In two recent Blog posts, I explored how bonds aren’t just for old people – first taking a look at the ways millennials can use bonds, then providing tips for 30-somethings (and beyond) to put bonds to work. The story wouldn’t be complete without some bond basics for retirees, so that’s what I’ll walk us through today.
As a person approaches retirement they are often looking at their investments to do two things: provide income and preserve wealth. The need for income is obvious. If you retire, you need to find a way to replace your paycheck. The desire to preserve wealth is a little more nuanced. Most investors look for their investments to grow through time, but as you enter retirement you may have met your wealth accumulation goals. You could then shift your priority towards preserving that wealth.
For a portfolio this generally means reducing exposure to growth asset classes like equities, and increasing exposure to bonds. Bonds pay a regular coupon payment which makes them ideal as an income source. They also have a maturity date, so you know you are getting your principal back in the future (assuming the issuer does not default, of course). For these reasons the bond strategy many investors use in retirement is called “laddering”. An investor purchases a number of bonds, each with different maturity dates. The investor receives income from the bonds, and at regular intervals one of the bonds matures. The investor can use the proceeds from the maturity if they need it, or they can simply re-invest it into a new long maturity bond, extending out the ladder.
Laddering: A Practical Example
To look more closely at laddering in practice it is helpful to use a case study. Let’s say that you are just entering retirement (Congratulations!). You have reduced the risk in your portfolio by selling down some of your equity holdings, and you are now looking to build out a bond ladder for future income needs. In addition to your own income needs, you also have some future expenses that you want to make sure you are prepared for. Your daughter is going to be getting married next summer, and you would like to help with the cost. You also have a son who recently had a baby and you want to set aside some money in a 529 college savings plan for your new grandchild. Lastly, your parents may need to move into an assisted living space in five years and you’d like to help them financially.
In this example you have $900,000 to use to build your ladder, it may look something like this:
You have $100,000 invested into each rung of the ladder for your ongoing income needs. You also have another $100,000 spread across four different maturity dates to meet your future expenses. When the bond in year 1 matures you would have $25,000 for your daughter’s wedding, and you could re-invest the other $100,000 into a bond that matures in Year 9, extending out the ladder.
Of course, bond ladders are not the only way to invest in fixed income. Some investors chose to use mutual funds or ETFs instead. Such an investment doesn’t have a maturity date, but it does provide diversification to help protect against default risk, and can provide regular income. There are also investments have features of both bonds and funds, term maturity bond funds like iShares iBonds® ETFs. These seek to provide regular income and known maturity dates like a bond, along with the benefits of an ETF such as diversification and exchange liquidity.
No matter the vehicle you choose, bonds are likely to be a healthy part of your retirement portfolio.