue my FedBCBS into retirement. That's a "full" plan, so I better not ever get a 100K bill!
Last edited by azanon on Tue Nov 29, 2016 12:19 pm, edited 1 time in total.

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Re: Three fund portfolio for retirement

Post by Kevin K » Tue Nov 29, 2016 12:18 pm

I can't help but wonder if Vanguard will eventually revise the composition of their Target Date Retirement and Income funds to reflect this approach. I sure hope so, as it seems to me the logic behind this approach is compelling.

I guess the only options open to someone who doesn't want to pay the 1% a year to access DFA on top of the component funds ER's is to do some sort of "roll your own" liability-matching portfolio (e.g. an iteration of Larry Swedroe's "Larry" portfolios). Really hard to justify paying advisor fees on a portfolio with a tiny equity allocation and huge bet on low-returning TIPS.

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Re: Three fund portfolio for retirement

Post by Levett » Tue Nov 29, 2016 12:46 pm

Thanks for the link to the roundtable discussion, Bob.

Very interesting.

Lev

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Re: Three fund portfolio for retirement

Post by feh » Tue Nov 29, 2016 1:01 pm

bertilak wrote:
In retirement, it is income that matters.
Not if one is a total return investor.

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Re: Three fund portfolio for retirement

Post by Erwin » Tue Nov 29, 2016 1:05 pm

Sorry, duplicated
Last edited by Erwin on Tue Nov 29, 2016 1:08 pm, edited 1 time in total.
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Re: Three fund portfolio for retirement

Post by Erwin » Tue Nov 29, 2016 1:07 pm

Erwin wrote:It seems to me that what is being discussed here is nothing more than another way to accomplish what many financial experts advocate in retirement, including Pfau, Bernstein, Bodie. I mean, develop a 30 year TIPS ladder that covers your basic needs and put the rest in a well diversified equity portfolio. The problem, of course, is that very few have the wealth necessary to accomplish this.
In my specific case, I am 68, I have constructed a 10 year bond ladder, which I plan to continue for perpetuity. The rest is invested between a total bond fund and a global equity fund. Given this discussion, I wonder if instead of the total bond fund, a 10 year + TIPS fund would not be more adequate. Comment?
Erwin

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Re: Three fund portfolio for retirement

Post by garlandwhizzer » Tue Nov 29, 2016 1:52 pm

Taylor wrote:
Bogleheads:

The big unknown costs in retirement are medical costs which can often exceed $100,000 (I already know).

The average lifetime retirement health care premium costs for a 65-year-old healthy couple retiring this year and covered by Medicare Parts B, D, and a supplemental insurance policy will be $266,589.
1+

TIPS currently guarantee you essentially a zero real yield. They are safe against unexpected inflation and default risk but you pay dearly for that safety. Unless you have a massive portfolio, we're talking millions here, you may run a real risk of running out of money if lock up too many assets paying for inflation at a zero real yield. It is also important to remember that TIPS reimburse you for inflation as measured by the CPI, I believe. Health care costs, which is as Taylor points out, is a major portion of retirement expenses, has increased in cost at more than twice the inflation rate for years with no end in sight. Extended care and nursing home costs as well are increasing at well more than the inflation rate. So protection from inflation offered by TIPS might not equate to protection from inflation experienced in real life by retirees. Complete and total safety against all possibilities is an expensive and perhaps illusory goal for most of us. For the rest, the mega-rich with more than ample assets, there are very few portfolios that don't work. Most of us are in an asset base situation where we are forced by arithmetic to take some degree of risk in return of higher long term expected returns. A 3 fund portfolio is a very effective and easy to manage vehicle for doing just that. As the saying goes, "If it ain't broke, don't fix it."

Garland Whizzer

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Re: Three fund portfolio for retirement

Post by gips » Tue Nov 29, 2016 2:00 pm

Bob,

what are current real yields of tips? When you say long and short term, what durations are you talking about? How much principal can an investor expect to lose if (I should really say when) rates rise 1%?

thanks,

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Re: Three fund portfolio for retirement

Post by feh » Tue Nov 29, 2016 2:06 pm

garlandwhizzer wrote:
Taylor wrote:
Bogleheads:

The big unknown costs in retirement are medical costs which can often exceed $100,000 (I already know).

The average lifetime retirement health care premium costs for a 65-year-old healthy couple retiring this year and covered by Medicare Parts B, D, and a supplemental insurance policy will be $266,589.
1+

TIPS currently guarantee you essentially a zero real yield. They are safe against unexpected inflation and default risk but you pay dearly for that safety. Unless you have a massive portfolio, we're talking millions here, you may run a real risk of running out of money if lock up too many assets paying for inflation at a zero real yield. It is also important to remember that TIPS reimburse you for inflation as measured by the CPI, I believe. Health care costs, which is as Taylor points out, is a major portion of retirement expenses, has increased in cost at more than twice the inflation rate for years with no end in sight. Extended care and nursing home costs as well are increasing at well more than the inflation rate. So protection from inflation offered by TIPS might not equate to protection from inflation experienced in real life by retirees. Complete and total safety against all possibilities is an expensive and perhaps illusory goal for most of us. For the rest, the mega-rich with more than ample assets, there are very few portfolios that don't work. Most of us are in an asset base situation where we are forced by arithmetic to take some degree of risk in return of higher long term expected returns. A 3 fund portfolio is a very effective and easy to manage vehicle for doing just that. As the saying goes, "If it ain't broke, don't fix it."

