Fidelity U.S. bond index vs. inflation protected bond index fund

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Topic Author
mesaverde
Posts: 517
Joined: Wed May 02, 2007 4:14 pm

Fidelity U.S. bond index vs. inflation protected bond index fund

Post by mesaverde »

Hello!
I'm 48 and plan on retiring around age 52. My primary source of income from age 52 to 59.5 will be a government 457b (penalty free withdrawals). The 457b (with Fidelity) will act as a "bridge" to age 59.5. After age 59.5 I'll rely on a combination of 403b/Trad.IRA/Roth IRA/pension/social security as sources of income.

Because I'll use the 457b as the first primary source of income, this is the current allocation in it:
50% Fidelity Total Market Index fund (FSKAX)
50% Fidelity U.S. Bond Index fund (FXNAX)
Yes, I like simplicity. Currently all contributions are going into the U.S. bond index fund (expense ratio .025%, 30 day SEC yield 1.43%, duration 6.44 years, maturity 8.2 years)

I'm also able to contribute to the Fidelity Inflation Protected Bond Index fund, FIPDX (expense ratio .05%, 30 day SEC yield .50%, duration 5.5 years, maturity 8.1 years).
I'm thinking of either:
1. putting all new contributions into the inflation protected fund instead of the bond index fund
or
2. putting all new contributions AND my current bond allocation in the inflation protected bond fund (so that all bonds are in FIPDX, for simplicity).

Do you recommend that I do either #1 or #2, or stay on the same course that I'm on? Any feedback would be appreciated.
"Learn from the past, live in the present, plan for the future"
dbr
Posts: 37901
Joined: Sun Mar 04, 2007 9:50 am

Re: Fidelity U.S. bond index vs. inflation protected bond index fund

Post by dbr »

What fraction of the 457 are you withdrawing? If it is all of it I would not have anything in stocks. If it is small fractions per year 50/50 is probably fine. Also in that case investing in a TIPS fund is a good idea. If you are spending all the money you might want a shorter TIPS fund.
Topic Author
mesaverde
Posts: 517
Joined: Wed May 02, 2007 4:14 pm

Re: Fidelity U.S. bond index vs. inflation protected bond index fund

Post by mesaverde »

dbr wrote: Wed Nov 24, 2021 9:48 am What fraction of the 457 are you withdrawing? If it is all of it I would not have anything in stocks. If it is small fractions per year 50/50 is probably fine. Also in that case investing in a TIPS fund is a good idea. If you are spending all the money you might want a shorter TIPS fund.
From age 52 to 59.5 I'll need to withdraw $40k per year from the 457. Currently there's $390k in the 457.
"Learn from the past, live in the present, plan for the future"
dbr
Posts: 37901
Joined: Sun Mar 04, 2007 9:50 am

Re: Fidelity U.S. bond index vs. inflation protected bond index fund

Post by dbr »

mesaverde wrote: Wed Nov 24, 2021 12:13 pm
dbr wrote: Wed Nov 24, 2021 9:48 am What fraction of the 457 are you withdrawing? If it is all of it I would not have anything in stocks. If it is small fractions per year 50/50 is probably fine. Also in that case investing in a TIPS fund is a good idea. If you are spending all the money you might want a shorter TIPS fund.
From age 52 to 59.5 I'll need to withdraw $40k per year from the 457. Currently there's $390k in the 457.
In that case I would not invest anything in stocks or even anything very volatile as it doesn't take very much negative return in a year to run out of money in that account before you reach 59.5 while by contrast there is no incentive to try to grow the residual that might be left after the withdrawals. Also it makes a great deal of difference if you do or don't want to increase those withdrawals by inflation.

If you have alternative means to raise the income then you don't need to be so concerned.
retiredjg
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Joined: Thu Jan 10, 2008 12:56 pm

Re: Fidelity U.S. bond index vs. inflation protected bond index fund

Post by retiredjg »

You have 4 more years before you start withdrawals from the 457. So there will be another $80kish in there by then. That gives you a little leeway. But I agree with dbr that this account should be mostly bonds starting soon if this is the only account you are going to draw from in those years.

I don't recall ever seeing a suggestion to have all of a person's bond allocation in a tips fund. It used to be very common to suggest half tips and have total bond market though. That is probably what I would do in your shoes although I might get there incrementally.

Your salary is "supposed" to keep up with inflation while working. Holding a tips fund when nearing and in retirement makes sense to me.
exodusNH
Posts: 1360
Joined: Wed Jan 06, 2021 8:21 pm

Re: Fidelity U.S. bond index vs. inflation protected bond index fund

Post by exodusNH »

mesaverde wrote: Wed Nov 24, 2021 9:12 am Hello!
I'm 48 and plan on retiring around age 52. My primary source of income from age 52 to 59.5 will be a government 457b (penalty free withdrawals). The 457b (with Fidelity) will act as a "bridge" to age 59.5. After age 59.5 I'll rely on a combination of 403b/Trad.IRA/Roth IRA/pension/social security as sources of income.

