Worry-Free Retirement Investing
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest in, how to live without worrying about it. I'm your host, David Stein. Today's episode 407. It's titled, Worry-Free Retirement Investing.

Two weeks ago in episode 405, we discussed how many UK pension plans were using liability-driven investment strategies. These plans got into trouble because they went beyond trying to match their assets with the liabilities, but instead used implicit leverage debt that is baked into derivative contracts in

in order to try to grow their assets. When these derivative contracts fell in price as interest rates rose, these UK pension plans were forced to sell bonds, which caused those bond prices to plummet and the yields or interest rates to spike. Interest rates got so out of hand that the Bank of England had to step in and purchase bonds in order to calm markets.

Liability-driven investment in its simplest form is a sound concept. It is at the heart of what insurance companies do. They estimate what their payout for claims, such as in the case for life insurance, or annuities, where they promise an ongoing payment to annuitants,

They estimate what those cash flows will be each year and then develop an investment strategy, which mostly consists of bonds so that the cash flow from their investments and premiums are sufficient each year to meet the expected claims and cash flow needs, including covering expenses. And so there's enough so that there's a profit for the insurance company.

In 2003, I read a book by finance professor Zvi Bodhi titled Worry-Free Investing. He proposed a liability-driven investment strategy for retirees. That made a lot of sense to me. It used what at the time was a relatively new investment vehicle, Treasury Inflation Protection Securities, or TIPS. TIPS are U.S. government

inflation index bonds. Bodie recommended structuring what is known as a bond ladder using tips. A bond ladder is a series of bonds that mature and the proceeds from that bond maturity is then used to cover the cash flow that the retiree has that year.

At the time the book was issued, the real yield on 10-year tips was around 2%. That meant an investor would earn 2% plus the rate of inflation on those bonds. A retiree could buy a series of tips that would mature each year for the next 20 years, and those bonds would be used to fund the investor's spending for that year. And since the bonds had an interest rate of 2% before inflation, the retiree would benefit from compounding to meet the

those future expenses. That intuitively makes a lot of sense to me, and it did when I read the book.

However, the ability to implement it basically went away. Since 2007, the yield on 10-year tips has been less than 2%, except for a period of market dislocation in 2008 when the yield on tips spiked to 4%. Believe me, I bought tips then. It was the opportunity of a lifetime to buy tips. And then I sold it once rates fell down and I got the capital appreciation.

But that foray into tips wasn't an asset liability matching approach. And it's been difficult to match those assets with projected cash flows because the yields on tips have generally been less than 1% for most of the past decade. And there have been extended periods of time when the yield has been negative, relatively

which means a TIPS investment actually didn't keep up with inflation because the real yield or the yield net of inflation was negative. It's costing money on a real basis to hold those TIPS.

Last fall, the 10-year TIPS yield hit an all-time low of negative 1.1%. Now there has been an incredible change. TIPS are again yielding between 1.7% and 2% depending on the maturity. That's a huge interest rate move. From negative 1.1% to positive 1.7%, as interest rates go up, the value of bonds plummet, and

And tips aren't excluded from that. Even though they get an adjustment, the principle of the bonds are adjusted based on the rate of inflation. The price of those bonds can still fall when interest rates rise. So even though the inflation adjustment over the past year for tips...

has been over 8%. There's also been a price decline of 20% for TIPS over the past year as interest rates have risen. And that's why we see the iShares TIPS ETF lose 12% in the past 12 months. Why have TIPS interest rates spiked in the last several months?

Last week in our free Insider's Guide weekly email newsletter, we discussed this. I shared a quote from U.S. Treasury Secretary Janet Yellen. She said, we are worried about a loss of adequate liquidity in the market. She was referring to the U.S. government bond market. Liquidity measures how easy it is to trade an asset.

without moving its price or paying excessive transaction fees. Yellen noted the ability and willingness of broker-dealers to act as market makers in the treasury market, including for tips, that their ability to act in that role hasn't expanded much even as the supply of treasuries has increased. Since 2019, the amount outstanding of U.S. government bonds has increased by $7 trillion. With the increased supply and inflation,

because bank regulations have had banks hold more capital, making them less willing to facilitate some of the transactions in the government bond market. And then with the Federal Reserve no longer buying bonds, but letting their bonds mature that they bought as part of quantitative easing, the supply of treasury bonds and tips has increased. The amount of issuance has increased.