Garland Whizzer
+2

This is the main reason I have rejected Liability Matching Portfolios.

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Re: Three fund portfolio for retirement

Post by Erwin » Tue Nov 29, 2016 2:08 pm

garlandwhizzer wrote:
Taylor wrote:
Bogleheads:

The big unknown costs in retirement are medical costs which can often exceed $100,000 (I already know).

The average lifetime retirement health care premium costs for a 65-year-old healthy couple retiring this year and covered by Medicare Parts B, D, and a supplemental insurance policy will be $266,589.
1+

TIPS currently guarantee you essentially a zero real yield. They are safe against unexpected inflation and default risk but you pay dearly for that safety. Unless you have a massive portfolio, we're talking millions here, you may run a real risk of running out of money if lock up too many assets paying for inflation at a zero real yield. It is also important to remember that TIPS reimburse you for inflation as measured by the CPI, I believe. Health care costs, which is as Taylor points out, is a major portion of retirement expenses, has increased in cost at more than twice the inflation rate for years with no end in sight. Extended care and nursing home costs as well are increasing at well more than the inflation rate. So protection from inflation offered by TIPS might not equate to protection from inflation experienced in real life by retirees. Complete and total safety against all possibilities is an expensive and perhaps illusory goal for most of us. For the rest, the mega-rich with more than ample assets, there are very few portfolios that don't work. Most of us are in an asset base situation where we are forced by arithmetic to take some degree of risk in return of higher long term expected returns. A 3 fund portfolio is a very effective and easy to manage vehicle for doing just that. As the saying goes, "If it ain't broke, don't fix it."

Garland Whizzer
What is simply being proposed here is replacing the total bond index fund for TIPS. But the total bond index fund is currently yielding(SEC yield) a bit over 2%. That seems to me not much more than the expected inflation. If I am right, either way you have the same problem, except that with TIPS,mshould unexpected inflation occur, you have a bit more coverage.
Erwin

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Re: Three fund portfolio for retirement

Post by louiethelilac » Tue Nov 29, 2016 2:15 pm

I had thought (from reading and discussions with Vanguard reps) that since the goal of TIPS was to protect against inflation they would overlap with stocks (at least for that purpose) and that Total Bond would thus be a more suitable fixed income option for a 3 fund portfolio because of its lower correlation with global (or domestic) stock index funds. Is that not reality?

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Re: Three fund portfolio for retirement

Post by Jack FFR1846 » Tue Nov 29, 2016 2:18 pm

I believe the big focus of this thread is on the bond side. However, being somewhat overly focused on costs myself, I'd question whether a total global stock fund is currently a better choice than a total US stock plus total international stock fund as the conventional 3 fund portfolio uses. Although a total global fund is now available, it does cost more than US and international funds. Perhaps my cost gauge is calibrated differently because I didn't even look at my own fund costs until about 4 years ago, so to long time investors who remember low fees being 1%, I can't imagine ever paying 0.2% for my own funds.

Comments on this?
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Re: Three fund portfolio for retirement

Post by Erwin » Tue Nov 29, 2016 2:26 pm

Jack FFR1846 wrote:I believe the big focus of this thread is on the bond side. However, being somewhat overly focused on costs myself, I'd question whether a total global stock fund is currently a better choice than a total US stock plus total international stock fund as the conventional 3 fund portfolio uses. Although a total global fund is now available, it does cost more than US and international funds. Perhaps my cost gauge is calibrated differently because I didn't even look at my own fund costs until about 4 years ago, so to long time investors who remember low fees being 1%, I can't imagine ever paying 0.2% for my own funds.

Comments on this?
Unless you do not like the 50:50 split between US and the rest, the global equity index fund, although a bit more expensive, is a truly buy and hold investment, no rebalancing, etc. So, at least to me, very much worth it.
Erwin

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Re: Three fund portfolio for retirement

Post by Lieutenant.Columbo » Tue Nov 29, 2016 2:27 pm

feh wrote:...I have rejected Liability Matching Portfolios.
feh,
would you mind sharing your approach, then, please?
thank you
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Re: Three fund portfolio for retirement

Post by Toons » Tue Nov 29, 2016 2:27 pm

Personally,
I would be fine with 1 fund.
Balanced Index Fund.
Keep It Simple.
8-)
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Re: Three fund portfolio for retirement

Post by feh » Tue Nov 29, 2016 2:32 pm

Lieutenant.Columbo wrote:
feh wrote:...I have rejected Liability Matching Portfolios.
feh,
would you mind sharing your approach, then?
thank you
I'm a total return investor. Standard boglehead portfolio (US equities, ex-US equities, total bond), but with SV tilt.

