Warning: This post has a heavy dose of math, and plenty of highly specific details relating to retirement income.
Disclaimer: The article below discusses certain investment strategies, some of which I am currently using in my personal portfolio and some of which I am not. Do your own due diligence before making an investment decision. It’s your money; you’re the best person to judge what is best to do with it.
Recap of Part 1
In Part 1 of this two part series, we went through the basics that get us to the point where we can design a plan to reduce the risk of outliving our income in retirement to near zero. Real returns versus nominal returns, or the impact of inflation, factored heavily in the basics. It is much easier to plan 20-50 years in the future using real dollars, or today’s equivalent, as opposed to nominal values. Only US TIPS bonds guarantee a return that includes the rate of inflation. Currently, US TIPS bonds that are maturing 20-30 years from now return the rate of inflation over the next 20-30 years plus .80%-.90% percent above that. If inflation averages 3%, then the bonds will return ~3.9%. These returns are clearly not great, but they reflect the times. Most importantly, they remove the risk of underperforming the inflation rate from now until when you need the income. Stocks have underperformed inflation for periods of a decade or more, while bonds have an even worse record. Always live life from a position of strength. Sometimes this means taking a major risk off the table in exchange for a lower return.
Before we get into the process of using TIPS bonds to annuitize and secure our retiree’s lifetime income, let’s recap our assumptions first:
- The Retiree: Our wannabe retiree is currently 46 and plans to retire after the age of 67. Their spending is $50,000 and will grow at a real rate (above inflation) of .50% per year. Social security will cover $2,500 per month, or $30,000 per year, and grows along with inflation. They currently have $600,000 in assets in a “risky portfolio” of 80% stocks and 20% bonds. They will contribute 80% of the annual maximum allowance to their retirement accounts and do not have a pension.
- Rates of Return: Stocks have historically returned ~6-7% above inflation, while bonds have done half that number. Given the very expensive current market and the general gloominess forecasters have of the future, I’ll make the conservative estimate that stocks return 4.5% above inflation for the next 20-50 years, while bonds return 2% above inflation. Longer maturity TIPS will continue to earn .90% above inflation, as they do now.
In Part 1, we determined the amount of money needed from the retiree’s portfolio each year for the 25+ years of retirement. Now it’s time to do something with that information, and make sure this wannabe retiree lives life without the fear of having too little income.
We’ve been talking a lot about annuities and annuitization, but what exactly does that mean? Annuitization is the process of moving investments away from risky assets, such as stocks, into risk-free investments that mature and pay out near the time that we’ll need the money. Doing this process over a period of years makes the most sense, as you decrease your “point” risk, or the risk that you are buying in at an unattractive price. Similar to dollar cost averaging, this process spreads out your buys and your sells. Twenty years feels like a good amount of time to complete that process. By the time you hit your late 40s, you should have a decent sized nest egg and are able to max out your retirement contributions (or at least come close). The late 40s is also a time where retirement starts to feel like a reality and you’re near your peak earnings years (peak earning years for most Americans are from age 50-54).
This annuitization path factors in the amount of retirement income needed from your portfolio (after determining what you’ll receive from social security), as well as current yields that can be earned in the TIPS bond market. First, let’s look at the path for our retiree from age 47 through age 67. The goal is to have a certain percentage annuitized each year until we reach 100% right before retirement.
The slope from 0% to 100% is gentle, with the greatest increases corresponding with the retiree’s early 50s, a time of maximum peak earnings and the first years of the catch-up contribution. Figuring out the percent to annuitize is the easy part; we also have to determine the amounts.
We have to first go back and look at the income needed at all ages of retirement, from age 68 to age 93 or beyond if desired. We want to ensure that 100% of our retirement income is secured at age 67, but remember that the income needed at age 90 will not be needed for 23 years. This money has time to grow, so you actually have to put aside less by the time you retire; a calculation known as determining its present value.
As you can see from the chart below, although our retiree wants to spend nearly $33,000 in today’s dollars out of their portfolio at age 90, since they have 23 years for that money to grow once retired, they only need to buy $26,500 worth of TIPS bonds to successfully annuitize the income in that year. Since TIPS have a real rate of return that is positive, they can put away 10% fewer dollars at retirement. Recall that this number is lower than total spending because they also receive Social Security income.