And so it's been more difficult to trade those bonds. There's been more supply and not as robust demand, and that has led to real interest rates increasing significantly over the past few months.

We can look at, for example, the U.S. Government Securities Liquidity Index by Bloomberg. It shows the level of illiquidity in the government bond market is as high as it was back in 2020 when the pandemic shutdown started. The lack of liquidity in the government bond market and the supply-demand dynamic has led to real interest rates, the interest rate on tips, increasing to close to 2%.

Think about it. Would you be satisfied earning 2% plus inflation on your investments with incredibly low risk? There's no inflation risk. There's very little credit risk. The only risk is the U.S. government defaults. Now, that's not a non-zero risk.

But if the U.S. government defaulted on their government bonds and didn't pay the interest or the principal payment, that would be so incredibly devastating to the global economy, to financial markets. Not getting our money back on our tips would be the least of our worries. Huge financial repercussions if the U.S. government defaulted on its debt because it can't.

In the sense of it can always print more money to pay off those obligations, which could lead to higher inflation. It would be a political act to default on the debt. And it could happen. The risk is incredibly low. And if inflation spiked, we own tips. We're protected against it.

Last week, the U.S. Treasury did a new issuance of $21 billion of five-year Treasury inflation protection securities. The yield it was priced at was 1.73%. That was a 15-year high. This is a gift right now that the markets have presented where the yield on Treasury inflation protection securities are incredibly attractive.

at 1.7% to 2%. There's a plus member, a member of Money for the Restless Plus that is completely restructuring his retirement. He's building out a bond ladder, just like Zivoti recommended, of treasury inflation protection securities to meet his retirement expenses over the next 20 years.

We can use tips in a liability-driven approach, not just for retirement. If you have children that will be attending university in the next five to seven years, you could build a bond ladder of tips or just buy the seven-year tip. Lock in the 1.7% return plus inflation, and that will help meet that future liability. We could do the same thing for a down payment on a house.

We buy individual tips through our broker. You can buy tips that have already been issued, or you can buy them through Treasury Direct and buy them at auction. There's a guide on the website on how to invest in Treasury Inflation Protection Securities and I-Bonds, which are inflation-protected savings bonds offered by the federal government.

The government will be announcing the new interest rate on I-bonds in the coming weeks. We have a pretty good sense of what the inflation component will be, but what we don't know is what is the fixed rate on that I-bond, which is equivalent to the real yield. With real yields now close to 2%, the I-bond rate should be adjusted upward to reflect that.

Six months ago, that yield, that real yield on the I bond before the inflation component was zero. So we'll see if it will now be positive. In fact, one of the things we can do with I bonds is those that are older that have a lower yield. If the real yield on I bonds goes higher, we can sell our older I bonds and buy the newer ones that have the higher real yield, a higher base yield.

But one of the challenges with I-bonds is you're limited to only $10,000 per Social Security numbers. And we go into more detail to that in the investment guide. Treasury inflation protection securities right now are an excellent vehicle to implement a worry-free investing strategy. Back in the day, many retirees used certificates of deposits and they would just roll them over. They would build basically a ladder of CDs.

CD rates are also higher. If you purchase what's known as a brokered CD, so buy it through your brokerage such as Schwab or Fidelity, looking at those rates right now, a one-year CD is 4.5%, and three- to five-year CDs are 4.7% to 4.75%. If we compare CDs to tips...

a CDE that's yielding 4.75%, if the real yield on tip is 1.75%, if inflation comes in higher than 3%, then the tips will have been a better deal. But if inflation comes in less than 3% on average over the next five years, then the CDE will have been the better deal. We don't know what inflation will be. The tips guarantees inflation.

that the investor will outpace inflation by 1.7%. A CD that's yielding 4.75%, you don't have that guarantee. In addition, tips benefit from more favorable tax treatment because tips interest is not subject to state and local income tax.

