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Building bond ladders for retirement income is an important but understudied topic. Especially as we are at a point in time when many are worried about future interest rate increases, bond mutual funds will lose value as rates rise, while a bond ladder will still provide the desired income at the bond maturity dates no matter what happens with interest rates. This potentially suggests, to the extent that one is worried about future rate increases, that today’s retirees could be better off by building a bond ladder for their desired bond allocation rather than holding bond mutual funds.

I’m now working on a column for Advisor Perspectives in which I review existing knowledge (preview: the best work I’ve seen comes from the Asset Dedication team of Stephen Huxley and J. Brent Burns) and also investigate how long one might want their bond ladder to be. For that, I will be using Treasury Strips. In that column I will not be getting too much into the details of how to actually construct a bond ladder for retirement income. The purpose of this post is to explain how to build a ladder of TIPS to provide retirement income.

The difference between bond ladders as they are usually discussed and a bond ladder for retirement income, is that with retirement income the idea is to spend the income thrown off by the ladder each year. This means that you set up the bond ladder to generate the amount of planned income you desire. With a traditional bond ladder, you wouldn’t spend the income, but reinvest it to lengthen the bond ladder. With bond ladders for retirement income, you would generally lengthen the bond ladder using other resources, such as stock investments, rather than using the income provided by the bond ladder.

For anyone actually seeking to build a bond ladder with TIPS, I highly recommend Harry Sit’s book, Explore TIPS. He provides all the details needed to actually go out and buy TIPS. My discussion here is more technical in the sense that I’m explaining what you would need to buy, but I’m not getting into the mechanics of how you would actually go about making those purchases (opening a brokerage account, etc.).

I’m getting the raw data for this explanation from the Wall Street Journal‘s Market Data Center. They provide a daily report of wholesale prices from the secondary markets for all of the outstanding TIPS issues. [Note: one of the issues that Harry’s book explores is how household investors will need to pay a mark-up above these prices, so building the bond ladder could cost a couple percentage points more than the prices I’m reporting]. This is the data available for December 18, 2013:

There are a lot of details to note from this data. First, though the Treasury is again issuing 30-year TIPS such that we can find maturities out until 2043, they had stopped that for a period, and there are no TIPS maturing in 2024, 2030-31, and 2033-2039.  This actually complicates things a bit. If we try to build a 30-year bond ladder, we need to make assumptions for what to do about the missing years. The common assumption I’ve observed is that one buys more of the TIPS for the later available maturity date and assumes they can be sold off at their accrued value at the earlier date assuming that there are no changes in interest rates until that time. For example, to cover 2024, one buys more of the 2025 issue and then sells it in 2024 to get the income desired for 2024.

This does leave someone exposed to interest rate risk: if rates rise, the income they will receive from selling their TIPS early will be less than otherwise. But it’s the best we can do within the constraint that we are only using TIPS. Strips do provide a work-around for this issue, since one can get stripped coupon payments for years when no bonds mature, but they do not provide inflation protection. The general benefit of building a bond ladder for retirement income is that when you hold the bonds to their maturity dates, you know exactly how much you are going to get.

Next, we need to know what all of these columns are:

Maturity is the maturity date when principal and the final coupon payment is provided.

Coupon is the coupon rate paid by the TIPS. This is one of the most confusing aspects of bonds for people to understand. When the bond is issued, it pays a set coupon rate. For a regular Treasury bond, if the coupon rate is 2% and then face value is $1000, then the bond pays coupons of $20 per year. Usually these are paid semi-annually. Two coupon payments of $10 in this case. Note: the coupon rate NEVER changes.  Interest rates can change. But that will affect the yield, not the coupon rate.  If interest rates rise, then the price that the bond can be sold at will decrease, raising the underlying yield to maturity to match t he increasing interest rate. But if I buy a $1000 face value bond on the secondary market for only $700 and it has a 2% coupon, it is important to understand that my coupon income will be based on 2% of $1000, not 2% of $700. Though this may seem basic and simple as I explain it, I assure you that this can be a huge source of confusion.

