Normal Bonds for Normal People

Not a long time ago I wrote a post about Target Date Funds and their struggle to survive an inflation shock. With a target post-retirement allocation of 30% stocks / 70% bonds, they are basically bond funds.

I recently read two pieces about bonds and retirement strategies that fit nicely into that conversation.

The first one is from Cullen Roche, titled The Age in Bonds Rule is Wrong. Heuristics are great…until they stop working. The longer they worked, the harder it was to move away from them, because everyone forgot the key assumptions that made them suitable in the first place. It is the same reason why I get so mad with some “financial educators” that many see as net positive: they glue convictions in “young” (for the subject) minds that are then impossible to unstick (see everyone absolutely needs to have an emergency fund type). I do not know if the Age in Bonds Rule was designed thinking that inflation would not be an issue considering the circumstances vs inflation was mistakenly regarded as defeated for good. The majority of people used to work until they died since basically yesterday. And they used to die at 70. Combine these two facts with a 40-year bond bull market and voila, we have a new heuristic. The rule is surely broken when people live longer and inflation is back on the menu.

Here is Cullen: “When you’re young you have a lot of time and runway to make mistakes. When you’re old you have less time and less runway, but you have greater clarity over the specific time horizons. You’re either going to pass away soon OR the assets will become someone else’s. The messy part is when you’re middle aged and nearing retirement because you accrue a lot of financial liabilities that have different time horizons. This is compounded by your dependents who require short-term and long-term planning.“

If you stop at 70 in Cullen’s figure, the Age in Bonds Rule is conservative but directionally correct. It was a good shortcut but things have changed.

Living in the “Less Predictable Time Horizon”, I am glad to see Cullen acknowledging my drama: at least it is justified! There are indeed too many financial goals competing with each other and finding a balance, between today and tomorrow, between each component of the family, is impossible. At least from a piece-of-mind point of view.

Where I disagree with Cullen is that I see bonds as a useful ingredient in an All-Weather type of portfolio, the first responder role I wrote about here and a performer in the low growth/low inflation scenario. Allocating to bonds to match short to medium-term liabilities is not a game changer…unless you were using stocks for that. The time frame is too short for compounding and the marginal increase in returns compared to cash is not that relevant. Yep, that car you planned to buy would cost in total 6% less if you built a proper bond ladder instead of stashing everything in a savings account: will you hug your financial planner for that? Maybe.

It is a topic I discussed on this blog many times: it absolutely makes sense when you look at your Excel with a single goal in mind. When you add the many objectives at odds with each other, the timing flexibility, some utility in optionality and the fact that preferences for every family member change with time passing, you are better off lumping all those liabilities back together and hedging them with a single, higher return/vol, portfolio. Imagine glide pathing your son’s university saving bucket into bonds when he’s 12 (T-7) and when he’s 19 he tells you he prefers you to buy an apartment for him when he’s 25 rather than pay for Uni. That lost opportunity yield is a shrug only if you have plenty of financial resources (and if you are able to understand the concept).

Anyway, we are here to praise the “V” glide path (increasing the stock allocation while you get older), so let’s focus on that.

The second piece is from Early Retirement Now and it is about Safety First.

“What is Safety First? It involves using asset allocations different from those in the Trinity Study […] like TIPS (as a default-free and CPI-hedged investment option) and annuities (longevity risk-hedged option) in the context of Safe Withdrawal Rates. Low interest rates rendered the Safety First approach all but useless because neither TIPS ladders nor annuities generated enough income for a comfortable retirement. You would have been better off taking your chances with the volatility of a 60/40 portfolio.

In other words, there is no free lunch. You don’t get peace of mind for free. Rather, you likely pay a steep price for that safety by giving up most, if not all, of your portfolio upside and/or bequest potential. However, since interest rates started rising again in 2022, the entire fixed-income interest rate landscape looks more attractive now. Could this be the time to reconsider Safety First?”