Because I'll use the 457b as the first primary source of income, this is the current allocation in it:
50% Fidelity Total Market Index fund (FSKAX)
50% Fidelity U.S. Bond Index fund (FXNAX)
Yes, I like simplicity. Currently all contributions are going into the U.S. bond index fund (expense ratio .025%, 30 day SEC yield 1.43%, duration 6.44 years, maturity 8.2 years)

I'm also able to contribute to the Fidelity Inflation Protected Bond Index fund, FIPDX (expense ratio .05%, 30 day SEC yield .50%, duration 5.5 years, maturity 8.1 years).
I'm thinking of either:
1. putting all new contributions into the inflation protected fund instead of the bond index fund
or
2. putting all new contributions AND my current bond allocation in the inflation protected bond fund (so that all bonds are in FIPDX, for simplicity).

Do you recommend that I do either #1 or #2, or stay on the same course that I'm on? Any feedback would be appreciated.
Have you purchased any I Bonds? They're mostly superior for individual investors. You're limited to $10K per person per year, unless you set up a trust or over-pay your taxes. But they can be a good way to hold a riskless asset that will track "inflation". (Inflation in scare quotes because each person's inflation rate is different from what you see published.)

I would probably hedge my bests and continue splitting TIPS / nominal. TIPS are for unexpected inflation and will decline if we hit a deflationary environment. Nominal bonds (in theory) are already pricing in expected inflation and work well in deflationary environments.
Topic Author
mesaverde
Posts: 517
Joined: Wed May 02, 2007 4:14 pm

Re: Fidelity U.S. bond index vs. inflation protected bond index fund

Post by mesaverde »

exodusNH wrote: Wed Nov 24, 2021 1:14 pm
mesaverde wrote: Wed Nov 24, 2021 9:12 am Hello!
I'm 48 and plan on retiring around age 52. My primary source of income from age 52 to 59.5 will be a government 457b (penalty free withdrawals). The 457b (with Fidelity) will act as a "bridge" to age 59.5. After age 59.5 I'll rely on a combination of 403b/Trad.IRA/Roth IRA/pension/social security as sources of income.

Because I'll use the 457b as the first primary source of income, this is the current allocation in it:
50% Fidelity Total Market Index fund (FSKAX)
50% Fidelity U.S. Bond Index fund (FXNAX)
Yes, I like simplicity. Currently all contributions are going into the U.S. bond index fund (expense ratio .025%, 30 day SEC yield 1.43%, duration 6.44 years, maturity 8.2 years)

I'm also able to contribute to the Fidelity Inflation Protected Bond Index fund, FIPDX (expense ratio .05%, 30 day SEC yield .50%, duration 5.5 years, maturity 8.1 years).
I'm thinking of either:
1. putting all new contributions into the inflation protected fund instead of the bond index fund
or
2. putting all new contributions AND my current bond allocation in the inflation protected bond fund (so that all bonds are in FIPDX, for simplicity).

Do you recommend that I do either #1 or #2, or stay on the same course that I'm on? Any feedback would be appreciated.
Have you purchased any I Bonds? They're mostly superior for individual investors. You're limited to $10K per person per year, unless you set up a trust or over-pay your taxes. But they can be a good way to hold a riskless asset that will track "inflation". (Inflation in scare quotes because each person's inflation rate is different from what you see published.)

I would probably hedge my bests and continue splitting TIPS / nominal. TIPS are for unexpected inflation and will decline if we hit a deflationary environment. Nominal bonds (in theory) are already pricing in expected inflation and work well in deflationary environments.
I-bonds sure do look attractive right now. But all of my savings are currently going into maxing out a 457b + 403b, which puts me at the top of the 12% federal income tax bracket (I'll be in the 12% bracket in retirement also). There really isn't much money left after maxing these two accounts out.
"Learn from the past, live in the present, plan for the future"
ofckrupke
Posts: 827
Joined: Mon Jan 10, 2011 2:26 pm

Re: Fidelity U.S. bond index vs. inflation protected bond index fund

Post by ofckrupke »

mesaverde wrote: Wed Nov 24, 2021 2:11 pm I-bonds sure do look attractive right now. But all of my savings are currently going into maxing out a 457b + 403b, which puts me at the top of the 12% federal income tax bracket (I'll be in the 12% bracket in retirement also). There really isn't much money left after maxing these two accounts out.
Payroll-contributing down to the bottom of the 22% bracket, distributing at 12% later gets you an outright 10% tax arbitrage return, but for comparison against series I bonds that fixed 10% (or 7% if you think your bracket rate will return to 15% later...) needs to be spread out over the holding period.