Not yet in withdrawal phase, but will follow VPW.

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Re: Three fund portfolio for retirement

Post by bobcat2 » Tue Nov 29, 2016 2:54 pm

Of course life doesn't work out predictably. But what we are discussing with this three fund portfolio, using an LDI strategy, is basically making a DC savings plan more like a DB retirement plan. Namely, making a DC plan or IRA produce reliable retirement income the way Social Security or DB pensions produce reliable retirement income.

It's true that we may make mistakes estimating the amount of aspirational retirement income we target before retirement. Nonetheless, it shouldn't be that difficult to target a safe floor level of retirement income. Here's an example of a very simple goal for safe floor income. I want safe floor income to be my estimated SS benefit plus $20,000. Then duration match to get that $20,000 in either the form of a life annuity or $20,000/year from duration matched TIPS assets over some time frame by duration matching TIPS bonds or TIPS bond funds. If your estimate of SS benefits turns out to be somewhat inaccurate, you will have to make adjustments in your portfolio.

There is nothing in the LDI portfolio strategy that requires all of targeted retirement income to be duration matched so that it is safe income. Instead you duration match the level of safe income you want your portfolio to produce. We are not doing away with equity investing when following this strategy. In your 20s and early 30s in is recommended that the equity portion of your retirement portfolio be somewhere between 85%-95% of the portfolio. Even in retirement it is recommended that some of your portfolio be in equities. The DFA TDFs using this approach have approximately 25% in equities during retirement. But your allocation to equities can be higher or lower than that in retirement.

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Re: Three fund portfolio for retirement

Post by Erwin » Tue Nov 29, 2016 3:09 pm

bobcat2 wrote:Of course life doesn't work out predictably. But what we are discussing with this three fund portfolio, using an LDI strategy, is basically making a DC savings plan more like a DB retirement plan. Namely, making a DC plan or IRA produce reliable retirement income the way Social Security or DB pensions produce reliable retirement income.

It's true that we may make mistakes estimating the amount of aspirational retirement income we target before retirement. Nonetheless, it shouldn't be that difficult to target a safe floor level of retirement income. Here's an example of a very simple goal for safe floor income. I want safe floor income to be my estimated SS benefit plus $20,000. Then duration match to get that $20,000 in either the form of a life annuity or $20,000/year from duration matched TIPS assets over some time frame by duration matching TIPS bonds or TIPS bond funds. If your estimate of SS benefits turns out to be somewhat inaccurate, you will have to make adjustments in your portfolio.

There is nothing in the LDI portfolio strategy that requires all of targeted retirement income to be duration matched so that it is safe income. Instead you duration match the level of safe income you want your portfolio to produce. We are not doing away with equity investing when following this strategy. In your 20s and early 30s in is recommended that the equity portion of your retirement portfolio be somewhere between 85%-95% of the portfolio. Even in retirement it is recommended that some of your portfolio be in equities. The DFA TDFs using this approach have approximately 25% in equities during retirement. But your allocation to equities can be higher or lower than that in retirement.

BobK

Do you understand why their equity allocation is 25%. Doesn't that seem a bit low?
Erwin

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Re: Three fund portfolio for retirement

Post by bobcat2 » Tue Nov 29, 2016 3:28 pm

gips wrote:Bob,
What are current real yields of tips? When you say long and short term, what durations are you talking about? How much principal can an investor expect to lose if (I should really say when) rates rise 1%?
When you duration matching assets to income, you don’t lose anything in terms of income when interest rates rise. That’s the point of duration matching. When you duration match you will get your targeted income regardless of interest rate changes, higher or lower.

Consider the case of purchasing a real life annuity. Duration matching the TIPS to the annuity means if interest rates rise the TIPS assets will be worth less, but that will be offset because with higher interest rates the annuity will be cheaper. OTOH if interest rates fall the TIPS assets will be worth more, but that will be offset because with lower interest rates the annuity will be more costly. (If the duration matching is done very precisely, the offsets will be nearly perfect. But for most of us, close offsets should be good enough.)

The same concept applies to TIPS ladders for income, or what is essentially the same thing, a combination of TIPS funds whose weighted duration is the same as the duration of the ladder. Duration matching the TIPS assets to the targeted retirement income either way locks in the targeted retirement income, no matter how interest rates change. That’s the beauty of the beast.

Using duration matching with TIPS also protects against inflation, so that targeted real retirement income is protected against inflation, changes in inflation, and changes in interest rates.

BobK
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Re: Three fund portfolio for retirement

Post by longinvest » Tue Nov 29, 2016 10:26 pm

Bob,

I've read Zvi Bodie's Risk Less and Prosper book. He is a big promoter of safety-first investing. But, I think that the idea of completely securing the minimal income floor with risk-less securities is the most expensive approach to funding retirement. Some investors (small savers) probably can't afford to take more risk, but for the average Boglehead who lives below his means, safety can be achieved without artificially managing separate dedicated portfolios and making retirement more expensive than necessary.

