As Abraham Lincoln once said, “A goal properly set is halfway reached.”
Many people find the goal of saving for retirement to be challenging. Conventional wisdom (or perhaps more accurately fund company marketing) says to use target retirement date funds as the foundation for your retirement. The trouble is these funds didn’t exactly cover themselves in glory during the recent ‘08-‘09 market sell-off. Many pre-retirees (i.e. those close to retirement) who were invested in these funds were surprised at what heavy allocations to equities they had. Congress even held hearings on the issue:
Executive Summary wrote:Although target date funds have proved popular with participants and have won the approval of many investment professionals, the losses suffered by target date funds during the economic downturn raised concerns about the design and transparency of these funds. For example, an Aging Committee investigation found that the allocation of assets among stocks, bonds, cash-equivalents varied greatly among target date funds with the same target retirement date, with select firms’ 2010 target date funds’ equity holdings ranging anywhere from 24 to 68 percent. It was also unclear to what extent plan sponsors educate their participants on these funds, as well as how fiduciary standards would be enforced.
The rude shock of the ‘08-‘09 market market sell-off caused many pre-retirees to lose confidence in their ability to retire comfortably. See for example this 2009 EBRI study
2009 EBRI study wrote:RECORD LOW CONFIDENCE LEVELS: Workers who say they are very confident about having enough money for a comfortable retirement this year hit the lowest level in 2009 (13 percent) since the Retirement Confidence Survey started asking the question in 1993, continuing a two-year decline. Retirees also posted a new low in confidence about having a financially secure retirement, with only 20 percent now saying they are very confident (down from 41 percent in 2007).
There must be a better way…
In this paper Zvi Bodie argues that TIPs are the natural financial instrument to use in laying a proper foundation for one’s retirement.
http://papers.ssrn.com/sol3/papers.cfm? ... _id=260628
Bodie wrote:This paper proposes a new approach to investing for retirement that takes advantage of recent market innovations and advances in finance theory to improve the risk/reward opportunities available to individual investors before and after retirement. The approach introduces three new elements:
- It uses inflation-protected bonds to hedge a minimum standard of living after retirement.
- It takes account of a person's willingness to postpone retirement.
- It uses option "ladders" to lever growth in retirement income.
With a series or ladder of long dated (e.g. 30 year) individual TIPs, younger workers can lock in a future real income stream today for their future retirement years. Since TIPs are real return instruments, their value is guaranteed to keep up with inflation if held to maturity. TIPS are best held in tax advantaged accounts and so one constraint to this approach is whether you actually have enough space in IRAs and 401ks (brokerage option) to buy them.
Let’s look at an example to see how the mechanics of Bodie’s strategy might work (it may be slightly trickier than you might think but it’s not rocket science).
Let’s say you plan to retire at age 2029 at age 62 (i.e. you are currently 44) and you want to guarantee an annual “real” income of $50,000 a year- i.e. $50,000 in today’s dollars that will increase with inflation. Based on this social security calculator
you estimate that your social security benefit at 62, in today’s dollars, will be $20,000. So will need $30,000 a year of other “real” income- i.e. 30,000 in today’s dollars.
To fund 2029, the first year of your retirement, you could buy $30k of face value of the 2.5% coupon TIP maturing at 1/2029. The cost works out to $35.28 k = $30k*1.026*1.146 = face*(inflation factor)*(price)
To fund the 2032 year, you would buy a smaller face amount of the 3.375% TIP maturing at 1/2032. This is because this bond has a substantial inflation factor of 1.24. So to lock in $30,000 in todays dollars you would buy 24k worth of face value (24 k*1.24 = face*inflation factor = $29.76 k) which would cost $38.78k = face*(inflation factor)*(price) = 24k *(1.24)*(1.302).
What about the 2030 and 2031 years? Well unfortunately there are no TIPs maturing in those years yet. So instead just buy the 2029 TIP for the 2030 year and the 2032 TIP for the 2031 year- i.e. it’s not a big deal to be a year or so off in your TIPs ladder.