One way of looking at is is that your future investments in the sinking age 52-59.5 fund, either by payroll deduction to 457b or by post-tax cash flow to treasurydirect, will take place over the next 3-3/4 years and be uniformly distributed over the subsequent 7.5 years - the purpose is to increase your standard of living aka ability to consume, without invasion of other sources, throughout the period. Looked at this way the average holding period would be 5-5/8 years. Another way of looking at it would be to say that you've already saved for the early part of the decumulation so your future investments are filling out the last part or delaying the invasion of the 403b and other components of the nest egg planned for post-59.5 access...in which case the holding period for a fresh investment from today's payroll is longer...arguably 7+ years.

Today, Bloomberg shows real yield for a 5y TIPS at -1.74% and 10y at -1.00%. Fidelity doesn't seem to report the real SEC yield of FIPDX, so the yield of a 5.5y TIPS is probably a reasonable proxy. Straight interpolation between the 5y and 10y TIPS yields puts FIPDX at about -1.67% real then (note this neglects the drag of the fund's 0.05% ER). So if you had $78 (post-tax) to put in a series I bond today at 0% real, vs. $100 (pre-tax) into FIPDX in the 457b by payroll deduction, what I claim is that their expected real values on liquidation/distribution, after respective taxes, should be about equal at 6 years; thereafter, expected after-tax real value of the I bond is higher.

Stepping back for a minute: to minimize the interest rate risk you'd ideally be managing the fixed income portfolio's duration to match that of the assigned obligations during the pre-59.5 years of your retirement. FIPDX will have a comparatively steady duration so won't help with this - ideally you'd be decanting it into a shorter TIPS fund as time passes (and ditto for nominal bond holdings intended for the same purpose). Accumulating series I bonds (duration = 0) will reduce the portfolio duration as their slice of the portfolio grows - at least assisting, if not fully immunizing against interest rate risk. [You may want to stop buying them purposed to this decumulation period 5 years before its end, to avoid loss of a quarter's interest on redemptions in the first 5 years after issue.]

State taxes: probably turn out to be a wash for you, roughly speaking, for any holding period. You save now at payroll but unless you are in a very very retiree-friendly state you'll pay state taxes on the 457b distributions. Whereas to buy I bonds the amount you can buy is reduced by the state taxation on the payroll deductions you don't take...but later, neither the principal nor the accumulated treasury interest is subject to state taxation at redemption.

So in your case, with ~3.5 years to start of decumulation and 11 years to its end, for funds to be invested today, series I bonds vs. FIPDX is probably close to a wash. As time goes on, depending on your cash flow model in and possible changes in the tax code, whether the expected holding period times the difference in expected real yield may or may not overcome the tax arbitrage premium. On the other hand, if at some point you feel like you've got the 52-59.5y period covered and subsequent contributions are going to be spent long afterward, then the holding period might be long enough for a fixed rate advantage of I bonds to prevail over the tax arbitrage...maybe it's actually the 403b contributions you'd want to back off from somewhat in favor of series I bonds.

Sorry about not addressing at all the question in the OP about portfolio distribution between nominal and inflation-protected bonds. I'd echo earlier respondents' advice to reduce the equity slice - think of FSKAX as an approximation to an inflation protected bond fund with a duration of about 50-60 years....just not a good fit for your targeted liquidation period. Whether to pay, or just how much to be willing to pay in insurance premium for unexpected inflation protection is a matter of individual discretion. Lately, concern about inflation has probably driven up both the expected inflation rate and the market cost of protection against unexpected inflation.
Topic Author
mesaverde
Posts: 517
Joined: Wed May 02, 2007 4:14 pm

Re: Fidelity U.S. bond index vs. inflation protected bond index fund

Post by mesaverde »

ofckrupke wrote: Wed Nov 24, 2021 8:40 pm
mesaverde wrote: Wed Nov 24, 2021 2:11 pm I-bonds sure do look attractive right now. But all of my savings are currently going into maxing out a 457b + 403b, which puts me at the top of the 12% federal income tax bracket (I'll be in the 12% bracket in retirement also). There really isn't much money left after maxing these two accounts out.
Payroll-contributing down to the bottom of the 22% bracket, distributing at 12% later gets you an outright 10% tax arbitrage return, but for comparison against series I bonds that fixed 10% (or 7% if you think your bracket rate will return to 15% later...) needs to be spread out over the holding period.

One way of looking at is is that your future investments in the sinking age 52-59.5 fund, either by payroll deduction to 457b or by post-tax cash flow to treasurydirect, will take place over the next 3-3/4 years and be uniformly distributed over the subsequent 7.5 years - the purpose is to increase your standard of living aka ability to consume, without invasion of other sources, throughout the period. Looked at this way the average holding period would be 5-5/8 years. Another way of looking at it would be to say that you've already saved for the early part of the decumulation so your future investments are filling out the last part or delaying the invasion of the 403b and other components of the nest egg planned for post-59.5 access...in which case the holding period for a fresh investment from today's payroll is longer...arguably 7+ years.