I invite you to read a long post I wrote about it on our Canadian sister site FWF (Real Return Bonds are the Canadian equivalent of TIPS):
Risking Less and Prospering using Real Return Bonds? [RRBs] - Financial Wisdom Forum

Here's the main part:
(Edited to replace FWF with Bogleheads, and RRB with TIPS, to improve the readability on this forum)
[...]
Assuming that we agree with Bodie's description of risk as being the possibility of not meeting our future minimal needs, how do we build a portfolio?

Bodie's solution

In Risk Less and Prosper, Bodie suggests to build two distinct portfolios. One portfolio composed on inflation-indexed bonds to meet our future minimal needs with a near 100% certainty, and a second portfolio to meet our wants. I'll respectively call these portfolios needs-portfolio and wants-portfolio.

Bodie says that it's the investor's objective risk capacity which dictates how much of his investments should go into the needs-portfolio. As for the more subjective (emotional) risk tolerance of the investor, he says that it could be used to determine the composition of the wants-portfolio.

Criticism

Personally, I think that Bodie's proposed approach is a pretty naive implementation to meet his requirement of eliminating the risk of not meeting future minimal needs. Yes, it does the work and it is guaranteed to succeed (as much as such thing is possible, in real life). But it is likely to be one of the most expensive approaches to assure that future minimal needs are met.

In the book, Bodie seems to assume that his readers are either extremely risk averse, or that they know very little about markets and investing. While he takes the time to dispel myths about how to interpret "stocks for the long run" in an individual's life, he doesn't put any emphasis on the fundamental and logical relation between risk and reward.
[...]

A Better Solution?

I think that it would be reasonable to invest into a traditional balanced portfolio containing a certain allocation to TIPS. There is no reason to isolate TIPS and not let them participate into portfolio rebalancing*. I think that it is a good idea to consider Bodie's minimum needs requirements as a gauge to determine the objective risk capacity of the investor.

* Actually, there could be psychological reasons to keep TIPS separate (and possibly organized into a liability matched ladder), to help some investors sleep well at night during crises.

OK, I'll admit that Bodie is probably right that an investor who is barely saving enough to meet his future minimal needs (and can't save more or retire later) would have almost no choice but to put it all into TIPS properly matched with liabilities in a ladder. We're talking of someone in Jim Otar's red zone, here. (See Otar's Unveiling the Retirement Myth book).

But for the typical Bogleheads member, I don't think that Bodie's ratio of TIPS within a portfolio is warranted. I think that it would be OK for an investor to realistically* estimate the worst-case scenario for a chosen portfolio, and proceed with the chosen portfolio as long as the worst-case estimate reveals that future minimal needs will be provided for (through natural portfolio cash flows and by selling assets).

* Being realistic in assessing the worst-case scenario is crucial. It's not the time to hope for the best in this step.

So, it is possible to choose within a wide variety of portfolios while sticking to Bodie's definition of risk. The more one saves relative to one's basic needs, the more one has flexibility to invest into various portfolios.

Would a traditional 60/40 stocks/bonds portfolio work? Would a dividend portfolio work? Would a [fill in the blank] portfolio work? It depends on its estimated worst-case scenario: Will it meet future minimal needs? If not, add TIPS until it does. It's as simple as that.

When selecting a portfolio (or two distinct needs-portfolio and wants-portfolio [for psychological reasons]) and an investment policy, it is also important to ask the question: "Will I stick to my portfolio and investment policy in the midst of a really bad crisis?". If the answer is "no", one should change the portfolio or policy now, before the crisis happens!

We've been traditionally taught that once we estimate how much we want to accumulate for retirement, we should estimate the required rate of return then select the investment mix that will deliver this return. That's what some authors call the need to take risk.

The new solution, based on Bodie's definition of risk, contrasts with the traditional approach to investing; it eliminates the concept of needing to take risk. Instead, it first asks the investor to determine his future minimal needs to draw the line on risk. An investor willing to take risk must first develop the capacity to take risk, either by saving more than strictly necessary, by lowering his future minimal needs, or by planning to retire later.

When reading other books, something always seemed wrong to me when I read that one should take more risk if one's current savings were insufficient to meet one's objectives. It seemed like hoping that risk would not show up. That's like saying that if you think that you'll be late, you should go faster than the posted speed limit in order to get to your destination on time, ignoring the risk of having an accident or of having a cop giving you a ticket and, as a result, still get late. Sometimes, the right thing to do is just to call and say you'll be late. It is even better to simply leave earlier.
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Re: Three fund portfolio for retirement

Post by bobcat2 » Tue Nov 29, 2016 11:48 pm

Hi longinvest,

I think the methods you propose both understate the risk in equity heavy portfolios in retirement and overstate the cost of LDI strategy portfolios.

I simply don’t see the wisdom in stock heavy portfolios in retirement. The retiree is depending on withdrawals from the portfolio and will be in deep doo doo if events like the stock market crash of 2000-2002 or late 2007 thru early 2009 repeat themselves. It’s not like a 76 year old can readily get a job to replace the lost equity that is putting the remainder of his or her retirement in financial jeopardy.

