Economists have long considered bond ladders a more efficient way to fund a stable cash flow such as an income in retirement. Pensions use so-called liability-driven investing strategies that match the cash flow of the bond to the expected date of payment to retirees. These strategies are less common in financial planning, but fund innovations make implementing such retirement solutions easier.
With about 65% of lifestyle expenses — such as utilities, property taxes, health care and food — in retirement being fixed, some of a retiree’s investments need to provide income that can fund any inflexible expenses not covered by Social Security. Retirees who see inflexible spending as a future liability will need to allocate a portion of their portfolio to less risky assets that can be liquidated and turned into stable spending.
The most common of these assets in retirement accounts are bond funds. An advisor manages the bond portfolio, and a client makes withdrawals over time to fund spending as needed. One issue with this class is that changes in interest rates or credit conditions can affect the fund’s annual performance. For example, an extreme increase in interest rates caused the iShares Aggregate Bond index fund to drop by 13% in 2022.
A portfolio of commercial paper or T-bills will be less volatile, but short-duration, low-risk cash-like investments have historically underperformed both long-term Treasurys and the aggregate bond index.
Between 1928 and 2024, Baa-rated corporate bonds outperformed T-bills by 3.5% annually and long-term Treasury bonds by 1.4%. Of course, corporate bonds have received a credit premium because they are risky. In 2024, T-bills earned 4.97% while Baa bonds earned 1.74%. In 2022, Baa bonds fell over 15% while T-bills gained 2%.
Imagine retiring Jan. 1, 2022, and hoping to pull $2,000 monthly from a portfolio of corporate bonds. Long-term Treasury rates were below 2%, which would have pushed the cost of funding a bond ladder from age 65 to age 95 to about $550,000.
Instead, you choose to withdraw $2,000 monthly from a $500,000 corporate bond portfolio expecting to earn a higher return over time. At the end of 2022, your bond fund balance has fallen to $404,000 and you’re starting to wonder how you’ll fund $24,000 a year for the next 29 years without running out.
Retirees who bought a ladder at the beginning of 2022 don’t (or shouldn’t) care that the current value of their Treasury portfolio also fell by about $100,000. They’ve traded bond portfolio volatility for income security. If income is the goal, laddering is much more effective at creating a stable income.
The interest rate and credit risk of a corporate bond portfolio create the same sequence of returns risk that any portfolio of stocks and bonds will experience. The higher the standard deviation of the assets used to fund a spending liability, the greater the probability that the portfolio will both underperform (and outperform) the bond ladder.
At today’s interest rates, retirees hoping to fund $2,000 a month might set aside $400,000, but they may run out at age 90 or may still have $100,000 left at age 100. The longevity of the bond fund will depend on the sequence of returns they receive, and returns early in retirement will have an outsize effect on the amount of money they would have needed to set aside today to fund the liability.
Just because they invest in a bond category that has historically provided a higher average return does not mean that they will be able to fund the same spending goal as a ladder of Treasury bonds.
The Personal Pension
The risk of creating a defined cash flow in a volatile bond portfolio is why pensions use liability-driven bond investment strategies to match the amount of payments they will need to make in the future. Pensions need to know that when it comes time to cut a check to retirees, their investments will provide the precise amount needed to cover the obligation.
Individuals paying inflexible expenses in retirement should have the same goal — after all, why should a pension use an approach that ensures a stable income while an individual accepts greater income risk?
According to Dan Scholz, director of investment strategies at NISA Investment Advisors, firms that design liability-driven investing strategies for pension “income (or cashflow) objectives generally require identifying a cashflow profile that can be unique and usually not well-aligned with bond fund cashflow profiles.
Bond funds generally track market indices that have cashflow profiles that mirror whatever issuance patterns have been. There are no assurances that issuance patterns match desired cashflow patterns.”
With a Treasury bond ladder, retirees know exactly how much they’ll need to set aside to fund that liability. Their lifestyle will be insulated from both interest rate and credit risk.
Economist Robert Merton, a Nobel laureate, has been on a crusade to convince policymakers that retirees should have access to financial products that can provide greater lifestyle certainty through an inflation-protected defined future income.
Merton and Arun Muralidhar, AlphaEngine Global Investment Solutions’ co-founder, have championed Standard-of-Living indexed, Forward-starting, Income-only Securities, or SeLFIES, that offer workers a defined real standard of living in retirement adjusted for inflation.
The goal of a retirement plan, Muralidhar notes, should be to “ensure that individuals have a steady stream of real cash flows to maintain pre-retirement lifestyle.” Funding a lifestyle with a bond fund or even nominal Treasurys exposes the retiree to lifestyle risk even if the cash flows are stable.
SeLFIES, he adds, “deliver real coupons only (say $10 real/month and ideally indexed to standard-of-living), with a forward-start date (i.e., retirement), and for a period tied to average longevity (say 20 years), so that they serve as '240 paychecks in retirement,' and attempt to match desired retirement cashflows.”
The Ultimate Laddered Bond Fund: TIPS
A nominal stream of income may pay for fewer essential expenses over time as inflation eats away at purchasing power. Retirees who had ignored inflation faced increasing costs of insurance, travel, utilities, food and property taxes over the past few years. Those who retired with a nominal income of $100,000 in the late 1960s saw their purchasing power fall to less than $30,000 20 years later.
Inflation adds an additional layer of lifestyle risk to the interest rate and credit risk already present in bond funds. To manage this risk, new bond ladders of Treasury inflation-protected securities have been developed that advisors can use to create an off-the-shelf solution to funding fixed expenses.
“The power of bonds is predictable cash flow. Why introduce uncertainty by holding them through a bond fund you’ll have to sell over time?” said Nate Conrad, head of LifeX, a suite of bond ladder exchange-traded funds from Stone Ridge Asset Management.
“Bond ladders deliver cash flow more safely — and more simply — through a hold-to-maturity approach. And with a TIPS ladder to protect against inflation, you’ll know not only how much money you’ll receive, but also what your money will be worth,” Conrad said.
One risk not addressed by bond ladders is protection against longevity risk. Conservative investors may build the bond ladder to age 95, but there is still a risk that they could outlive their savings.
Building the ladder beyond average life expectancy requires setting aside a greater amount of savings in safe investments than an annuity, which costs roughly the same as a bond ladder to average longevity. An inflation-protected annuity could allow a retiree to set aside less money to fund basic expenses and leave more assets to fund flexible spending goals and wealth appreciation.
Annuities haven’t been especially popular, as Merton and Muralidhar note, but they do offer a dual benefit of a bond ladder and mortality credits. Retirees gain inflation-protected annuity income by waiting to claim Social Security, but delaying can buy only a limited amount of income.
Fixed annuities with a lifetime income benefit offer a liquid solution that can help overcome resistance to the irrevocability of a traditional single-premium immediate annuity by providing a guaranteed nominal spending amount like a bond ladder with the mortality credits of a life annuity.
Michael Finke, Ph.D., CFP, is a professor of wealth management and research fellow at the Retirement Income Institute.
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