Our retiree was spending $50,000 dollars at age 46 (typical annual spending, not including things like college tuition or a vacation home purchase) and plans on spending nearly $56,000 per year by the time they retire. Only about half of that amount is supplied by Social Security. Over a 25 year retirement, they will spend $765,000 in today’s equivalent dollars from their portfolio and will need to have $682,000 put away and annuitized by the time they retire. The difference between the two numbers represents the expected growth in value over the retirement years. $682,000 is the target minimum to have saved in their investment portfolio and be annuitized by age 67.
Unfortunately we have to take one more step before we calculate out how much per year we want to invest in TIPS. Since we’re investing in TIPS bonds and annuitizing over a 20 year period (from age 47 until retirement), we earn income along the way. Importantly, this means that we have to invest less in TIPS bonds each year than we otherwise would. The math behind finding that number is a bit of a circular logic, but you can determine it based on each year’s investment in TIPS bonds multiplied by the expected real rate of return (in our case, .90% per year). For our retiree, that translates into a little under $70,000 over the 20 year timeframe on a present value basis. Instead of using our $682,000 target to determine the annual transfer, we reduce that number by $70,000. In the end, our annuitization path looks like this:
By the time our retiree reaches age 67, they have reached their $682,000 goal, in today’s dollars, with a little bit of a buffer. If they’ve followed one of the two investment approaches outline below, they can rest easy knowing that their base expenses are covered by Social Security and US government bonds. Assuming the US government does not default, they will never have to worry about money again. If the US government does default, then no investment is safe.
Even better, this retiree will still have quite a bit of money in a risky portfolio. I have focused only on the TIPS bond portfolio thus far. Recall that our retiree started with $600,000 in a risky 80% stock/20% bond portfolio and will keep contributing to their retirement accounts. As seen in the chart above, most of the TIPS bond purchases will be done with new contributions, with sales of the risky portfolio assets only done during the heart of annuitization process in the early to mid 50s. Since we’re assuming that this risky portfolio continues to grow over this time (albeit in a consistent manner, which as we know will never happen), the TIPS portfolio ends up being only 44% of the retiree’s total retirement assets.
This retiree is officially in fantastic shape for retirement. Between the TIPS bonds and Social Security, their basic expenses are covered. On top of that, they still have nearly $900,000 in a risky portfolio (remember, all in today’s dollars). These assets can be used for unexpected expenses, leaving an inheritance to family members or charities, or having a wild and crazy retirement. At this point, the retiree has built their financial fortress and is well prepared for whatever the future holds.
Investing in US TIPS bonds can be done two main ways: buying TIPS through exchange traded funds (ETFs) or mutual funds, or buying individual bonds directly from the US government or through your broker. Investing in the right TIPS bonds so that the bonds mature at the same time you need the cash in retirement is the goal. Buying individual TIPS bonds provides a more precise annuitization, but you can get similar exposure through the use of TIPS ETFs.
Using TIPS ETFs
There are two main types of TIPS ETFs: a broad exposure that holds all TIPS bonds and ones that target specific maturities. The broad based TIPS exposure is too imprecise for our needs, so let’s focus on the ones that target specific maturities. There are three large and liquid ETFs that target the 0-5 year maturities: VTIP (Vanguard), STIP (IShares), and STPZ (PIMCO). VTIP is the largest ETF so I’ll use it for the example, but all are adequate and have similar fees. On the longer maturity TIPS (15+ years), there is only one option: LTPZ from PIMCO. This fund is not very large, but it trades between $750,000 and $1 million in total volume each day, which is sufficient for our needs. In between 5 and 15 years, there are no good options, so we’ll use a 70% VTIP/30% LTPZ mix. This will barbell the exposure and provide a conservative representation to the middle maturity bonds.