Next are the bid and asked columns. Bid is the price TIPS can be sold for, and Asked is the price they can be purchased for… in the wholesale market. The difference in prices is the spread made by the party helping to conduct the exchanges between buyers and sellers. Again, household investors will experience lower bids and higher asked than reported here as they are not participating directly on the wholesale market. For these prices, they are referenced in terms of face values of $100, though bonds usually have face values of $1000.

The Chg column is just how much change there was in the asked price since the previous day.

Next, the yield is the yield to maturity based on the asked price. This is the return that the investor would get for buying the bond today and holding it to maturity. If the Asked price is 100, then the yield would be the same as the coupon. If the asked price is above 100, then the yield will be less than the coupon, and if the asked price is below 100, then the yield will be higher than the coupon.

Why? This gets back to the point I was stressing before about how the coupon never changes. The bond provides a promise for a fixed set of payments. It pays all of the fixed coupon amounts and it repays the face value at the maturity date. These payments NEVER change. But bonds can be sold and resold on secondary markets prior to the maturity date. If I pay $900 for a bond providing a fixed set of promised payments, then I’m going to get a higher return on my $900 investment than if I paid $1,100 for the same set of promised payments. So lower asking prices imply higher yields, and vice versa. Note that these yields are expressed in real terms for TIPS.

That final point brings us to the final column: Accrued Principal. This is a unique term for TIPS. The accrued principal is the inflation-adjusted principal since the TIPS was issued. The special points about TIPS are that the coupon rate is actually paid on the accrued principal, not the nominal initial $1000 principal. As well, at the maturity date, the investor receives the accrued principal back, not the nominal $1000. This is how the inflation adjustments are incorporated:  a real coupon rate is paid on an inflation-adjusted amount and and inflation-adjusted amount is returned at the maturity date.

Another point about this data.  If I was constructing it, I would have made one difference. The ask price is in terms of 100, but when you purchase the TIPS, you have to pay in terms of the accrued principal, not in terms of 100.  The way I would have presented the asked price in that table is:

“Actual” Asked Price  =  [Asked]   x   [Accrued Principal]  /  1000

And one final point about this data.  Coupon payments are made every 6 months. When you buy the TIPS, you also have to pay any interest that the previous owner would have earned since the last coupon payment up until the data they sold it to you. I believe this is what really throws off the pricing for the TIPS maturing on January 15, 2014. The Yield is artificially high by quite a bit because the purchaser is going to also have to pay about 5/6 of the coupon payment to the previous owner  (which, for review, would be 0.5  x  2%  x  $1265 = $12.65). There is just a month left until maturity.

When I construct my bond ladder below, I will ignore this “accrued interest” problem because it is a rather minor issue, but it does affect that 2014 TIPS a lot. My bond ladder will use the first available TIPS maturing in each year except for 2014. In this case, I use the TIPS maturing in July 2014. Based on what I just wrote, this is the yield curve I have available for constructing the TIPS ladder for retirement income.

Now we are ready to actually construct the bond ladder and determine its cost. To do this, we work backwards. One more simplification I am now going to make to reduce the complexity of the explanations is to assume that coupons are paid only once per year rather than twice per year. I’m also going to assume we can buy fractions of bonds, when in reality we can only get as close as possible to our income goal in increments of $1,000, since fractions of bonds cannot be bought and sold.

Let’s construct a ladder to provide $10,000 of inflation-adjusted income for 30 years between 2014 and 2043. Starting at 2043, we need to buy enough shares of TIPS to give us $10,000 of inflation-adjusted income that year. This involves buying the TIPS maturing in 2043, which has a coupon of 0.625%, an asking price of 77.14, a yield of 1.596%, and accrued principal of $1016. The accrued asking price is this $783.74 out of $1000. In real terms based on today’s accrued principal, and with my simplification that only one coupon payment is made per year instead of 2, on Feb. 15, 2043, this bond will pay  1016 x (1 + 0.00625) = 1,022.35 in interest and principal. We want an income of $10,000.  So we need to buy 10000/1022.35 = 9.78 shares.