Another worry-free investment option are deferred fixed annuities, sometimes called multi-year guaranteed fixed annuities. I last discussed those in episode 326 of the podcast. These fixed annuities have a fixed payment, often monthly, for a specified period of time, such as five years, and they're also yielding around 5%.

Right now, where this leaves us as investors, if we can get a yield of 2% plus inflation or a return of 5%, it causes us to reflect how much additional risk should we be taking for a stock portfolio if the expected return for stocks is 5% to 8% because the dividend yields are much lower.

That's why investment markets are always changing. We have to look at the market's temperature. What is the market giving now based on interest rates, dividend yields, valuations? And in many regards, tips are one of the most attractive investments out there right now for worry-free, very low-risk investing.

Again, it's different owning individual tips from owning a tips ETF or tips mutual fund because those funds are always having to buy more tips. They have cash flows, and so they're going to be much more volatile. But if you buy an individual tips, you can hold it to maturity and then lock in that real return plus the inflation adjustment. Before we continue, let me pause and share some words from this week's sponsors.

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In previous episodes, we've discussed other annuity products. Multiple episodes, we've discussed single premium immediate annuities, where an annuitant pays a one-time premium and then gets a fixed payment for the rest of their life. But two annuities we haven't discussed much. One is a deferred variable annuity, and the other is a fixed indexed annuity.

With a deferred variable annuity, the assets are held in individual subaccounts at the insurance company. And the annuitants can see the value of their balance. So they can choose to invest in a stock subaccount or a bond or a non-U.S. subaccount, just like they were investing in a mutual fund. They can see the value of the portfolio. And those assets, because they're in a subaccount, are not merged into the general account of the insurance company.

Deferred variable annuities were originally created in the 1950s in the U.S. in order to allow for tax-deferred accumulation of assets, especially for today, for investors that have maxed out their 401k and other tax-deferred opportunities by participating in variable annuities, they can save more on a tax-deferred basis. But they're complicated. They're incredibly complicated. And they're not the focus of this episode. It

You have to be wary of the fees. You have to understand the structure, the surrender charges. Today, we want to focus on this second type of annuity, a fixed indexed annuity. In this case, we're also accumulating assets. But instead of a fixed annuity where there's a certain interest rate paid each month, a

credits the interest or return to the annuity value based on the performance of some index. It could be a stock index such as the S&P 500. Oftentimes, there's some principal protection. So if the stock market falls, the return on the annuity is zero. It won't go negative. There's often a cap. You'll be able to get the return of the S&P 500 up to, let's say, 8%. These

Fixed index annuities often offer some type of optional guaranteed lifetime withdrawal benefits. So they convert into more like an immediate annuity at some point. But typically there's a point in time, often annually,

where the return of the index, just the price return, and this is an incredibly important point, these annuities, when they look at the return of an index, it doesn't include dividends. And that can make a big difference. If we look at the 20-year annualized return,

of the MSCI All Country World Index, this includes US, non-US, and emerging market stocks on a total return basis, annualized, including dividends, the returns have been 8.5% annualized on a nominal basis.

The price return has only been 5.8%. So the dividend has contributed almost three percentage points to the return. Fixed income annuities can also be complicated, but they can also be beneficial because depending on how they're structured, having downside protection, so you can't lose money, even though you give up some of the upside, it constrains the return pattern.

So it's less volatile and can make it easier for planning purposes. We have one member of Money for the Rest of Plus who just turned 70, I believe, and is looking to purchase these index annuities. In this case, within a Roth individual retirement account. And he's sort of asking, how do we evaluate them? There's so many. And he sent me like six different versions.

The way we evaluate fixed index annuities is we need to understand the underlying index. Is there the downside protection so it can't have a negative return? Is there an upside cap? How frequently is that cap adjusted? Can it, will it, sometimes the cap be higher or lower? Because what these insurance companies are doing is they're

purchasing derivative contracts or entering into some type of swap agreement, options contracts. So they're paying a premium in order to generate the return they need and protect on the downside. The assets aren't actually invested in the index itself. It's all done within the general account of the insurance company. They're promising to credit based on the return of an index, but they're structuring it using derivatives and other products.

the amount of upside, that cap, can change from year to year. We want to know, so how is that index constructed? For example, I looked at the Merrill Lynch RPM Index. So there are fixed index annuities based on, in this case, issued by the Athene Annuity and Life Company, where the underlying index is a combination of domestic stocks, U.S. stocks, non-U.S. stocks, emerging market stocks, gold, real estate, and bonds.

