Bobcat2 has long been a proponent of applying the life cycle financial model of modern finance economics to the problem of creating a secure base of retirement income. In this guest post, he shows how a simple three-fund portfolio can be created to provide a secure, inflation-adjusted targeted income stream by applying a liability driven investment strategy .
There is a long running thread about the three fund portfolio at Bogleheads. The three funds in the proposed portfolio are a US total stock market index fund, an international stock market index fund, and a nominal US bond market index fund. The claim is that this portfolio is both simple and well suited for the individual investor.
Given that the asset allocation of the above portfolio is mainly determined by the estimated risk preference of each investor, the portfolio is certainly both simple and flexible. But individual portfolios have purposes and for most individuals the primary purpose of their portfolio is to provide retirement income. Is the above portfolio the best three fund portfolio for reliable retirement income, or is there a better choice? I believe there is a better choice, and that choice is clear.
If the purpose of the portfolio is to provide reliable income throughout retirement, a better portfolio of only a few funds would be based on a liability driven investment (LDI) strategy that duration matches real assets to targeted real retirement income.
Portfolio and glide path
Long before retirement this portfolio consists of simply a global stock index fund and a global nominal bond fund. When the investor is in their 20s or early 30s the portfolio is about 90% equity, shifting to roughly 75% – 65% equity when the investor moves into their late 30s and early 40s. During this period the differences between this portfolio and the traditional three fund portfolio are trivial.
However, once the investor is within about 20 years of their targeted retirement year, then at that point the portfolios become substantially different. At that point the nominal bond fund in the portfolio following a LDI strategy is replaced with a long-term Treasury Inflation Protected (TIPS) bond fund and a short-term TIPS bond fund in order to match the weighted duration of the real assets in the two TIPS funds with the duration of the targeted safe retirement income. In other words, there becomes an explicit strategy in the LDI approach to safely lock in a targeted level of real retirement income. The TIPS portion of the portfolio is mimicking a defined benefit pension income plan, by safely providing a pre-determined level of real retirement income. The equity portion of the portfolio can be used for withdrawals, but also gains from the equity portion can be used to obtain additional safe income in retirement, either through additional purchases of annuitized income or increasing the TIPS assets such as enlarging a retirement TIPS ladder.
As the investor draws closer to retirement using the LDI approach, the allocation first shifts slowly away from the stock fund to the long-term TIPS fund and then, as the retirement date approaches, the asset allocation shifts more rapidly to both the long-term and short-term TIPS funds. Once the investor is less than 10 years from retirement, the assets are moved aggressively to the TIPS funds. By the targeted retirement year, say about age 65, the portfolio would typically allocate about 75% to the two TIPS funds and the remaining 25% to the equity fund.
Beginning several years before retirement the weighted average duration of the two TIPS funds is continually matched to the duration of the targeted retirement income stream from the beginning of retirement to the age of average life expectancy – about age 85. (Some build in a few years fudge factor of five years or less beyond the average life expectancy.)
By duration matching real bond assets to the income stream, the retirement income stream is made much safer, because the duration matching immunizes that income against both the risk of changes in interest rates as well as inflation risk. This duration matching is equivalent to a TIPS ladder from the beginning of retirement to average life expectancy. Both the ladder and the two TIPS funds are accomplishing the same task of matching asset duration to targeted income duration. Note that this is also the approximate duration of a real life annuity.
The investor can use the TIPS to very safely purchase a life annuity for targeted very stable retirement income with longevity protection, or keep the TIPS for more flexible safe income but without longevity protection, or a combination of both annuitized real income combined with flexible real income from the TIPS. TIPS funds whose weighted duration is equal to the duration of a span of targeted income are, in essence, the same thing as a TIPS ladder over that span of years.
Annuitized real income and TIPS income serve as complementary forms of safe income and most retirees should hold both of these sources of safe income. The annuitized income is safer, because of the longevity insurance embedded in the product, but the income is inflexible. The income from the TIPS assets lacks the longevity insurance aspect of the annuitized income, but is more flexible. If I have a $20,000/yr TIPS ladder and want an extra $5,000 this year there is little risk in taking $5,000 from next year’s rung of TIPS. That risk is minimal, since next year’s rung of TIPS has duration of less than one. Therefore, it makes sense to hold both sources of safe income because the strengths and weaknesses of the two income sources are different and held together have a synergistic effect.
There is very little point in holding TIPS assets for income much beyond the age of 85. TIPS become an expensive way to hedge longevity risk on the off chance that you may live to age 99 or more. After age 85 the TIPS holdings should be replaced by income from a longevity annuity for a couple of reasons. At that age and later the priority should be longevity protection, not income flexibility. Holding the TIPS to age 99 or more, because you might live that long is very expensive longevity insurance compared to a longevity annuity. Lastly, the advantage of the flexibility of the TIPS holdings becomes outweighed by the complexity the holdings pose for the advanced elderly.
To sum up, the essential point of this three fund portfolio is to control retirement income volatility, and in turn retirement spending volatility, through the duration matching of assets to income. For in retirement planning it is the risk of the volatility of retirement income, not the volatility of the investment portfolio, which should concern us.
The amount of assets devoted to the TIPS determines how much reliable retirement income is provided by the portfolio. The TIPS assets used to purchase a life annuity, along with Social Security income and DB pension income, serve as a hedge in providing a stable floor of income throughout retirement, regardless of age of death. The amount of additional TIPS assets during retirement provides additional flexible safe retirement income above the floor through to the age of life expectancy. The remaining portion of the portfolio devoted to equity provides additional assets that can be used to increase the levels of safe annuity and TIPS assets during retirement. The equity and TIPS assets also allow for the purchase of a longevity annuity beginning at age 85 to replace the income from the TIPS and provide additional stable income in late old age.
This three fund portfolio is an example of a liability driven investment (LDI) strategy. In this case the LDI strategy reduces the uncertainty of the retirement spending stream. This is particularly true when compared to a portfolio of stock and nominal bond funds that seek to match portfolio volatility to the investor’s estimated risk preference. There is no strategy in the traditional or standard three fund portfolio for matching the results of the investment portfolio with the variability in retirement income outcomes brought about by changes in interest rates and inflation. The basic problem with the standard three fund approach is, even if you hit your portfolio target at retirement that tells you little about how much real income in retirement the portfolio will provide, because of changes in interest rates and inflation over time.
See the following articles by Wade Pfau and Robert Merton for more information on this three fund approach.
- Life-cycle Finance and the Dimensional Managed DC® Solution, Wade Pfau, May 22, 2012 (Personal disclosure – I helped prepare some of the background for this article.)
- Meeting Retirement Goals with Dimensional’s Target-Date Retirement Income Funds , Wade Phau, Advisors Perspectives
- The Crisis in Retirement Planning, Robert C. Merton, Harvard Business Review.
- Applying life-cycle economics, Robert C.Merton (See Merton for more on this at the following link. He refers to SS and annuitized income as level 1 safe income and income from TIPS as level 2 safe income. See pages 4 & 5 -listed as pages 67 & 68 in the report.)
By the way, this three fund approach is the method Dimensional Fund Advisors uses in all of its retirement target date funds. Click the following links for more information on the DFA’s target date retirement strategy.
At the following link click on the article “Liability-Driven Investing for Retirement Planning”, which is located near the bottom of the page as an article in the Summer 2016 issue of DC Dimensions.