Today, Bloomberg shows real yield for a 5y TIPS at -1.74% and 10y at -1.00%. Fidelity doesn't seem to report the real SEC yield of FIPDX, so the yield of a 5.5y TIPS is probably a reasonable proxy. Straight interpolation between the 5y and 10y TIPS yields puts FIPDX at about -1.67% real then (note this neglects the drag of the fund's 0.05% ER). So if you had $78 (post-tax) to put in a series I bond today at 0% real, vs. $100 (pre-tax) into FIPDX in the 457b by payroll deduction, what I claim is that their expected real values on liquidation/distribution, after respective taxes, should be about equal at 6 years; thereafter, expected after-tax real value of the I bond is higher.

Stepping back for a minute: to minimize the interest rate risk you'd ideally be managing the fixed income portfolio's duration to match that of the assigned obligations during the pre-59.5 years of your retirement. FIPDX will have a comparatively steady duration so won't help with this - ideally you'd be decanting it into a shorter TIPS fund as time passes (and ditto for nominal bond holdings intended for the same purpose). Accumulating series I bonds (duration = 0) will reduce the portfolio duration as their slice of the portfolio grows - at least assisting, if not fully immunizing against interest rate risk. [You may want to stop buying them purposed to this decumulation period 5 years before its end, to avoid loss of a quarter's interest on redemptions in the first 5 years after issue.]

State taxes: probably turn out to be a wash for you, roughly speaking, for any holding period. You save now at payroll but unless you are in a very very retiree-friendly state you'll pay state taxes on the 457b distributions. Whereas to buy I bonds the amount you can buy is reduced by the state taxation on the payroll deductions you don't take...but later, neither the principal nor the accumulated treasury interest is subject to state taxation at redemption.

So in your case, with ~3.5 years to start of decumulation and 11 years to its end, for funds to be invested today, series I bonds vs. FIPDX is probably close to a wash. As time goes on, depending on your cash flow model in and possible changes in the tax code, whether the expected holding period times the difference in expected real yield may or may not overcome the tax arbitrage premium. On the other hand, if at some point you feel like you've got the 52-59.5y period covered and subsequent contributions are going to be spent long afterward, then the holding period might be long enough for a fixed rate advantage of I bonds to prevail over the tax arbitrage...maybe it's actually the 403b contributions you'd want to back off from somewhat in favor of series I bonds.

Sorry about not addressing at all the question in the OP about portfolio distribution between nominal and inflation-protected bonds. I'd echo earlier respondents' advice to reduce the equity slice - think of FSKAX as an approximation to an inflation protected bond fund with a duration of about 50-60 years....just not a good fit for your targeted liquidation period. Whether to pay, or just how much to be willing to pay in insurance premium for unexpected inflation protection is a matter of individual discretion. Lately, concern about inflation has probably driven up both the expected inflation rate and the market cost of protection against unexpected inflation.
I really appreciate the thoughtful feedback. You've made a compelling argument to consider directing $ to I bonds instead of the 403b, 457b, or both.
One thing I did not mention: Currently I pay 5.75% state income tax, and soon after retirement there's a 50/50 chance I'll move back to my home state that has no state income tax (Tennessee) or at a minimum a state with a lower state income tax like Arizona.
"Learn from the past, live in the present, plan for the future"
ofckrupke
Posts: 827
Joined: Mon Jan 10, 2011 2:26 pm

Re: Fidelity U.S. bond index vs. inflation protected bond index fund

Post by ofckrupke »

mesaverde wrote: Thu Nov 25, 2021 7:49 pm One thing I did not mention: Currently I pay 5.75% state income tax, and soon after retirement there's a 50/50 chance I'll move back to my home state that has no state income tax (Tennessee) or at a minimum a state with a lower state income tax like Arizona.
Depending upon how you model the expected state tax arbitrage return, this would add anywhere from 0 to 3.3 years to today's expected breakeven holding period for I bonds vis a vis FIPDX (as of this weekend, a expected real return gap = 1.74% using the current 0% fixed rate on I bonds). 0y if you stay, maybe 0.5-1.0y if AZ depending on likely bracket, 3.3y if TN. So, anything from de minimis to moderately weakening the argument for buying I bonds from taxable in preference to maintaining the existing schedule of contribution to 457b in the next payroll. WRT 403b contributions, the argument was always tempered by the fact that there, your horizon today is long enough to use positive expected-real-return vehicles like stock funds as another source of protection against inflation (both expected and unexpected).
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