Today, we are introducing the first of four articles detailing our unique set of tactics which we believe, when integrated as one cohesive strategy, optimize cash flow for retirees in a tax efficient and cost effective manner. This is accomplished without conflicts of interest or the exorbitant fees and restrictions of annuities as we do not sell any financial products.
Together, we call our strategy the Cash Flow Optimization for Retirees and it is comprised of “Four Cornerstones”.
- Bond Ladder Implementation & Management
- Social Security Optimization
- Systematic Roth Conversion
- Tax Efficient Asset Distribution
This strategy is ideally suited for people who are 1 to 15 years from retirement but this can also be very effective for people already in retirement. It combines low cost investments, tax efficiency and most importantly, peace of mind that our clients’ portfolios are “doing their job” by effectively matching future liabilities (living expenses) with assets (portfolio).
While we cannot control the stock and bond markets, we can control our reaction (or lack of reaction) to the markets and our investment costs. In addition, we believe legally minimizing our client’s tax liability provides extra “alpha”, which could enhance portfolio returns and extend the life of the portfolio in retirement. While we would never guarantee returns, we believe our strategy maximizes the chance of success, which we define as funding a retiree’s lifestyle without falling victim to high fees and sales commissions paid to an annuity salesman.
Part 1 of our series starts with the Bond Ladder. Throughout 2017, we will outline the other three strategies. Again, we believe the combination and coordination of these strategies is unique, differentiated and ideal for individuals or couples either in retirement or anticipating retirement in 15 years or less.
The Bond Ladder
In the simplest terms, a bond ladder is nothing more than a series of individual bonds, each maturing at a specified date in the future. We believe integrating this seemingly simple concept into a coordinated strategy is a critical component to optimizing the long term cash flow needs for retirees.
What It Is: The bond ladder is a series of bonds (not bond funds), each with a maturity date that corresponds to a year of living expenses above and beyond pension or social security income. To build this bond ladder, we first determine how much “income” is needed from the maturing bond each year. We then purchase (at existing rates) US Treasury STRIPS, which do not pay annual interest but instead are purchased at a discount and then mature at the par value over time. (Income tax is still owed on the “imputed” interest each year).
How It Works: Our sample clients are 58, looking to retire in 5 years at age 63. They are starting with a portfolio of $2,000,000 and they expect to receive $35,000 / year from Social Security at age 67. They spend $100,000 per year in today’s dollars and we would like to build a 10 year bond ladder to provide peace of mind that their living expenses are covered for 10 years, regardless of stock market fluctuations. To ensure an inflation adjusted $100,000 “matures” each year from 2022 to 2031, we would need to take $675,928 (or about 1/3 of the portfolio) and invest it in US Treasury STRIPS that mature over that time frame.
This leaves the remaining portfolio (about 66%) eligible to invest in stocks (and even some additional bonds) for long term growth as we won’t have to rely on what will likely be a fluctuating value over the years. So even if the remaining portfolio were 100% stocks, we wouldn’t worry too much about year-to-year volatility as we have reasonable assurance, based on long term history, that over 10 years a stock portfolio is almost always higher after 10 years!
In fact, a great article in the Wall Street Journal last year (please click HERE for a copy) noted that the average recovery period for the stock market from a bear market (down 20%) to a new high is about 3.3 years! We all remember 2008. The recovery period from that terrible bear market was 5.3 years.
Now what happens if it’s 2021 and the stock market were to drop 10%? The bond matures and their living expenses are funded. But now we’re not forced to sell any of our portfolio because we know we still have the remaining 9 years for our portfolio to recover and likely, outgrow its current level. Now, what if (in 2021) the stock market rose only 4%, the client could still fund their living expenses with the bond that matures that year. We could then sell about $52,000 of stock (the 4% gain of the non-bond ladder funds) and fund another year of living expenses buying a 2032 US Treasury.
Why It Matters: First and foremost- we must emphasize the implementation of a Bond Ladder is not intended to maximize portfolio returns. In retirement- that’s not the job of a portfolio! Instead, we think of the portfolio in risk adjusted terms that must be custom-fit to fit retirees’ cash flow needs. This is NOT a market-timing, stock picking or “reach for yield” strategy. Instead, the Bond Ladder provides psychological comfort and insulation from knee-jerk reactions to stock market volatility. Instead of fearing a bear market, we can have reasonable assurance the client’s lifestyle is protected for up to 10 years without having to liquidate the stock portfolio at fire-sale levels.
In addition, we are effectively self-funding an annuity-like stream of income, without paying egregious up-front commissions (as high as 10%) and annual fees (~3%) to the annuity company. Using our example client, buying an income stream with an annuity could cost our retirees $67,598 up front and about $20,300 in annual fees!
Finally, the psychological impact of knowing you have 10 years of retirement income fully funded cannot be understated. As we discussed in our prior post ROI vs. ROS, we’re much more concerned with providing retirees ROS (“Return on Sleep”) than we are taking too much risk for ROI (Return on Investment).