Given the wholesale accrued asking price, these shares cost us 9.78 x 783.74 = $7,664.98. Actually, these numbers have been rounded. In my computer, the precise cost without rounding is $7,666.09. In other words, paying $7,666.09 today entitles you to $10,000 of REAL income on Feb. 15, 2043. The amount you actually receive on that date in nominal terms will actually be larger to the extent that we experience inflation over the next 30 years.

Now we move to 2042. We want $10,000 of real income for that year too. The trick is that we have to account for the fact that the 2043 maturing TIPS we just purchased is going to give us coupon payments of 9.78 shares x 0.625% coupons x 1,020 accrued value =  $62.11 of income in every year for years 1-29 as well. So we can subtract that from what we need to purchase. We need to buy enough 2042 bonds to provide real income of $9937.89 in 2042.

And so this process goes, working backward to 2014. Actually, for 2014, we will have $4280.32 of real income coming from all of the coupons for bonds we purchased which are maturing between 2015-2043. So we only need to purchase enough 2014-maturing bonds to get $5719.68.

That is the logic behind the following table, which shows our menus of purchases to obtain a 30-year TIPS ladder.

Now for some final comments on this table. Note that the cost of building a 30-year TIPS ladder providing $10,000 of annual real income is $247,588.14. This is scalable. If you want $50,000 of real income, the cost is 5 times greater ($1.24 million), etc. Also, this is an approximation due to some simplifying assumptions I’ve listed throughout the post.  Note that this cost with regard to the $10,000 income represents a 4.04% withdrawal rate.

With the bond ladder, nothing will be left at the end of the 30th year though. Actually, interest rates have been rising in recent months, and 4.04% is currently the payout rate on an inflation-adjusted SPIA for a 65-year old couple with joint and 100% survival benefits. Also, for what it’s worth, the implied return on the $247k to get these cash payments is 1.29% in real terms. That’s the current “riskless” rate of return for 30 years of retirement income. There is still longevity risk though.

© 2013 Wade Pfau.

The earth has circled the sun again and, without stopping for breath, has begun yet another lonely lap around the solar stadium. The solstice is past; a pale new year awaits. What will happen in the retirement industry in 2014? Beats me. But I hope that:  

Someone will engineer a plan to stabilize Social Security. We need to solve the Social Security question soon, and not by shrinking the program. Young people need their confidence in it restored. Older people need to appreciate that it protects them against sequence of returns risk, which is to say that, unlike the markets, it prevents the division of neighbors into retirement winners and losers.

Interest rates will rise without toppling equity prices. A decade ago, Alan Greenspan played a game of Jenga with the short-term rate, raising it in quarter-point increments. The strategy worked for a while, but eventually the stock market tumbled like a tower of Jenga blocks. Maybe we’ve learned a lesson or two since then. Good luck, Chairman Yellen!

The Department of Labor issues a sagacious re-proposal of the fiduciary rule. Granted, mandating a fiduciary standard for all financial intermediaries seems a bit quixotic. But it does seem reasonable to me that more of the ERISA restrictions and protections that apply to 401(k) money should follow that money when it rolls over to an IRA, and/or for as long as it continues to grow tax-deferred.      

Employers start contributing more money to their employees’ retirement accounts. I once worked for a company that contributed 10% of pay to employees’ 401(k) plans and matched a chunk of the employee contributions. If plan sponsors are concerned about their employees’ retirement security, they need to try this—even if means carving some or all of the contribution out of take-home pay. Nudges and calculators aren’t enough.

Deferred income annuities find their way into 401(k) plans. Participants need the option of allocating at least part of their contributions to an account that will produce guaranteed income 10, 15 or 20 years hence. It’s unrealistic to expect many people to buy annuities at retirement; the loss of liquidity is too drastic and interest rate risk is too high.

