Morningstar - Q4 2021 - 13

Using Bonds for Total Return
So far, substituting immediate annuities
for investment-grade bonds appears to be sound.
However, the competition tightens when using
bonds to generate total return rather than income
alone. That is, instead of clipping bond coupons
while retaining principal, our retiree in effect
creates her own annuity by dipping into capital.
Doing so would sharply increase her sustainable
withdrawal rate. Over 30 years, a bond that
yields 2.79% can maintain 4.82% annual
withdrawals, at which point the capital is drained.
Such a rate is not far behind the annuity rates
for single retirees and slightly above that
for married couples. What's more, because most
retirees won't survive the full 30 years, the
bond investor will probably retain some assets
at the time of death.
Bonds Versus Immediate Annuities,
Total Return Strategy ($100,000 Investment)
Annual
Type
AAA Bonds
Annuity
(Single Men)
Annuity
(Single Women)
Joint Annuity
5,090
4,750
Sources: Federal Reserve Bank of St. Louis, Blueprint Income,
author's calculations.
This table is preliminary, as it omits both the
cost and market risk of gradually liquidating the
bond. That is, while the annuity's payments
are fixed and guaranteed, the figures presented
for the bond are uncertain. Nevertheless,
the table illustrates an important point: Singlepremium
immediate annuities are not always
better than bonds. Regrettably, knowing when
to use annuities and when to avoid them
often requires specific analysis. Rules of thumb
may not suffice.
Holding Bonds Isn't So Simple
Let's dig deeper into using bonds to provide
retirement income. Broadly speaking, bonds fulfill
two purposes.
Payment
($)
Legacy
25 Years
($)
4,820 23,000
5,270
Legacy
30 Years
($)
Legacy
35 Years
($)
0 -26,000
Long Treasury Bonds
Year
1990
2021
Nominal
Yield (%)
8.45
1.89
Inflation
(%)
5.10
1.75
Sources: Morningstar Direct, author's calculations.
Making It Real
Even in 1990, though, buying and holding
Treasuries required forethought. A 3.35% real yield
is excellent. With that return, investors can
not only hold their own against inflation but also
grow their purchasing power. Except ... they
can't. That 3.35% figure applies only in the year
the bond is first acquired. Thereafter, the margin
shrinks, as the bond's distributions remain
constant while the effects of inflation accumulate.
EXHIBIT 1 portrays the difference between
the bond's nominal payments and its real outlays,
assuming a $100,000 initial purchase. (When
determining the real cash flows, I used the
trailing 10-year inflation rate rather than what
Real Yield
(%)
3.35
0.14
For workers, bonds build wealth. They diversify
portfolios that build for the future. How
bonds deliver their results is immaterial. What
matters is that they outgrow inflation
while protecting against stock market declines.
For most retirees, things are different. Retirees
expect bonds to provide income. True, some
invest for total return, dipping into capital as
required, but clipping coupons from high-quality
bonds is easier. Buy Treasuries, spend the
distributions, and don't touch the principal. What
could be simpler? All receipts are stipulated
in advance, guaranteed by the U.S. government.
This strategy can be very successful. Consider,
for example, the opportunity facing December
1989's retirees, when 30-year Treasuries yielded
8.45%. True, inflation had averaged 5.1%
annually over the previous decade. If it continued
at that level, the long bond's real income
would be appreciably lower than its stated payout.
However, its steep yield offered adequate
compensation, barring a further rise in inflation.
In contrast, today's 30-year Treasury leaves
no room for error.
actually occurred over the ensuing 30 years,
because 1989's retirees did not know what the
future would bring.)
So far, so familiar. Even noninvestors are at least
vaguely familiar with the ravages of inflation.
Not many people, though, have attempted
to calculate how they might smooth their fixed
bond payments so that they receive stable
real cash flows. (My UCLA-educated stepfather
certainly did not, nor from my recollection
did his friends, most of whom emulated him by
retiring on a combination of Social Security
payments and income from their bond portfolios.)
Let's try. Because the value of the bond's
payments after inflation declines over time, the
process of creating a single, consistent withdrawal
rate involves setting aside money today to
be used later. Initially, our retiree will spend less
than her annual $8,450 payment, reserving
the remainder for future years, when she must
withdraw ever-larger sums to retain the same
purchasing power. But how much less? What is
the break-even amount?
Possible Answers
Regrettably, those questions cannot be answered.
The calculation requires two inputs that cannot
be known in advance, one being future inflation
and the other the interest rate that applies to
excess proceeds-that is, the reinvestment rate.
Nonetheless, I will present some possible answers
after making two simplifying assumptions.
First, I will continue to use the 5.1% inflation rate
rather than alternatives that 1989's investors
might have considered. Second, I will evaluate
three reinvestment rates: the bond's original yield
of 8.45%, a more conservative value of 4%,
and the lowest possible rate of 0% (the mattress).
The results are shown in EXHIBIT 2 . Here's what
they mean: If the retiree could buy more of
her bond at the original price, thereby receiving an
8.45% annual payout on the excess cash, she
could spend an inflation-adjusted 5.01% per year.
In Year 1, she would spend $5,010 of the initial
$8,450 payment while saving the remaining $3,440.
Those dollars would increase over the next 12
months to become $3,731, thanks to the 8.45%
interest rate. The next year, the retiree
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