Strategies for Building a Laddered Retirement Portfolio

Key Points
If the goal of saving for retirement is to provide financial security, then a
key objective of retirement portfolio management should be generating a stable
stream of income while preserving investment principal. Bond laddering is a
strategy that may address both aspects of that key objective.
What Is Laddering?
A bond ladder is a portfolio of bonds with maturity dates that are evenly
staggered so that a constant proportion of the bonds can be redeemed at par
value each year. By holding bonds to maturity rather than trying to buy and
sell them in the secondary market, investors may minimize the potential for
losses caused by interest rate volatility and market inefficiency. These losses
and transaction costs can be considerable.
Generally speaking, there are two broad types of bond ladders. One can be
implemented more or less perpetually for trusts, endowments, and other
applications with extended planning horizons. Another form of bond ladder can
be implemented for individuals whose personal financial plans might have a
definite end-point in mind. Both types of ladders can potentially play a role
in reducing some bond market risks.
Perpetual Bond Laddering
This bond laddering strategy is most useful for an investor who plans to
conserve investment capital indefinitely and whose need for cash flow is
predicable. A typical ladder might be constructed from Treasury bonds, with
one-tenth of the portfolio being redeemed and reinvested each year. As the
following chart shows, such a structure would have been significantly more
productive and less volatile over the past four decades than a strategy of
simply buying and rolling over short-term notes, such as three-month Treasury
bills. Keep in mind, however, that the long bond ladder is significantly less
liquid than a short bill portfolio. Virtually all of the assets in the short
portfolio can be liquidated at face value within three months. In contrast, only
10% of the long portfolio can be liquidated at face value in any given year;
the remaining 90% might be exposed to considerable market and interest rate
risk if it were sold in the secondary market rather than held to maturity.
Comparative Performance Over Various
Long-Term Horizons
10 years ended

