Should bonds be kept in mutual funds or purchased as individual securities and held to their maturity dates? The former option receives much far more attention, as managers compete in a performance-driven marketplace. But investing, especially for retirement, shouldn’t be driven by maximizing risk-adjusted returns. Advisors must focus on securing a client’s future spending needs. I will investigate the role of bond ladders in retirement and which ladder length is best for clients.

A client’s lifetime spending goals represent a stream of liabilities that need to be funded with a retirement income strategy. When the Financial Planning Association (FPA) surveyed1 its members about their retirement-planning experiences and approaches, it divided retirement income strategies into three fundamental categories: systematic withdrawals, time-based segmentation and essential-versus-discretionary income. You can refer to my June 2012 column for further background about these three strategies.

Time-based segmentation differs from systematic withdrawals in that fixed-income assets are held to maturity to guarantee upcoming retiree expenses over the short and medium term. More volatile assets with higher expected returns are then deployed to cover expenses in the more distant future. Bond ladders are a core component of time-based segmentation strategies. With systematic withdrawals, bonds are generally held in mutual funds.

Due to fears that interest rates may rise, now is a wonderful time to discuss with clients the differences between bond mutual funds and individual bonds when used in retirement-income portfolios. When interest rates rise, bond funds will suffer capital losses. The higher the duration of the bond portfolio (which in the absence of callable bonds is the dollar-weighted average time to maturity for the cash flows, including interest and principal), the greater will be the losses accompanying a rate increase.

Regrettably, too many investors do not understand that their bond funds can register losses as rates rise.

Likewise, interest-rate increases will reduce the value of an individual bond. But, unlike active bond managers, retired clients need not be flustered by this. These capital losses are only relevant if the bond is sold prior to its maturity date. Investors financing a retirement goal can happily ignore the fluctuating value of their individual bonds. The annual return on their portfolio is not the guiding criterion for success, as retirees are instead seeking a sustainable income for life.

Barring default, a bond price naturally creeps toward its face (par) value as the maturity date approaches, no matter how much interest rates have changed. Bond holders will receive the face value at the maturity date. When laddered bonds are held to maturity, cash flows are known and there is no interest-rate risk. Reinvestment risk is also neutralized if income from coupons and maturing bonds is used to finance spending goals. In fact, rising interest rates could even help with issues such as reducing the IRS required minimum distribution (RMD) amounts for bonds in tax-deferred accounts.

Relatively little information is available to advisors about building bond ladders for retirement income. Perhaps the best source for education about the logic of holding individual bonds is provided in the work of Stephen Huxley and J. Brent Burns, who developed the concept of asset dedication (for instance, see their July 2013 article). With traditional bond ladders, one reinvests assets as they mature into new bonds to extend the ladder. With retirement income, however, income from maturing bonds is spent rather than reinvested. Huxley and Burns criticized bond mutual funds for providing equity-like performance, albeit with lower returns and volatility, in a retirement portfolio. Given bond funds’ volatility, it is hard to explain to clients why their asset allocation should be 60/40 rather than 50/50 or 70/30.

For Huxley and Burns, the appropriate way to choose a stock allocation is to use whatever is left over after immunizing one’s liabilities, by first creating a bond ladder to lock in upcoming spending needs. Asset classes are used for what they do best: Bonds provide specific income amounts at specified dates and stocks provide growth. This is a form of asset-liability matching, as bonds are used to meet specific cash needs. A client would understand that his or her bond allocation is, for example, 40%, if this is the amount needed to lock in spending goals for a targeted eight-year horizon.

My focus here is to simulate how time-based segmentation can work in practice. My assumption is that most clients will not have saved enough to immunize their entire lifetime of spending. Spending needs may change, so there needs to be some flexibility built into the retirement income approach. Time segmentation calls for the creation of an income floor at the front-end of retirement to meet upcoming lifestyle spending goals, with growth achieved through more volatile equity investments held in the remainder of the portfolio.

See full article on How to Use Bond Ladders in Retirement Portfolios by Wade Pfau, Advisor Perspectives