A reader writes in asking,
“I was laid off 20 months ago at age 61 and have been unable to find another job. I think at this point it’s time to start calling myself retired. I had planned to work until 65 at least, so my savings aren’t what I’d hoped they’d be.
My question is about asset allocation. I don’t care about getting rich. I don’t feel the need to go on cruises or travel the world. I just don’t want to run out of money.
I just want to know what is the safest allocation I can use. I know that bonds are safer than stocks, but with no stocks, how does one keep up with inflation? On the other hand, I understand that it’s problematic to be caught by a bear market at the beginning of retirement if you have too much in stocks.”
Inflation-Adjusted Fixed Income
The idea that bonds expose you to a great deal of inflation risk is left over from a time prior to the existence of inflation-adjusted bonds. These days, there are fixed income investments that provide inflation-adjusted income:
TIPS are Treasury bonds that promise a specific after-inflation (“real”) interest rate, as opposed to a before-inflation (“nominal”) interest rate. And a lifetime inflation-adjusted annuity is essentially a pension that you can buy from an insurance company, that will be adjusted upward with inflation.
If your goal is to come as close as possible to eliminating the risk of running out of money, these are the tools for the job. Of course, the drawback is that using your entire portfolio to buy TIPS and inflation-adjusted lifetime annuities will completely eliminate any possibility of a happy surprise — the sort of thing that at least could happen with stocks.
In addition, it’s important to recognize that neither TIPS nor inflation-adjusted lifetime annuities are risk-free. (Nothing is risk-free.)
Risks with a TIPS Ladder
A bond ladder is a portfolio of individual bonds, designed so that some bonds mature each year, thereby freeing up money to spend. If you create a ladder of TIPS, your two primary sources of risk would be reinvestment risk and longevity risk.
Reinvestment risk is the risk that, when your bonds mature, you’ll have to reinvest the money at a lower rate of interest than you had anticipated. This risk arises because it’s not always possible to find TIPS with the exact maturity dates you need. For example, the longest-term TIPS mature 30 years from now. If you wanted to build a 35-year TIPS ladder, there’s no way to know right now — while you’re doing your planning — what interest rates you’d get in years 31-35.
Longevity risk is the risk that you’ll live longer than you had planned. For example, if you design a TIPS ladder to be liquidated over 25 years, but then you end up living 30 years, you have a financial problem.
Risks with a TIPS Mutual Fund
If you hold an individual TIPS until it matures, you know exactly what return you’ll get over the life of the bond. If you sell the bond prior to maturity, however, there’s no way to know with certainty what return you’ll earn, due to the fact that TIPS’ market prices fluctuate with changes in market interest rates (specifically, real interest rates).
With a TIPS mutual fund, each time you sell shares to pay living expenses, you’re effectively selling a smattering of TIPS of different maturities, all before their maturity date. As a result, if you’re using a TIPS mutual fund (as opposed to a TIPS ladder), you’ll have an additional source of risk: interest rate risk.
Risks with Inflation-Adjusted Lifetime Annuities
Because inflation-adjusted lifetime annuities promise a certain (inflation-adjusted) level of income for your entire life, they do not expose you to longevity risk or interest rate risk.
They do, however, expose you to more credit risk than TIPS because they’re backed by an insurance company rather than by the federal government.
Overall, however, the degree of credit risk is quite low given that:
- Insurance companies tend to be financially healthy, and
- There’s a second level of credit protection provided by the state guarantee associations.
(It’s worth noting, however, that those guarantees have limits, which vary by state, and it’s not the state itself that provides the guarantee. Rather, the association is funded by the insurance companies doing business in the state.)
TIPS or Inflation-Adjusted Annuities?
Given that TIPS and inflation-adjusted annuities expose you to different types of risk, the safest overall plan, naturally, is to use some of each.
As far as choosing how to allocate between the two, it’s largely a question of whether you care more about:
- Spending more during your lifetime, or
- Leaving more to your heirs.
Because lifetime annuities provide a meaningfully higher level of income than TIPS, they allow you to spend more per year. But the money disappears when you die, whereas a not-entirely-liquidated portfolio of TIPS would be left to your heirs.