Most folks think investing is about picking stocks and dodging in and out of the market before the roof falls in. Maybe with play money. In real life, investing is about figuring out your life goals, how to pay for them, and then designing an investment approach that will get you to a successful outcome, the funding of your life goals.
In most plans, the key life goals are covered by Floor, Longevity, and Reserves. Floor covers annual expenses, Longevity provides insurance that you will still have income if you live longer than your portfolio (ie, run out of money!), and Reserves is for current spending and the unexpected. These three allocations are critical to managing the risks that can derail a retirement when you can no longer earn your way out of trouble.
What about the market?
The surplus after the critical goals are covered is your Upside. Upside is the amount you can afford to risk in the market for long-term growth without jeopardizing your lifestyle. It’s the risk capacity on your balance sheet when lifestyle (Floor), Longevity, and liquidity (Reserves) are covered, referencing Wade Pfau’s apt “four Ls.” Upside is legacy.
Most of us can afford a lot less risk than we think. A legacy might be a goal but it’s not essential to your lifestyle.
As we near and enter retirement, focus shifts from chasing the market—the preoccupation of the young and employed who can earn their way out of a downturn—to Floor. Building Floor. Covering a hopefully long future without a paycheck. You can live without Upside, but life without Floor is not a pretty sight. Risk is the enemy of Floor, so you won’t find risky assets in well-built Floor.
An effective way to build a Floor is to ladder out the first five to ten years of needed annual income using CDs, Treasury STRIPS, or TIPS (Treasury Inflation Protected Security) bonds matched to provide the income needed for the year they mature. The high cost of bonds during ZIRP (zero interest-rate policy) has created a rough patch for Floor builders the last few years, but prices have dropped a bit recently.
Here are some options today for a rung maturing in about five years on a Floor ladder:
- TIPS maturing 4/15/20, priced a bit below par at 99.20, with a real-yield-to-maturity of about .297%. That’s .297% above inflation over the next five years, whatever inflation turns out to be. TIPS protect against inflation risk.
- Treasury STRIPS (zero coupon bond) maturing 8/15/20, priced at 92.096, pays no interest but matures at 100, with a yield-to-maturity of 1.657%
- CapOne brokered original issue CD, maturing 8/19/20, no call, selling at 100, paying 2.4% to maturity.
If inflation averages more than 1.36% over the next five years, the TIPS beats the STRIPS. If it averages more than 2.1% over the next five years, the TIPS beats the CD. The TIPS provides a modest real yield above inflation no matter how high (or low) inflation is during the period, so in effect, it’s inflation insurance that pays for itself.
The one risk TIPS fail to cover is deflation—TIPS will loose the corresponding value of the inflation adjustment already accrued during periods of deflation, but will pay no less than par. Since this TIPS is selling slightly below par, with a small accrued adjustment, there’s little risk to capital from deflation with this TIPS bond. In short, the 4/15/20 TIPS today is a pretty good option for the 5 year rung of a Floor ladder, with interest rates and inflation likely on the rise.
Protecting Retirement Lifestyle
As you can see, the logic of creating a secure retirement Floor to protect your lifestyle is very different than coping with the up/down total return price action of risky assets in the market. A five to ten year Floor ladder built from CDs and TIPS provides a rock solid foundation Floor for a retirement lifestyle.
The more solid the Floor, Longevity, and Reserves allocations in your plan are, the more “safely” you can invest Upside in the market for long-term growth, without risking your critical goals. This approach manages the real risks to your lifestyle without adding market risk on top of the risks you can’t otherwise avoid.
Which would you choose to provide absolutely positively provide the income you need in five years—a TIPS, STRIPS, or a CD?