If the argument is to keep from running out of income in late old age, stock heavy portfolios in retirement are odd reasoning and costly IMO.

One reason for a stock heavy portfolio in retirement is - I want to spend more in late retirement. That doesn’t make much sense. Why would you want your living standard to be higher in your late 80s or older compared to your 60s and early & mid 70s? If the argument is instead, I may have significant medical expenses if I make it to advanced old age, then the solution is better medical insurance and a bigger safe reserve fund, perhaps funded by a reverse mortgage line of credit – not more equities.

If instead the retiree is simply worried about running out of income if he or she should survive to advanced old age, then the better solution is purchasing a longevity annuity, or several in chunks over time, that kick in payouts beginning around age 85. Tail insurance thru a longevity annuity is both cheaper and more reliable than holding an equity heavy portfolio throughout retirement and hoping really bad returns never happen.

We are going to have to agree to disagree.

Respectfully,
BobK
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Re: Three fund portfolio for retirement

Post by longinvest » Wed Nov 30, 2016 12:12 am

Bob,

I think that you misunderstood my post. Let me just copy a crucial part:
But for the typical Bogleheads member, I don't think that Bodie's ratio of TIPS within a portfolio is warranted. I think that it would be OK for an investor to realistically* estimate the worst-case scenario for a chosen portfolio, and proceed with the chosen portfolio as long as the worst-case estimate reveals that future minimal needs will be provided for (through natural portfolio cash flows and by selling assets).

* Being realistic in assessing the worst-case scenario is crucial. It's not the time to hope for the best in this step.

So, it is possible to choose within a wide variety of portfolios while sticking to Bodie's definition of risk. The more one saves relative to one's basic needs, the more one has flexibility to invest into various portfolios.

Would a traditional 60/40 stocks/bonds portfolio work? Would a dividend portfolio work? Would a [fill in the blank] portfolio work? It depends on its estimated worst-case scenario: Will it meet future minimal needs? If not, add TIPS until it does. It's as simple as that.
Let me illustrate this with an exaggerated example, to make sure my point is clear.

Let's say that some investor needed at least $40,000 (forty thousands) of income per year. That is his bare bottom minimum to pay taxes, food, car, house, etc. This investor happens to be 70 years old and has a portfolio of $100,000,000 (one hundred million). At a 0% discount rate, the present value of 50 years of basic expenses would represent 2% of his current portfolio.

Does this investor need to buy an inflation-indexed SPIA or to build a 50-rung TIPS ladder to cover his $40K of basic annual spending? No! He can leave it all in Taylor Larimore's Three-Fund Portfolio (Total Stocks, Total International, Total Bonds). Do you agree?

If you don't agree, then, I'll stop here. There's just no point pursuing this discussion.
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Re: Three fund portfolio for retirement

Post by bobcat2 » Wed Nov 30, 2016 12:34 am

I don't agree. Your example is wildly unrealistic. Someone with a million dollar portfolio would almost certainly have a relatively large SS benefit. So if $40,000 is the targeted floor income and $32,000 comes from SS, why shouldn't the investor put aside $8,000 in safe income to reach his targeted floor income?

BobK
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Re: Three fund portfolio for retirement

Post by longinvest » Wed Nov 30, 2016 12:38 am

Bob,

As I said, there's just no point pursuing this discussion.

Best regards,

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Re: Three fund portfolio for retirement

Post by Lieutenant.Columbo » Wed Nov 30, 2016 6:31 am

longinvest wrote:...there's just no point pursuing this discussion...
longinvest,
I'm following this exchange closely.
Would you please at least reply to Bob's latest question?
bobcat2 wrote:...Someone with a million dollar portfolio would almost certainly have a relatively large SS benefit. So if $40,000 is the targeted floor income and $32,000 comes from SS, why shouldn't the investor put aside $8,000 in safe income to reach his targeted floor income?
thank you both
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Re: Three fund portfolio for retirement

Post by longinvest » Wed Nov 30, 2016 7:19 am

Lieutenant.Columbo wrote:
longinvest wrote:...there's just no point pursuing this discussion...
longinvest,
I'm following this exchange closely.
Would you please at least reply to Bob's latest question?
bobcat2 wrote:...Someone with a million dollar portfolio would almost certainly have a relatively large SS benefit. So if $40,000 is the targeted floor income and $32,000 comes from SS, why shouldn't the investor put aside $8,000 in safe income to reach his targeted floor income?
thank you both
LC,

Here's the context of my question to BobK (bobcat2):
longinvest wrote: Let me illustrate this with an exaggerated example, to make sure my point is clear.
Note how I explicitly stated that I had chosen an exaggerated example to make my point clear.
longinvest wrote: Let's say that some investor needed at least $40,000 (forty thousands) of income per year. That is his bare bottom minimum to pay taxes, food, car, house, etc. This investor happens to be 70 years old and has a portfolio of $100,000,000 (one hundred million). At a 0% discount rate, the present value of 50 years of basic expenses would represent 2% of his current portfolio.