The public-pension funding crisis gets resolved in a non-divisive way. The current crisis is a symptom of the 2008 crash, low interest rates and the erosion of the tax bases of America’s towns and cities. It’s a shame to see retired firefighters, bus drivers and policemen ridiculed for expecting to receive the pensions they legally bargained for.

Americans elect smarter politicians in the 2014 elections. We need fewer hacks and ideologues, and more men and women with the brains, courage, and large-mindedness necessary to collaborate on wise, far-sighted solutions to our problems, including our retirement problems. Too many elected officials seem to know almost nothing about the way our financial system works (and even less about how insurance works).   

© 2013 RIJ Publishing LLC. All rights reserved.

One year ago, in a year-end column for 2012, I predicted that the easy-money bubble would continue inflating through 2013, which should be a good year for asset prices, but that 2014 would be more problematic.

Having been “right so far” with this prediction, I thought it worth re-examining to determine whether the crash will indeed occur in 2014, as I then predicted, or whether investors may be able to enjoy another good year before doom hits. My crystal ball is more clouded than it was a year ago, and the first half of 2014 looks good, but I wouldn’t be too certain about the fourth quarter.

I was certainly right to be pretty optimistic for 2013. The Standard & Poor’s 500 Index is up today 25% from Dec. 31, 2012, and the Dow Jones Industrial Average is up 21%. On the other hand, the MSCI World Ex. U.S. Index is up only a more modest 12% and gold is sharply down, by about 26%.

I confess an expensive error in the last area – it seemed to me (and still seems) that with Japan having joined most Western economies in mad monetary stimulus, gold had to rise sharply—indeed I suggested a price of $3,000 an ounce. Instead, all the money seems to have gone into Bitcoin—a sad commentary on the downfall of solid values in modern life. Still, overall, I was right for 2013 and am tempted to repeat the prognostication for next year.

Well, let’s have a look, shall we? If next year is an exact replica of this year, the S&P 500 Index will end at 2,224 and the Dow Jones Industrial Average will end the year at 19,232. Gold, on the other hand, will end the year at $912. Hmm.

I have to say that combination looks pretty unlikely. I could indeed see gold at $912, which would imply that monetary stimulus had been scaled back and that the inflationary psychology had been eliminated from the markets—including those in India and China from where the majority of today’s incremental demand for gold arises. Perhaps we would have had some actual deflation in the West, with prices declining, thus removing gold’s psychological advantage as an inflation hedge.

In that case, real interest rates would have risen, since at least long-term rates can’t fall below zero. Corporate profits would surely have fallen and much of the bubble psychology would have been wrung out of the stock market. In other words, the S&P 500 Index would most likely be chasing the gold price down toward 900.

Conversely, to get the S&P 500 index up to 2,224, corporate profits would have to show considerable further oomph beyond today’s level, which is already an all-time high in terms of U.S. Gross Domestic Product. To get profit margins rising like that money would still have to be very cheap and inflation would have to have ticked up a bit. In that case, gold would surely be chasing the S&P 500 Index up beyond $2,200.

In other words, 2014 can’t be like 2013. It will therefore have to be different. Polish the old crystal ball, and let’s estimate in which direction the differences might arise.

One factor that should make us bearish is that everyone else is bullish. The top-ten Wall Street banks, polled by Marketwatch, all think the market will be higher at the end of 2014 than it is today. They forecast rises in the S&P 500 Index ranging from 4% to 17%—all of them short of the “naïve” forecast of 25%, let it be noted. That’s not definitive. You could get a net rise of 10% on the year with a market that rose 50% and then turned round and fell 27%, in which case the net 10% rise would pretty clearly be the harbinger of dark days ahead in 2015.

However, the overall optimism of Wall Street pundits does suggest that most of the buyers are in the market already, which you’d expect in a market up 25%. Those who were out—or who like me bet on the sectors of precious metals and emerging markets that have performed worst this year—have to feel pretty stupid right now. 

Ben Bernanke’s decision last week to reduce the amount of bond purchases undertaken by the Fed is bullish for the long term—at least as it avoids one form of catastrophic risk—but it clouds the picture in the short term, although the market’s initial reaction was euphoric.

