Silver Lining

Consider a couple who retired on January 1, 2010, with a $1 million nest egg. Assume their advisor recommended a 60% stock/40% bond allocation with an initial withdrawal rate of 5% increasing each year with inflation. The couple withdrew $50,000 for living expenses for 2010. If inflation during 2010 turns out to be 3%, they will expect to withdraw $51,500 in 2011, and so on.

To generate and protect the future cash flows regardless of market performance, the couple could buy $400,000 in individual bonds and hold them to maturity. Each bond would supply income in two ways: the coupon interest it produces each year plus its redemption value when it matures. These cash flows are known in advance and would arrive as scheduled, regardless of what happens to interest rates.

The trick is to buy the bonds in just the right amounts and maturities so that the total cash flows match the withdrawals needed for each year. An income stream starting at $51,500 and growing at 3% per year would add up to $457,955 over the next eight years. These are the liabilities that drive the investment, hence the moniker "LDI."

The table above illustrates an example of a set of bonds that would supply this income stream. At current low yields on CD's and TIPS (about 2.9%), this bond portfolio would cost $401,068. But its cash flows sum to $458,474, matching the annual targets nearly perfectly (bonds must be bought in $1000 increments, so the match cannot be exact).

Once the dedicated bond portfolio is in place, it will provide cash flows for the withdrawals in just the right amounts at just the right times. As each year passes, the same 8-year time horizon of protection can be maintained for as long as needed by adding a new bond with an 8-year maturity if desired. In practice, the entire portfolio would need to be re-configured to adjust for the cash flows from the new bond but this is the idea. Doing it every year over a lifetime would be the equivalent of self-annuitizing.

There is nothing sacred about eight years. Other horizons can be used (5 to 10 year are common for retirees). At today's yields, each year of cash flow takes about a 5% allocation to fixed income, assuming the initial withdrawal rate itself is at or below 5%. For instance, if the couple had wanted a 30% allocation to fixed income, they could have secured about six years of income; a 50% allocation would buy about 10 years of income. Most retirement portfolios' fixed income allocations fall into a 30% to 50% range, with 40% being the most popular.

The Impact of Rising Rates

At higher interest rates, the cost of funding the cash flow stream in our example would drop. This is why personal investors following this strategy might welcome a rise in rates.

To project the impact of higher rates, assumptions must be made. Starting with the base case of current rates, the same analysis was done assuming a parallel shift in the yield curve and using yields higher by 0.5%, 1%, 1.5% and 2%. The table above tabulates the results.

In the Base Case of current rates, the cost of the portfolio ($401,068) was about 87% of the 8-year cash flow it produced ($458,474). But if rates rose by 2%, the cost would be $370,426 or about 81% of the same cash flow. That represents a drop of about 8% for the cost of the overall bond portfolio.

Imagine that interest rates dropped by 2% immediately after the investor purchased the portfolio. Although the paper losses would be significant at more than $30,000, notice the income delivered by the portfolio remains unchanged. This same rate change would impact a bond fund values in a similar way. But there is a difference: the investor using a total return approach would have to sell shares in order to generate enough cash thereby selling a depressed asset. This sequence risk magnifies the impact of the withdrawal on the portfolio.

In fact, rising interest rates will be seen as a blessing for investors who use a dedicated bond portfolio. As shown in Table 2 (above), rising interest rates make it cheaper to buy future income. As income is consumed out of the portfolio each year, investors will likely look to extend the portfolio time horizon back out to the original (8-years in the case above).

Conclusion

Rising interest rates do indeed cause bond values to fall. For investors who utilize bond funds in a total return approach to generating income, rising rates may well continue the whipsaw effect that started in their equity portfolio in 2008. Portfolios of individual bonds dedicated to generating cash flows with redemptions and coupon interest will fare much better. The simple idea of precision laddering bond maturities to match income needs solves many of the problems that rising rates and fluctuating markets can cause. Rising rates mean lower costs to provide the same cash flows, and will be viewed as a silver lining for smart bond investors.