Does this investor need to buy an inflation-indexed SPIA or to build a 50-rung TIPS ladder to cover his $40K of basic annual spending?
My questions wasn't about if the investor should, but about if he needed to buy a SPIA or a TIPS ladder. I contend that the investor has no need to do it. This does not mean that he shouldn't or can't do it, it simply means that he will be safe without doing it.

BobK has answered that he disagrees, implying that the investor needs to buy a SPIA or a 50-rung TIPS ladder.

I don't think that I need to explain why I won't pursue discussing this topic on this thread, even if prompted by you to do so. I encourage you to read the entire thread I linked to, on our Canadian sister FWF forum, if you want to know more about what I think.

Best regards,

longinvest
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Re: Three fund portfolio for retirement

Post by Lieutenant.Columbo » Wed Nov 30, 2016 7:41 am

bobcat2 wrote:...Someone with a million dollar portfolio would almost certainly have a relatively large SS benefit. So if $40,000 is the targeted floor income and $32,000 comes from SS, why shouldn't the investor put aside $8,000 in safe income to reach his targeted floor income?
longinvest wrote:Let's say that some investor needed at least $40,000 (forty thousands) of income per year. That is his bare bottom minimum to pay taxes, food, car, house, etc. This investor happens to be 70 years old and has a portfolio of $100,000,000 (one hundred million). At a 0% discount rate, the present value of 50 years of basic expenses would represent 2% of his current portfolio.

Does this investor need to buy an inflation-indexed SPIA or to build a 50-rung TIPS ladder to cover his $40K of basic annual spending?

My questions wasn't about if the investor should, but about if he needed to buy a SPIA or a TIPS ladder. I contend that the investor has no need to do it. This does not mean that he shouldn't or can't do it, it simply means that he will be safe without doing it.

BobK has answered that he disagrees, implying that the investor needs to buy a SPIA or a 50-run TIPS ladder.

I don't think that I need to explain why I won't pursue discussing this topic...
you didn't want to, but you did answer (with your latest post) Bob's question :wink: Now I understand. Should vs Need.
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Re: Three fund portfolio for retirement

Post by Erwin » Wed Nov 30, 2016 8:46 am

longinvest wrote:
Lieutenant.Columbo wrote:
longinvest wrote:...there's just no point pursuing this discussion...
longinvest,
I'm following this exchange closely.
Would you please at least reply to Bob's latest question?
bobcat2 wrote:...Someone with a million dollar portfolio would almost certainly have a relatively large SS benefit. So if $40,000 is the targeted floor income and $32,000 comes from SS, why shouldn't the investor put aside $8,000 in safe income to reach his targeted floor income?
thank you both
LC,

Here's the context of my question to BobK (bobcat2):
longinvest wrote: Let me illustrate this with an exaggerated example, to make sure my point is clear.
Note how I explicitly stated that I had chosen an exaggerated example to make my point clear.
longinvest wrote: Let's say that some investor needed at least $40,000 (forty thousands) of income per year. That is his bare bottom minimum to pay taxes, food, car, house, etc. This investor happens to be 70 years old and has a portfolio of $100,000,000 (one hundred million). At a 0% discount rate, the present value of 50 years of basic expenses would represent 2% of his current portfolio.

Does this investor need to buy an inflation-indexed SPIA or to build a 50-rung TIPS ladder to cover his $40K of basic annual spending?
My questions wasn't about if the investor should, but about if he needed to buy a SPIA or a TIPS ladder. I contend that the investor has no need to do it. This does not mean that he shouldn't or can't do it, it simply means that he will be safe without doing it.

BobK has answered that he disagrees, implying that the investor needs to buy a SPIA or a 50-rung TIPS ladder.

I don't think that I need to explain why I won't pursue discussing this topic on this thread, even if prompted by you to do so. I encourage you to read the entire thread I linked to, on our Canadian sister FWF forum, if you want to know more about what I think.

Best regards,

longinvest
There are many ways to potentially accomplish the goal, it is all a matter of the level of risk one is willing to take. And, it appears to me that the less risky is Bob's. Each of us must decide which way to go, depending on our own specific circumstances, which above all is our ability or willingness to fund Bob's expensive alternative. Right?
Erwin

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Re: Three fund portfolio for retirement

Post by bertilak » Wed Nov 30, 2016 9:10 am

bobcat2 wrote:Alternatively, purchase small real life annuities over time to compensate for the real income losses incurred by the nominal pension income.
A while back laddered SPIAs were my "official" plan but I decided paying off my mortgage was a better use of the money, so that's what I did. It's more bang (improved cash flow) for the buck than an annuity and I still own the equity, in the form of my house.

(Minor extra detail: I didn't pay it ALL off but paid it MOSTLY off. I reduced the remaining 24 years to 3.5 years thinking if inflation continued at the current low pace that was about how long I could go before dipping deeper into my portfolio. I now have just two years to go.)