December 31, 2010
25 years ended

December 31, 2010
40 years ended

December 31, 2010
Treasury bond ladder 3-month

T-bills

Treasury bond ladder 3-month

T-bills

Treasury bond ladder 3-month

T-bills

Average annual
income from a $100,000 laddered bond portfolio:
$5,217 $2,397 $7,398 $4,294 $7,470 $5,706
Compounded
annualized yield:
5.7% 2.4% 8.9% 4.9% 7.7% 6.8%
Sources: Standard
& Poor’s; the Federal Reserve. Constant maturity yields are calculated by
the Federal Reserve each day for each Treasury security based on that day’s
market trading. Annualized yield assumes that all payments from each security
is rolled over into a comparable issue at the then-current market rate. In
this hypothetical example, the entire content of the T-bill portfolio matures
and is reinvested four times per year, while one-tenth of the 10-year bond
ladder matures and is reinvested each year. Compounded annualized yield is
the internal rate of return for the investment calculated over the entire
period assuming the portfolio was liquidated at its fair market value on
December 31, 2010. While a United States Treasury bond returns 100% of
invested principal when held to maturity, the market value of a bond before
redemption fluctuates as market interest rates change. The cumulative market
value of the bonds in the laddered portfolio on December 31, 2009, was
estimated to be $106,522 based on then-prevailing market yields. Past
performance is not a guarantee of future results.
Laddering With a Fixed Term in Mind
Another type of bond ladder is one built to provide a steady cash flow for a
predetermined number of years. This can be done with a zero-coupon bond, a type
of bond that pays all of its interest in one lump sum at maturity. Generally
speaking, the further in the future that one expects to receive the redemption
value, the less one needs to spend today for the bond.
Here is how the principal of a fixed-term bond ladder can be applied to the
needs of a retirement investor. In this hypothetical example, the retirement
portfolio is worth $250,000 at retirement and the presumed withdrawal rate is
4% of assets per year, or $10,000. Based on the interest rates that prevailed
at the end of 2010, an investor could buy a series of 20 zero-coupon Treasury
bonds, one of which would become redeemable in each of the next 20 years. The
total discounted cost of those 20 bonds would be approximately $153,000. The
balance of the original $250,000 could be allocated to equities for growth
potential, creating a portfolio that still holds almost 40% equities. The core
income of $10,000 would be stable, and the value of the equity portfolio should
be available to help augment income as needed to compensate for inflation or
provide extra latitude for spending. Equity value could also be available to
extend the term of the plan if needed. Planning horizons of greater than 20
years can also be addressed at the outset, albeit at somewhat greater cost.
Note also that bonds in the ladder will have value during the course of the
plan, even though their value may be subject to fluctuations caused by interest
rate volatility.
Investment Needed to Create $10,000 per year
Term: Immediate total investment needed:
20 years $159,000
25 years $182,000
30 years $200,000
Source: Standard
& Poor’s. Indicated costs assume the initial amounts are invested in
zero-coupon U.S. Treasury bonds maturing on the anniversary dates of the
investment and yielding the market rate for that maturity that prevailed on
December 31, 2010. Estimated investment needs for similar ladders created on
other dates will vary — increasing as prevailing market yields fall and
decreasing as prevailing yields rise. This hypothetical example does not
account for potential custody expenses, transaction costs, or tax
liabilities, if any. The value of Treasury bonds can be assured only when
they are held to maturity and redeemed by the U.S. government. Until
redemption time, the market value of Treasury securities varies as prevailing
interest rates rise and fall. Past performance is not a guarantee of future
results.
Work With a Professional
An investment portfolio that has some of its assets allocated to bonds may
produce stronger cash flow with less volatility than a portfolio allocated
solely to equity investments such as common stock shares. As such, a bond ladder
offers investors a formula for allocating their fixed-income holdings to
potentially reduce the unique risks of bond holdings and to achieve the results
they seek from their bond investments. Your financial advisor can help you
determine whether bond laddering is an efficient solution for your needs.
The Language of Bonds
  • Par Value
    is the face value of the bond, i.e., the value the bond was assigned when
    the issuer created it.
  • Market value
    is the price for which a bond can be bought or sold at any give time after
    it is issued and before it is redeemed in the process known as secondary
    market trading. The prices of bonds in the secondary market depend on the
    overall level of interest rates. Prices of existing bonds rise when the
    general level of interest rates falls, and prices fall when the general
    level of interest rates rises. Individual bond prices can rise relative to
    their peers in the secondary market if the creditworthiness of the
    borrower improves, or they can lose ground relatively if the creditworthiness
    of the borrower deteriorates.
  • Redemption value
    is the amount of money that the issuer will return to the investor on the
    specified maturity date. Redemption value is generally not affected by
    changes in the secondary market price.
  • Maturity date
    is the date set for repayment of the bond’s principal; it is normally
    established at the time the bond is issued. A conventional bond
    is issued for a fixed period. A callable
    bond
    can be redeemed at the initiative of the issuer
    whenever the call conditions specified in the bond are met. A putable bond
    can be redeemed at the initiative of the investor whenever the specified
    put conditions are met. A convertible
    bond
    is one that can be exchanged for common stock at
    specified times.
  • Coupon value
    is the cash amount of the interest payment made to the investor each year.
    In most cases, the coupon value never changes throughout the life of the
    bond, regardless of any changes in secondary market value of the bond.
  • Coupon yield
    is the value of the interest payment given to the investor each year
    expressed as a percentage of the original par value of the bond. This
    figure does not change during the life of the bond.
  • Current yield
    is the value of a bond’s interest payment expressed as a percentage of its
    current trading price in the secondary market. Current yield is actually
    the primary basis for defining a bond’s trading price in the secondary
    market because current yields on existing bonds need to maintain their
    relationships with market averages. To keep yields synchronized with the
    market, trading prices are adjusted. Lowering a bond’s price has the
    effect of increasing its current yield because the coupon payment would be
    divided into a smaller market value. Increasing a bond’s price has the
    effect of lowering the current yield because the coupon payment would be
    divided into a larger market value.
Points to Remember
  1. A bond ladder is a portfolio of bonds whose
    maturity dates are evenly staggered so that a constant proportion of the bonds
    can be redeemed at par value each year. As a portfolio management strategy,
    bond laddering may help you maintain a relatively consistent stream of income
    while managing your exposure to potential losses caused by interest rate
    volatility and market inefficiency.
  2. A perpetual bond ladder may be most useful for
    a trust or endowment. It can conserve investment capital indefinitely and
    provide continuously predictable cash flow.
  3. A fixed-term bond ladder will provide a steady
    cash flow for a predetermined number of years. It can be expanded as the
    planning horizon changes or it can be allowed to expire when its last bond
    matures.
  4. A bond ladder can be liquidated if needs or
    circumstances change, but the process of selling bonds prior to maturity can
    introduce added elements of instability and cost, as the value of the bonds may
    not equal their face value.
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© 2011 McGraw-Hill
Financial Communications. All rights reserved.
September 2011 — This column is provided through the
Financial Planning Association, the membership organization for the financial
planning community, and is brought to you by Ronald J. VanSurksum, CFP® , a
local member of FPA.

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