It's a classic investment strategy: You hit retirement - and promptly swap your savings into a "laddered" bond portfolio.
Sensible? Sure, if you own bonds that mature at regular intervals, you will have some financial predictability. That can be comforting in a year like 2006, when the bond market is yo-yoing up and down.
But make no mistake: You shouldn't go overboard. While laddering is a clever idea, you can't build a great retirement-income strategy with bonds alone.
Trailing inflation
With a ladder, the idea is to purchase, say, five separate bonds that mature in one, two, three, four and five years.
When the one-year bond matures, you reinvest the proceeds in a new five-year bond. Meanwhile, for income, you live off the interest and, if necessary, spend some of the money from each year's maturing bond.
Thanks to the ladder, you are relatively immune to bond-market fluctuations because you're collecting a steady stream of interest and because there's always a bond maturing soon. In addition, because only a slice of your portfolio is maturing each year, there is no risk you will end up reinvesting a huge sum at a lowly yield.
All this might seem appealing. But it doesn't give you what a retiree really needs: a generous stream of lifetime income that grows along with inflation.
In fact, with a ladder, the interest you collect will likely remain fairly constant, which means its spending power will shrivel due to inflation. Moreover, if you always reinvest the proceeds from maturing bonds, you will die with a decent-size portfolio - and you might pinch pennies unnecessarily throughout your retirement.
Stepping up
Still, if you are determined to stick solely with bonds, it is possible to construct a ladder that delivers a growing income stream. For instance, you might purchase 30 Treasury bonds that mature at regular intervals over the next 30 years, says Larry Swedroe, co-author of "The Only Guide to a Winning Bond Strategy You'll Ever Need."
"If you're age 65, that gets you to 95," he notes. "But a 30-year ladder creates other risks. I'm not sure I'd ever recommend it."
Nonetheless, it could be done - and relatively cheaply. You can buy new Treasury issues at no commission through TreasuryDirect (www.treasurydirect.gov). New Treasurys are also available commission-free to some online-brokerage customers, including those at Fidelity Investments, Charles Schwab Corp. and larger investors at Vanguard Group.
For income, you could spend the interest you receive and the proceeds from maturing bonds. Problem is, as you spend the maturing bonds, you will be left with a shrunken portfolio that kicks off less interest. To make matters worse, the spending power of this interest will be further eroded by inflation.
One solution: Invest more money in those bonds that are further from maturity, Swedroe says. If each year's maturing bond is worth more than the prior year's bond, that will compensate for inflation and the loss of interest as earlier bonds were cashed in.
But investing the right sum in each bond would be tricky and, for some of the later years, there aren't Treasurys available. More important, there is a risk that you will live longer than 30 years or that you will underestimate inflation.
Taking five
What to do? Instead of conventional Treasurys, you could build your ladder with Treasury inflation-protected securities, or TIPS. The value of these bonds is stepped up along with the inflation rate, plus you get a small yield, currently over 2 percent.
Upon retirement, divide your portfolio into sevenths, suggests William Bernstein, author of "The Four Pillars of Investing." Put one-seventh into a mix of money-market funds and short-term bonds, and use it to pay for the first five years of retirement.
Meanwhile, stash one-seventh each in five-year, 10-year, 15-year and 20-year TIPS. There are some years for which there are no TIPS issued, so you may have to tweak Bernstein's strategy. As each block of bonds matures, use it to pay for the next five years of retirement.
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