According to Bernanke, we can expect a gradual further decrease in bond purchases, perhaps with a $10 billion decline at each Fed meeting in 2014 so that by the end of the year purchases would have halted altogether and the Fed balance sheet would have stabilized at $4.5 trillion. That’s a much more tolerable situation than we would have been facing if Bernanke hadn’t tapered: expanding the Fed’s balance sheet until it swallowed the U.S. economy.

The global economy is nowhere near capacity, which leads me to suspect a further lengthy period of recovery before the next recession hits. You’d expect recovery to continue fairly slowly in the rich Western countries, as wages continue equalizing between the West and emerging markets.

On the other hand, there seems no reason why Africa should not continue to get rich rapidly. Indeed, while Chinese growth has slowed and India, Brazil and Russia have all in their different ways run into problems, sub-Saharan Africa is so much poorer than other emerging markets (at around $1,400 per capita GDP compared with $9,600 in Latin America) that it should have a decade or so of rapid growth ahead before the inevitable constraints of its poor government and infrastructure really begin to bind.

Nevertheless, between the two extremes of an early crash and a stock-market boom that goes on and on, there seems to be a likely outlook somewhere in the middle. At the extreme case, it would seem very unlikely that the current market boom can last until the end of 2015, even if the Fed does indeed hold short-term interest rates near zero for the whole period.

For one thing, long-term interest rates have risen substantially in spite of the $85 billion of monthly bond purchases. So reduction of the pace of bond purchases should cause the rise in rates to continue, or otherwise accelerate. In the long run, that has to cause a market decline as corporate profits will be affected.

At the other extreme, the Fed still will be purchasing $50 billion or more of bonds monthly until the middle of next year, which should limit the rise in long-term rates in the next six months. Only when Fed purchases taper toward zero, in the second half of 2014, does the current market euphoria seem likely to lessen.

In the meantime the market will have gone much higher—it is rising at far more than the average market prediction of 10% a year—because of the flood of money into it, and should continue doing so.

On balance, therefore, we can guess at a market peak sometime between Sept. 2014 and June 2015, at a level much higher than the current one. We can, however, be pretty sure that once the market has peaked, its fall will be both prolonged and steep. Long-term interest rates will rise, so corporate profits will decline. The mass of malinvestment caused by the last five years of zero short-term interest rates will be a massive overhang on the market.

The outlook for investors is thus difficult. The opportunity to make money will extend for only a few more months, after which there will be a period, possibly as long as 3-4 years, during which any foray into the market will be rewarded by massive losses. Sell too early and you could miss not just the last 10% of the run-up, but the last 30-40% if it extends into 2015. Sell too late and your invested capital will spiral into the abyss.

In any case, bears can be comforted by one thing: the higher the market climbs, the harder it will fall.
© 2013 Prudent Bear, Martin Hutchinson.

Here’s an offer you can easily refuse: Send me $100,000 in cash today, and let me keep it for at least three months. At the end of that time, I will give you $250… and maybe a bunch of commission-free online trades to boot.

Attractive? No, not really. But a significant number of day traders or would-be day traders must be vulnerable to this sort of temptation. Why else would serious companies like Merrill Edge, TDAmeritrade, and E*Trade offer nearly identical variations of it?

You’ve seen the ads in glossy magazines or on television. The three companies named above all promise “up to $600” to anyone who funds a new brokerage account with money that’s new to the firm. 

After seeing a few of these ads, I thought it would be edifying to go online and read the fine print behind these teasers. As you might suspect, the offers aren’t nearly as generous as the headlines suggest.      

Merrill Edge

Merrill Lynch pitches a “Simply a Great Offer”: Up to $600 when “you enroll, open and fund a new Merrill Edge investment account or IRA.” But you have to move at least $200,000 in cash or securities to Merrill Lynch in order to qualify for $600.