And then it will adjust based on specific rules and will exit assets that have negative price momentum. They replace it with bonds. It's a complicated but diverse index. And over the lifetime, based on the back test, it's returned about 5.5% annualized. They have an option based on the Shiller's Barclays Cape Allocator 6 Index.

where it's looking at the valuation of particular sectors, it's looking at momentum of different U.S. equity sectors, and then it's selecting the ones that have the best combination of lowest value, best momentum, and invest based on that. It will also allocate between stocks and bonds based on the fundamentals. And no wonder this member's confused. There's so many different options. And I didn't even look at the other ones, except one was a combination of six underlying indices. If...

There's a principle that we want to take. I think generally the more diversified approach is better. But the reality is because there is no dividend factored in, it's just the price adjustment. These products end up being sort of a hybrid between stocks and bonds. They will not do as well as the overall stock market.

Hopefully, they'll do better than the bond market, where the overall adjustment averages 5% to 6% per year. But we need to understand the index, how it's constructed. Understand the fees. Typically, with a fixed index annuity, the fees itself are baked into the product. So there isn't an explicit fee, except...

Some of these more specialized products using trademarked indices or at least registered indices, there's often an index fee, a licensing fee for the index, which can be up to a half a percent per year. With these products, we need to understand what are the surrender charges. Because there are fees baked in to the products and because there is a commission to whoever sold it, there is a time period of

potentially up to 10 years, whereby exiting the contract, getting the value out of it, there's a fee for doing that in order to cover the insurance company's expenses. It's important to understand the insurance company's ratings and go with a highly rated insurance company. And then that's just the accumulation phase. There's the option to just buy

buy the contract, accumulate, and then decide, well, do I want to convert that into a guaranteed income source going forward, similar to an immediate annuity?

These annuities are not bad, just like hiring a financial advisor is not bad. We just need to understand what we're getting when we do that. Annuities can play a big role in a retirement. When I retire, I will purchase an immediate annuity with a portion of our assets so that we have some guaranteed income for life and we have a segment of the portfolio of our net worth that we just don't have to worry about. It's not a big deal.

It's the safety-first retirement approach that we've discussed that's recommended by Wade Fah, where you cover most of your expenses with some type of guaranteed income source. And that can be a pension plan. It could be Social Security. It can be an immediate annuity. It could be a ladder of

of tips that can serve that role. And what that does, it frees up the remainder of our assets to invest more aggressively because the bases have been covered. We're now at a point, because inflation has been high, hopefully coming down, but because real rates are higher, interest rates are higher, annuity payouts are higher, and the yield on tips is also higher, and we'll see, but the yield on I-bonds should also be higher.

So we have more flexibility to not be so dependent on the stock market because the reality with more volatile investments, over the long term, having exposure to stocks is not less risky, a point we've made before, because the distribution, the range of potential outcomes is so much wider with stocks. And that's where annuities, such as a fixed index annuity, can have a benefit because we constrain the

the range of outcomes by protecting on the downside and capping the upside. And that's where bonds and bond proxies in some of these hybrid products can shine so that we're not, I can't imagine going into retirement completely dependent on the stock market unless we've covered the basis with some type of guaranteed income source or immunized bond ladder using some type of liability-driven investment approach.

That's our discussion on worry-free investing. Thanks for listening. I have enjoyed teaching you about investing on this podcast for over eight years now, but I also love to write. There's a benefit to writing over podcasting, and that's why I write a weekly email newsletter called The Insider's Guide.

In that newsletter, I can share charts, graphs, and other materials that can help you better understand investing. It's some of the best writing I do each week. I spend a couple of hours on that newsletter each week trying to make it helpful to you. If you're not on that list, please subscribe. Go to moneyfortherestofus.com to subscribe to the free Insider's Guide weekly newsletter.

Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation. I've not provided investment advice. This is simply general education on money, investing, and the economy. Have a great week.