Since mortgage payments are about 25% of my expenses that allows LOTS of room for inflation before I need to spend any more of my portfolio but it is getting tight. I have plenty of time to think about my next move.

Bottom line: guaranteed income (TIPS or otherwise) is not the only way to deal with covering essential expenses. A large enough nest egg allows for some flexibility.
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Re: Three fund portfolio for retirement

Post by garlandwhizzer » Wed Nov 30, 2016 12:33 pm

Erwin wrote:
What is simply being proposed here is replacing the total bond index fund for TIPS. But the total bond index fund is currently yielding(SEC yield) a bit over 2%. That seems to me not much more than the expected inflation. If I am right, either way you have the same problem, except that with TIPS,mshould unexpected inflation occur, you have a bit more coverage.
The allocation promoted by Bobcat had 3 funds: ST TIPS, LT TIPS, and a global equity index, two bond funds and one equity fund based on a cap weighted global index. The 3 fund portfolio included one broadly based bond fund, and two separate index funds, TSM and TISM. In the former case the equity allocation of US versus INTL is fixed by global cap weight. In the latter case you can adjust your own US versus INTL equity exposure according to your own desires rather than accepting the allocation defined by a total world market cap weighted index. Many US based investors wish to overweight US equity relative to INTL which is somewhere around 50/50 in most global equity funds. Among others, Buffett and Bogle believe that US equity should be substantially overweighted relative to cap weight. A 3 fund portfolio allows each investor to choose exactly the US versus INTL equity exposure he desires.

The second point is that 2 TIPS funds and no nominal bond funds seems to me a bit too tilted toward covering for unexpected inflation risk at the expense of expected return. Currently, the Vanguard ST TIPS fund yields -0.45% with a 2.6 yr. average duration and its longer term TIPS fund (ave. duration 8.2 yrs) yields -0.12%. Both guarantee negative real yields over their duration. Not exactly going to make you rich if you aren't already rich. TBM with an ave. duration of 5.8 yrs yields +2.22% nominal at present with less duration risk than the LT TIPS fund. Risk is everywhere, but as for me, I'll take my chances with unexpected inflation and not put all my bond eggs in the TIPS basket.

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Re: Three fund portfolio for retirement

Post by matjen » Thu Dec 01, 2016 11:47 am

Bobk,

As always, thank you for championing the LifeCycle investing point of view. Although not for everyone, I think this is a very good strategy for many and should be considered seriously. :beer

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Re: Three fund portfolio for retirement

Post by bobcat2 » Fri Dec 02, 2016 7:39 pm

A few observations after reading through and considering the comments and questions posted in this thread.

1) Typically until an investor is within 20 years of their targeted retirement year, there is no substantive difference between this three fund portfolio, which uses a LDI strategy, and the three fund portfolio people are used to reading about here at BHs. Until then this portfolio consists of a global stock fund and a global nominal bond fund. That is essentially the same as the standard three fund portfolio, and almost identical if we replace the global stock fund with a US stock fund and an international stock fund. I see no appreciable difference between these equity holdings either with respect to performance or portfolio complexity. Nor do I see any significant difference between holding a broad based US nominal bond fund vs. a broad based nominal global bond fund. The distinctions between these simple portfolios are trivial.

However, once the investor is within 20 years of their targeted retirement year, then at that point the portfolios become substantially different. At that point the nominal bond fund in the portfolio following a LDI strategy is replaced with a LT TIPS bond fund and a ST TIPS bond fund in order to match the weighted duration of the real assets in the two TIPS funds with the duration of the targeted safe retirement income. In other words, at that point there becomes an explicit strategy in the LDI approach to safely lock in a targeted level of real retirement income. In essence, the TIPS portion of the portfolio is mimicking a defined benefit pension plan, by safely providing a pre-determined level of real retirement income. The equity portion of the portfolio can be used for withdrawals, but primarily the gains from the equity are used to obtain additional safe income in retirement, either through additional purchases of annuitized income or increasing the TIPS assets such as enlarging a TIPS ladder.

There is no strategy in the standard three fund portfolio for matching the results of the investment portfolio with the variability in retirement income outcomes brought about by changes in interest rates and inflation. A basic problem with the standard three fund approach is, even if you hit your portfolio target at retirement, that tells you little about how much real income in retirement the portfolio will provide, because of changes in interest rates and inflation over time.


2) Duration matching is difficult for most people to grasp.
The two TIPS funds are used in the LDI strategy to duration match real assets to real retirement income to safely provide for a safe level of real spending in retirement. The safest financial asset is always the asset that is duration matched to the liability the asset is targeted to cover – in this case reliable retirement income to be used to provide dependable stable consumption during retirement.

For example, if I want to spend $15,000 ten years from now, the safest way to make sure I will have $15,000 in income in ten years is to be invested in an asset with ten year duration. If the $15,000 is nominal then 15 ten year zero coupon Treasuries, which will be worth $15,000 at maturity in ten years and by definition have a duration of ten years, is the safest asset I can own. If the spending is real, rather than nominal, then the safest asset is a combination of TIPS bonds or a combination of TIPS funds, but either with a weighted duration of ten years.