Using our chart above, at age 47, we begin annuitizing our portfolio by buying $18,250 worth of TIPS. Our retiree will use their entire year’s contribution plus a small sell of $4,000 in their risky portfolio to fund this purchase. Since retirement is 20 years away, they buy 100% in the longer maturity TIPS bonds, using the PIMCO ETF LTPZ. In fact, because retirement is still quite a few years out, our retiree only buys long dated TIPS until they turn 54. Once our retiree turns 54, the first year of retirement at age 68 is only 14 years away. The first year of retirement income ($25,800) is now invested in the 70% VTIP/30% LTPZ. We have to use a portion of our new investment to put $18,120 in VTIP, with the rest going towards LTPZ. As our retiree gets closer and closer to retirement, they will look at each year’s spending and ensure the proper ratio of VTIP to LTPZ based on time. However, even at retirement, a good portion of the TIPS investments is held in longer maturity TIPS because retirement is a 20+ year affair. By the time our retiree gets their gold watch, their portfolio of TIPS ETFs looks something like this:
Selling out of longer maturity TIPS to buy shorter maturity TIPS will continue each year throughout retirement. Using ETFs as opposed to individual bonds means that you will have to manage the process throughout retirement. Aligning the assets with the expected needs for income is the core tenet of annuitization.
Using Individual TIPS
Individual TIPS bonds, as opposed to ETFs, can be purchased either directly from the US government (through TreasuryDirect.gov) or through your broker. Your broker will likely charge you a mark-up or a commission to buy while the US government does not. Individual 30 year TIPS (along with others) are issued every year in February, and are available beginning in year 2040 (nearly the same year our retiree expects to retire). While using individual TIPS bonds is more complicated than using ETFs, you can also get more precise. For example, if you know that you need $26,000 in 2040, you can buy $26,000 worth of TIPS bonds maturing in February of 2040. Also, because you are receiving interest along the way, you can buy a smaller amount than what you need and just reinvest the coupon payments in the same bond.
For individual TIPS bonds, I recommend buying three to five bonds per year, starting with the first years of expected retirement. You spread out your purchases among several bonds, and as you buy the required amount in each year of maturity, you continue to move through time and buy new longer maturity bonds. For example, at age 60 for our retiree, they have already fully annuitized the first 20 years of retirement (2039-2058), and are investing in 2059, 2060, and 2061 maturity bonds to ensure income in those years. While the process of buying individual bonds is more complicated logistically, it also is more intuitive since you have a specific bond maturing at the same time that the income is needed.
Live Life from a Position of Strength
The process of annuitizing and securing your retirement income involves heavy math, lots of details, and complex processes. Heck, it took me two articles and over 5,000 words to give a pretty mediocre explanation! Since our goal is to be above average, we’re not afraid to roll up our sleeves, get a little dirty, and do the math. Living your life from a position of strength is worth it!
The process of securing your retirement income involves the following:
- Understand Real versus Nominal: Real returns and real interest rates account for inflation, whereas nominal returns and nominal interest rates take inflation risk. Knowing the difference, and knowing how to use Real returns to plan for the future, is important to calculating our income and investment needs.
- Make Assumptions: Planning for the future requires making some assumptions. In almost all cases, these assumptions will be wrong. However, in order to begin the process of planning, some assumptions must be made. Be conservative, but attempt to calculate your spending needs, return expectations, and ability to fund new portfolio contributions through time.
- Estimate Portfolio Income Needs: Go to the Social Security Administration website and find out your expected level of Social Security income. If you have a pension, find out how much you expect to receive. Once you have those numbers, you can use your expected spending needs to determine how much your portfolio needs to generate in retirement.
- Calculate How Much to Buy in TIPS Annually: Here’s where the hard math begins. Once you determine your portfolio spending needs, you can begin to calculate how much is needed each year and the path to ensure you have it through your portfolio. Assuming a twenty year timeframe until retirement, you can plan a steady progression each year. Remember to factor in interest earned along the way as well as interest earned throughout retirement, which will reduce your required TIPS bond purchase each year.
- Buy TIPS Bonds or ETFs: Once you’ve done your calculations in step four, executing the plan begins. Buying individual TIPS bonds or TIPS ETFs will secure your retirement income. Follow the progression you’ve set out in step four and make adjustments along the way as necessary.
- Live the Good Life: Once you’ve reached retirement with your income secured, you can live life to its fullest. No longer will the fear of outliving your money concern you. You’ve built your financial fortress, now go enjoy!
Securing your retirement income is a complicated process done over decades. It’s also worth doing. Don’t be afraid of the math and always live your life from a position of strength!
Keep building my friends.