If you bring between $25,000 and 49,999 to Merrill Edge, you get $100. Bring $50,000 to $99,000 and you get $150; bring $100,000 and you get $250; to get $600, you must bring $200,000 or more. The money must come from outside Merrill Lynch and Bank of America (including Merrill Lynch 401(k) plans), must arrive within 30 days of the opening the account, and must stay for at least 90 days.

Even then, you don’t get your bonus right away. “Please allow up to 45 days for the cash reward to be credited to your account,” the footnote said. I called Merrill Lynch’s customer service line to ask if my account would bear interest. The phone rep said yes: at the rate of one basis point per year (0.01%). If I put my money in a money market account it could earn 1.15% per year, he said, but I wouldn’t be able to trade in and out of that account.

The Merrill Edge offer came with 300 commission-free equity, ETF or options trades, which had to be executed within 90 days. In addition, anybody who maintains a balance of at least $25,000 at Merrill Edge gets 30 commission-free trades a month, every month.

TD Ameritrade

TD Ameritrade’s bonus offer was slightly different. There, the account must be opened by December 31, 2013, and funded within 60 days with $2,000 or more. To receive a $100 bonus, the account must be funded with $25,000 within 60 days; to receive $300, it  requires $100,000 or more; and to receive the maximum $600 bonus, the account must be funded with $250,000 or more within 60 days of account opening.

Regarding the amount of time your money must be deposited, TD Ameritrade is more demanding than Merrill Lynch. “The Account must remain open with minimum funding required for participating in the offer for nine months, or TD Ameritrade may charge the account for the cost of the cash awarded to the account,” the disclaimer on the firm’s website said. (Emphasis added.)

The TD Ameritrade program comes with 500 commission-free online trades of equities, ETFs or options. They must be used within 60 days of opening an account.

E*Trade

This online discount brokerage, whose hard-boiled toddler-spokesperson is as familiar as GEICO’s green-and-yellow gecko, demands more skin-in-the-game than the others. New accounts must be funded with at least $10,000. But the top bonus is $2,500, not a mere $600. Like TD Ameritrade, E*Trade offers 500 commission-free trades, available during the first 60 days after the account is funded.

To get the full $2,500 bonus, you have to deposit $1 million at E*Trade. People who deposit $500,000 to $999,999 get $1,200; people who deposit $250,000 to $499,999 get $600; those who deposit $100,000 to $249,999 get $300; those who deposit $25,000 to $99,999 receive $200.

Please note that not all $600 bonuses lead to the same service. Merrill Lynch can afford to offer a slightly less attractive bonus because its flat online trading fee is just $6.95, compared with $9.99 for TD Ameritrade and $7.99 at E*Trade (for people who trade 150 to 1499 times a quarter).

OK, I get it. These three firms compete strenuously for the loose cash of over-confident amateur traders (many of whom might just as well apply their animal spirits to slot machines, the Lotto or bingo at the Odd Fellows lodge). In a hyper-competitive market, you need a sexy teaser just to lure eyeballs to your website. If one brokerage firm promises a bonus, the others have little choice but to match it.

But it’s tacky, frankly, to offer cash—and so little cash, relatively speaking—to potential investors. It also seems vaguely unsuitable to solicit hundreds of thousands of dollars from people without knowing if they can afford to put that much at risk. As for meeting a fiduciary standard, forget it. If day trading is a losing game, as everyone knows it to be, no fiduciary could recommend doing it. 

It’s surprising that such promotions are even legal. A few years ago, after repeatedly watching the talking E*Trade baby imply that anybody with a sippy cup, a highchair and a smartphone can succeed as a day trader, I called FINRA to ask why or how such an ad could elude the compliance police. I was told that because E*Trade provides an investment service, not an investment product, none of the usual rules against promissory claims applied.

I find it a little scary to think that a retiree or job-changer could roll his or her entire 401(k) nest egg into a discount brokerage IRA account, invoke the spirit of Jim Cramer, and start betting on short-term volatility.

© 2013 RIJ Publishing LLC. All rights reserved.