Now after 2032 things get a little trickier because there is a long gap (8 years) till the next available TIP maturity of 2040. To handle this, I would advocate a “roll your own TIPs” approach for some of these years. Take the 2036 year for example. The “roll your own TIPs” approach involves first buying the 2026 TIP and then when that matures “rolling” it into a newly auctioned 10 year TIP that would take you up to 2036. So, factoring in the various inflation factors, here’s the ladder or series of TIPs you would buy:
2029: Buy 30 bonds of the 2029 TIP: cost = $35.28 k
2030: Buy 30 bonds of the 2029 TIP: cost = $35.28 k
2031: Buy 24 bonds of the 2032 TIP: cost = $38.78 k
2032: Buy 24 bonds of the 2032 TIP: cost = $38.78 k
2033: Buy 24 bonds of the 2032 TIP: cost = $38.78 k
2034: Buy 30 bonds of the 2029 TIP and then on maturity roll into a newly auctioned 5 year TIP: cost = $35.28 k
2035: Buy the 26 bonds of the 2025 TIP and then at maturity roll into new 10 yr TIP: cost = $34.43 k
2036: Buy 27 bonds of the 2026 TIP and then at maturity roll into a new 10 yr TIP: cost = $32.34k
2037: Buy 27 bonds of the 2027 TIP and then at maturity roll into a new 10 yr TIP: cost = $33.18 k
2038: Buy 29 bonds of the 2028 TIP and then at maturity roll into a new 10 yr TIP: cost = $31.51
2039: Buy 30 bonds of the 2040 TIP: cost = $32.93 k
2040: Buy 30 bonds of the 2040 TIP: cost = $32.93 k
2041: Buy 30 bonds of the 2041 TIP: cost =$32.49 k
The total works out to $450.89 k and guarantees you a maturing amount of $30k (in todays dollars) for each year from 2029 to 2041 (i.e. age 62 to 74) This $30 k a year is from maturing principal only- we haven’t even factored in the $7.21 k real income generated by the TIPs ladder each year (more on that later).
Going forward you would buy 30k worth of the newly auctioned 30 year TIP each year. Of course you would have to adjust the amount for inflation. For example if CPI is 3% in 2012 then you would actually buy $31k (=$30k *1.03). You would keep buying each year until you hit 62 in 2029 (when you would buy a TIP maturing in 2059, the year you turn 92).
Now the point of this strategy is to lay a floor or a foundation for your retirement by guaranteeing a certain minimum income in retirement- in this example $50 k of real –(i.e. inflation adjusted) income. Since you have this in place, any other funds you have available could be invested very aggressively, for example 100% in equities, perhaps in small cap value stocks, etc. These investments will hopefully provide excess funds in retirement to enhance your standard of living beyond the minimum provided by Social Security and your TIPs ladder.
Bodie actually mentions at-the-money 3 year LEAPs or long term equity index options (on for example the S&P 500) as one alternative to consider. These are risky because if, for example, the stock market drops and stays down for 3 years, then these LEAPs could expire worthless (i.e. go to zero). One approach here might be to invest only the coupons from your TIPs ladder in these LEAPs. That way if the LEAPS go to zero, the combination of the TIPs ladder and the LEAPS will still have produced a minimum real return of zero.
Going back to our TIPs ladder, it generates $7.21k of real TIPs coupons per year. The S&P 500 is currently at 1332 and SPY (S&P 500 etf) is at 131. Options on SPY expiring in December 2013 with a strike of 135 are currently priced at $15. So you could buy 480 of these options each year or around 5 option contracts (an option contract is for 100 shares). These options would pay off if the S&P 500 rises above 1500 by the end of 2013. That works out to a 12.7% rise or 4.4% annualized, which doesn’t seem that much of a stretch.
Let’s say the LEAPs and heavy equity allocation really pay off as you approach retirement. You end up with say an extra $160k (in todays dollars). The nice thing now is that you can cash in those bets and use the money to replace the Social Security part of your retirement income for the first 8 years. By delaying Social Security from 62 to 70 you will make your later retirement even more secure.
Again going back to the example we’ve been considering, by taking Social Security at age 62 you are actually getting only 70% of your full retirement benefit (which is at age 67 in this example). If you delay retirement till age 70 you would actually get 124% of your full retirement benefit. That works out to a 77% increase over your age 62 SS benefit. In this example that would increase your SS benefit from $20 k per year to $35.4 k per year, and your total income from the SS/TIPs ladder combo would increase from $50 k per year to $65.4 k per year (again all in today’s dollars).
But again if disaster strikes and the heavy equity/LEAPs approach fails, you still can fall back on that $50 k per year to retire on.
This is the 8th in a series of 10 investment tips. Here are the previous tips:
Tip #1: Take your risk on the equity side
Tip #2: Use Cash to dampen portfolio risk
Tip #3: Index, Index, Index! But...
Tip #4: Rebalance early and often
Tip #5: To keep real wealth skip Gold, buy TIPs
Tip #6: Be aligned: Buy this, not that!
Tip #7: Skip foreign bonds