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​​by Wade D. Pfau, Ph.D., CFA

Wade D. Pfau, Ph.D., CFA, is a professor of retirement income at The American College, a principal at McLean Asset Management, chief planning strategist for inStream Solutions, and host of He is a two-time recipient of the Journal’s Montgomery-Warschauer Award.

Bonds can be incorporated directly into a retirement income strategy as a way to meet retirement expenses in three broad ways. The first is an assets-only approach to build a total returns investment portfolio. Two additional methods put the retirement liability (meeting an ongoing spending goal in retirement) at the forefront and will try to choose bonds to best protect the spending plan from interest rate volatility. These include matching the duration of bond funds to the duration of the retirement liability, and holding individual bonds to maturity to generate the desired cash flows to fund expenses on an ongoing basis throughout retirement.

Using Bond Funds in an Assets-Only Framework

The first approach is the standard investing philosophy for accumulation that does not really consider how the nature of risk changes post retirement. That is, use modern portfolio theory to choose an asset allocation strategy that includes bonds as part of a total returns investment portfolio. Bonds, with their lower expected returns and less volatility, provide a way to reduce the overall portfolio volatility to an acceptable level while still maintaining a sufficient overall portfolio return.

Asset allocation in this framework is generally determined in terms of assets-only considerations to build a diversified portfolio with the highest expected return for the accepted level of risk. To the extent that retirement income needs are considered, it is generally to find an asset allocation that will minimize the probability of failure for the financial plan. Looking back to William Bengen’s original work in the 1990s about sustainable spending rates, the best worst-case historical spending rates could be achieved with an overall bond allocation of 20 to 65 percent. Bengen also found that intermediate-term U.S. government bonds provided a sweet spot in terms of return/volatility trade-offs in order to keep worst-case historical spending rates at the highest possible level. (See “Determining Withdrawal Rates Using Historical Data,” published in the October 1994 Journal.)

Using Bond Funds to Immunize Interest Rate Risk

With basic asset allocation used for wealth accumulation, efforts are not necessarily made to match assets to liabilities. The retirement liability (the desire to meet a spending goal in retirement) is typically not part of the analysis. Investment decisions made in an assets-only wealth management framework (where the goal is to maximize wealth subject to an acceptable volatility) can differ from the decisions made when the goal is to meet ongoing spending needs. In an assets-only framework, the duration of a bond portfolio is more likely to be set based on the investor’s willingness to accept volatility and on the risk-return trade-offs for increased duration.

However, a bond fund (a mutual fund or ETF) can be chosen specifically so that its duration matches the duration of the retirement liability in order to immunize the retiree against interest rate risk and bond price volatility. For bond funds, the idea is to immunize interest rate fluctuations by matching the durations of the fund and the retirement spending liability. Bond funds provide advantages in terms of their greater diversification of bond holdings, as well as the possibility of trading more cheaply than individuals are able.

The difficulty with this approach, though, is that determining the duration of the retirement liability is complex. With each passing year, remaining life expectancy decreases, but not on a one-to-one basis. In practice, this duration matching for a retired household will be highly complex and not necessarily practical, making immunization from interest rate risk an often insurmountable obstacle for a household to accomplish on their own. It requires constant monitoring and rebalancing of the bonds to match the desired duration as interest rates change and bonds mature.

This being said, at least two companies have created mutual funds to provide duration matching with bonds. First, Dimensional Fund Advisors’ target-date retirement income funds define the retirement liability specifically as a goal to support inflation-adjusted spending for 25 years after the target date. Using TIPS to support the inflation-adjustment goal, they are able to create a portfolio with a duration that matches their defined liability from a given target date and hedges inflation and interest rate risk.

A second approach used by BlackRock’s CoRI® retirement indices is to develop a bond portfolio that hedges the price of a lifetime income annuity with a 2.5 percent cost-of-living adjustment so that the potential amount of income available from annuitizing a portion of one’s portfolio can be locked in without actually purchasing an annuity. Income goals are survival-weighted rather than fixed at 25 years, and they grow with a 2.5 percent COLA, rather than the CPI. However, the underlying concept of hedging interest rate risk by defining a retirement liability and then matching its duration to that of the supporting assets is the same.

Holding Individual Bonds to Maturity

Outside of these mutual fund solutions, I think financial advisers seeking a do-it-yourself approach to duration matching with bond funds may underestimate the difficulty of the task. Duration matching is not so straightforward when shares of the bond fund must be sold to meet ongoing retirement expenses. If rates have risen, shares of the bond fund may need to be sold at a loss, with more shares sold to meet a given spending objective. This triggers sequence risk. Funds are not fully reinvested so that reinvestment risk and interest rate risk do not get neutralized. Immunization is harder when there is also a spending goal to support.

As an alternative, I will make the case for using individual bonds in a retirement income plan. A retirement income bond ladder can be structured so that the cash flows provided through coupons and maturing face values will provide a steady and known stream of contractually guaranteed income for the ongoing expenditure needs in retirement. Cash flows from the bonds are matched to fund desired expenses at desired dates. Interest rate risk is eliminated for the retirement expenses that have been matched with these dedicated assets. Rebalancing may be required in terms of extending the length of the bond ladder as time passes to cover more future expenses, but the complexities involved in an ongoing effort to match durations can be better avoided.

For a household retiree, maximizing investment returns is often not the goal; the goal is to meet expenses. Paper losses on individual bonds do not have to be realized if the bond is held to maturity. The retiree does miss out on the opportunity to buy the bond more cheaply later, but this cannot be known in advance. Yes, it is unfortunate if bonds are purchased and then rising rates would have subsequently made it possible to purchase those bonds more cheaply. But if the initial purchase allows the retiree to meet their retirement objective, then the goal has been met successfully no matter what interest rates subsequently do.

A retiree who realizes that it is impossible to predict interest rate fluctuations may take comfort in knowing that the individual bond allows them to enjoy their retirement and ignore subsequent interest rate fluctuations. Ignoring interest rate fluctuations is not possible with a bond fund strategy that has to make frequent adjustments to the portfolio’s duration in order to immunize against interest rate risk.

Bonds may provide other roles in a retirement income plan, such as creating liquidity for unexpected expenses. But the focus here has been on using bonds to meet expected expenses, and these are the three basic options available for advisers. ​

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