So far, we've discussed bonds, bond funds, bond ladders, and TIPS in particular. In this article, we'll look at TIPS ladders, which many retirement professionals consider the safest investment for the risk-free portion of a retiree's portfolio. (reference past articles – safe income floor).
To simplify things, I will use the term "ladder" to refer to a series of TIPS bonds maturing annually instead of owning a TIPS fund.
As we've discussed previously, bond ladders are most effective in funding a future known spending need, such as a year of retirement income. We can know with relative certainty how much money we'll have to spend sometime when the bond matures. Bond funds don't offer that assurance.
If you're investing in bonds mainly for portfolio diversification and regular income, a ladder will have limited benefit to you. A bond fund will meet that need quite well, albeit with some interest rate risk.
Short-term TIPS funds (such as STIP, the one I own) are relatively safe and will not lose much in just a few years if interest rates rise. And a short-term TIPS ladder will probably not do much worse than a short-term TIPS fund, but there is the potential for it to do better, depending on what interest rates do.
As I said in the last article, my short-term TIPS fund lost money last year, but 2022 was a worst-case scenario in many ways. My principal would've been safer if I'd instead used a short-term ladder. But the relatively small loss (compared to longer-term bond funds and stocks) is not a significant concern to me. If it were, I should have gone with a ladder in the first place.
Retirees who build TIPS ladders to provide safe income for future spending needs in retirement tend to build longer-term ladders, perhaps 20 years or more. I'll call these "long TIPS bond ladders," and what's in view is a non-rolling ladder, which I discussed previously.
But as I've studied this more closely, I have some concerns that may or may not be showstoppers for you or me in terms of using a TIPS ladder.
For starters, we don't know how long we will live (one of the reasons some people don't like annuities). We could die before we deplete the ladder, or we could live beyond it.
An even bigger concern is that uncertainty increases as we plan further out in the future.
The risk of outliving our resources can be mitigated by life annuities (such as Single Premium Immediate Annuities—SPIAs). Long (20-years plus) TIPS ladders may also be a good alternative but come with their own risks, including some level of longevity risk.
Many retirement income planning professionals consider TIPS bonds held to maturity to be virtually risk-free assets. TIPS have virtually no default risk, no interest rate risk, no inflation risk, and no correlation to stock market returns. Still, no asset is totally risk-free.
With a TIPS bond ladder, there is the risk, as mentioned earlier, that you might live longer than the ladder you buy, and there is also the risk that you'll need to liquidate some bonds before they mature, despite your best intentions (life happens), in which case you'll have interest rate risk.
That risk is greater for a 20 or 30-year ladder than a 5 to 10-year one. Short ladders are about as risk-free as you can get—risk grows with the length of the ladder.
Suppose I buy that 30-year bond today (which I would have to do on the secondary market—more on that later); I'll lock in a relatively low coupon rate for the next thirty years. If long-term rates rise in the future, I may regret that decision.
Plus, if I buy that bond today, I'll be buying the bond at a discount and a higher real yield. Plus, that 30-year bond will be adjusted for inflation every year, so its accrued value could still go up significantly over that period as inflation-related growth compounds.
I would ultimately get what I intended: a near-certain match of future spending needs in year 31.
If I decide to build a long TIPS ladder at age 70 and want it to provide income to my wife or me until we reach age 95, I'd have to purchase 20 to 25 years of expenses in long-term bonds. If I should have to liquidate any of them before they mature, I could lose a lot of my principal.
Things to consider
I think the appropriateness of a TIPS ladder will come down to weighing longevity risk and the risk of unplanned early liquidation against the degree of certainty a TIPS ladder held to maturity would supply. Many variables could enter our financial life that either exacerbate or mitigate the risks.
Most married couples are very likely to have at least one spouse who would live long enough to use most, if not all, of the ladder. The longer they survive, the less likely the ladder will contain bonds with a significant loss since a bond's market price will approach its original face value as time passes.
If you have other savings and income sources in retirement (Social Security, pension, annuity, and investments), you may be less likely to sell bonds in your ladder in an emergency. (You could, for example, sell appreciated stocks or stock funds if you have them.)
But those who need to fund most of their annual income with a ladder will have greater risk exposure than those who need to spend less from their investments.
So, what's the solution? Are there better alternatives? There are some, but none of them addresses the inflation problem.
The best alternative is probably an annuity. But they're less liquid than a ladder; plus, there is no longer any such thing as an inflation-adjusted fixed-income annuity. Another option is a Multi-Year Guaranteed Annuity (MYGA), a deferred annuity that also offers no inflation protection. CDs are paying much higher rates now but could also suffer from inflation, especially at longer durations.
If you can keep your portfolio withdrawal rate below 4% for most, if not all, of retirement using some mix of stocks and bonds, you may not need to annuitize with a TIPS ladder or an annuity.
Many retirees, especially those with lower savings balances, won't be able to. In that case, the best way to provide safe, inflation-adjusted income for known spending needs in the future is to purchase TIPS bonds and hold them to maturity.
Another reasonable option may be some combination of TIPS funds with an average duration that aligns with your spending requirements (known as "duration matching" or "liability matching"). For example, using a short-term TIPS fund for expenses over the next one to five years and a longer-term (intermediate-term) fund for years five to ten.
To ladder or not to ladder?
I already own a TIPS fund, but deciding whether to stick with it and my other bond funds or build a TIPS bond is proving to be a much harder decision than I thought.
I've done okay (but not great) investing with TIPS funds (notwithstanding the 2022 anomaly), but building a TIPS ladder from scratch to lock in slightly higher yields and at least keep up with inflation is attractive to me too. I may need to sell some bonds at a loss before they mature, but a TIPS ladder seems like a wise choice for providing future-certain, inflation-adjusted income.
I tend to view this as constructing a personal, inflation-adjusted annuity, something I can't buy from an insurance company.
I recently read an article by Alan Roth (link), a respected retirement advisor and writer. He described how he built a TIPS ladder that would permit an inflation-adjusted 4.3% of income per year for 30 years. He invested in 24 TIPS in the secondary market at an average real yield of 1.83%.
If 4.3% of income per year sounds high, that's because when you draw down a TIPS ladder to meet spending needs, you are spending both principal and growth. In that way, it's much like owning an annuity but with inflation protection.
On the other hand, committing my savings to a 20 or 30-year TIPS ladder makes me more than a little uncomfortable for reasons I've already given. I'm thinking of more of a hybrid approach whereby I might create an intermediate-term TIPS ladder and invest in TIPS funds and other bonds for diversification.
I'll dig into that in the next (and maybe the last) article in this series. I'll also let you know what I decide (assuming I can make a decision—I'm still on the fence on this one).