I do not know if is my Italian heritage but I have always been attracted by the concept of annuities. 100% certainty of a perpetual cash flow. Until you realise that tiny counterparty risk. Until you realise that not-so-tiny inflation risk. I mean, ffs I am paying all this money and even then I cannot be carefree?!?

ERN’s post is excellent at showing how expensive safety is. Unconditional safety. It is even better if you consider that real rates in Europe are way lower compared to the US: the idea of using TIPS for retirement in Europe might never materialise…even if we ignore that EU Treasuries are actually reducing their issuance of TIPS. One day real rates might get there and we won’t have the instruments to exploit them.

Annuities are expensive, do not leave anything behind for your children and have a big inflation issue.

Inflation eats capital fast and tends to be sticky once it is unleashed.

Even if you buy an annuity that grows at 2%/year, you can lose big when inflation runs hot. I do not want to go full ZeroHedge here but politicians everywhere say that they want to bring inflation down and act exactly in the opposite direction. I do not want to predict the future but I would rather have a plan if inflation stays than not. And these things have to be planned.

On the other side, annuities are your best companion if you lose your mental capabilities.

TIPS and annuities are not game-changers for the early retiree: TIPS allow to lock real rates only for max 30 years and the inflation-issue of annuities compounds the longer they are used. But they might be useful tools, under the right circumstances and investor preferences.

For example, converting part of a stock portfolio when stocks are “expensive” (that’s for your peace of mind to decide) for a 20-year deferred annuity can solve a lot of retirement issues:

• you know that the remainder of the portfolio has to last only for 20 years, not in perpetuity
• the inflation risk related to the annuity is lower because you are not going to live forever (it has less time to compound)
• your variable expenses will be at best equal to what you estimated today

but

• you have to estimate inflation for the next 20 years
• your fixed, health-related expenses might explode
• you might die tomorrow and the annuity cost will be lost forever
• the annuity sponsor might default

Using the Immediate Annuities calculator a guaranteed 20-year deferred $67k annuity, which corresponds to $40k at 2.5% annual inflation for 20 years, today costs $127k. This means you need to design a portfolio that can sustain a 4.6% SWR for JUST 20 years (hello 60/40). If the 60/40 in the next 20 years won’t behave worse than the WORST historical case, you will end up with a $67k annual check plus what’s left from your initial portfolio to cover additional expenses/leave to your grandkids. As a reminder, there are only a few cases in which, after 20 years, your portfolio value would be lower than the initial inflation-adjusted 870k.

I love how ERN presents these trade-offs.

I do not think TIPS and annuities offer strictly better solutions to increase the SWR compared to others we already wrote around here (like trend, gold, long vol, leverage): cannot say if someone is more comfortable “believing” that gold past results would materialise in the future or trying to time TIPS. I like the approach of accepting that some instruments are “right at the right price”.

Like a $JEPI done right: sell future upside, even a lot of it, for a higher SWR. If I think about my wife, I would be more comfortable leaving her an annuity than my IBRK portfolio to manage. But the biggest lesson here is that safety is expensive and should be taken opportunistically. Looking at the couple retiring at 50, they are probably better placed to create some income by working part-time/some months of the year than going all-in on the safest portfolio, because they still have 40 years to grow their savings (and spending). The cost of the 7th free day in the week is steep, if you know what I mean. I do not see many scenarios where is not better to optimise your time than trying to squeeze an additional 10bps of SWR in your portfolio.

“All of this is interesting but I live in Europe…”

On one side, all the above is relevant because also in Europe we have government inflation-linked bonds and annuities.

On the other, go find the data…

I was not able to find any free source for EUR real rates, maybe a reader will? There is also no aggregator for annuities, if you want a quote you have to call and ask each insurer. But as I said, I think real rates in Europe are too low anyway to make any of the instruments a good option at the moment.

Lastly, there are tax considerations. In Switzerland, the pension second pillar can act already as an annuity, with a % rate fixed at retirement and no inflation adjustment. Regular annuities are tax inefficient, so if you want one, better take that route (but also, no way to fix rates in advance).

What I am reading now:

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