The LDI strategy is not investing in TIPS simply because the bonds are inflation-indexed, but rather because using the TIPS in a duration matching strategy is the safest way to provide reliable real retirement income.

My impression is that most BHs have a great deal of trouble understanding that duration matching is always the safest form of investing for meeting a goal. I no longer find that to be all that surprising, given that a leading public finance research scholar at Brookings, while discussing SS funding at a conference on retirement last summer, also failed to understand this fundamental concept of finance.


3) Annuitized income versus income from TIPS holdings.
Several posters on this thread appear to view annuitized income and income from TIPS ladders (or the duration matched equivalent of TIPS ladders held as TIPS funds) as substitutes. I don’t. I view annuitized income and TIPS income to be complements and believe the retiree should hold both of these sources of safe income.

The annuitized income is safer, because of the longevity insurance embedded in the product, but the income is inflexible. The income from the TIPS assets lacks the longevity insurance aspect of the annuitized income, but is more flexible. If I have a $20,000/yr TIPS ladder and want an extra $5,000 this year there is little risk in taking $5,000 from next year’s rung of TIPS. That risk is minimal, since next year’s rung of TIPS has a duration of less than one. Therefore, it makes sense to me to hold both sources of safe income because the strengths and weaknesses of the two income sources are different and held together have a synergistic effect.

(See Merton for more on this at the following link. He refers to SS and annuitized income as level 1 safe income and income from TIPS as level 2 safe income. See pages 4 & 5 -listed as pages 67 & 68 in the report.)
https://www.nestpensions.org.uk/schemew ... cs,PDF.pdf

However, I see little point in holding TIPS assets for income much beyond the age of 85. TIPS become an expensive way to hedge longevity risk on the off chance that you may live to age 99 or more. After age 85 the TIPS holdings should be replaced by income from a longevity annuity IMO for a couple of reasons. At that age and later the priority should be longevity protection, not income flexibility. Holding the TIPS to age 99 or more, because you might live that long is very expensive longevity insurance compared to a longevity annuity. Lastly, the advantage of the flexibility of the TIPS holdings becomes outweighed by the complexity the holdings pose for the advanced elderly.

BobK
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Re: Three fund portfolio for retirement

Post by itstoomuch » Fri Dec 02, 2016 8:11 pm

An observation:
Those of us who have a nice defined benefit plan or some type of annuities with whatever allocation, tend to have a higher Stock portfolio than those who have only a defined contribution plan.
YMMV
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Re: Three fund portfolio for retirement

Post by Rodc » Fri Dec 02, 2016 8:13 pm

Erwin wrote:
garlandwhizzer wrote:
Taylor wrote:
Bogleheads:

The big unknown costs in retirement are medical costs which can often exceed $100,000 (I already know).

The average lifetime retirement health care premium costs for a 65-year-old healthy couple retiring this year and covered by Medicare Parts B, D, and a supplemental insurance policy will be $266,589.
1+

TIPS currently guarantee you essentially a zero real yield. They are safe against unexpected inflation and default risk but you pay dearly for that safety. Unless you have a massive portfolio, we're talking millions here, you may run a real risk of running out of money if lock up too many assets paying for inflation at a zero real yield. It is also important to remember that TIPS reimburse you for inflation as measured by the CPI, I believe. Health care costs, which is as Taylor points out, is a major portion of retirement expenses, has increased in cost at more than twice the inflation rate for years with no end in sight. Extended care and nursing home costs as well are increasing at well more than the inflation rate. So protection from inflation offered by TIPS might not equate to protection from inflation experienced in real life by retirees. Complete and total safety against all possibilities is an expensive and perhaps illusory goal for most of us. For the rest, the mega-rich with more than ample assets, there are very few portfolios that don't work. Most of us are in an asset base situation where we are forced by arithmetic to take some degree of risk in return of higher long term expected returns. A 3 fund portfolio is a very effective and easy to manage vehicle for doing just that. As the saying goes, "If it ain't broke, don't fix it."

Garland Whizzer
What is simply being proposed here is replacing the total bond index fund for TIPS. But the total bond index fund is currently yielding(SEC yield) a bit over 2%. That seems to me not much more than the expected inflation. If I am right, either way you have the same problem, except that with TIPS,mshould unexpected inflation occur, you have a bit more coverage.
Two things I took away:

1) swapping out total bond and replacing with TIPS funds. Over time TIPS may do a little less than total bond because of reduced risk meaning reduced return, but as you note this is likely pretty minor but in the off chance there is unexpected high inflation might be very useful.

and

2) improving the match of duration of bonds to your needs by using a mix of sort and long term bond funds (which you could do with or without TIPS if one does not like TIPS).

Seems like a reasonable and modest proposal.

How much to put in to bonds vs stocks is another topic but seems unrelated to these two points and unrelated to using TIPS vs nominal.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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