Creating a Runway of Safe Assets for Retirement Spending

On this episode of The Long View podcast, Dana Anspach talks retirement savings, inflation, rising interest rates, and what current retirees face in today’s market.

Here are a few excerpts from Anspach’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Constructing a Runway of Safe Assets

Benz: You referenced previously this idea of constructing this runway of safe assets. So, I want to switch over to discuss in-retirement portfolio construction, how you do it. Hoping you can talk about that system that you use and also just to help people think about this—can you compare and contrast with what people often think of as the bucket approach to retirement portfolio planning?

Anspach: Traditionally, we will build an asset allocation. Most people listening are probably familiar with that term. And a lot of withdrawal strategies have you take what’s called a systematic withdrawal. So, you’re withdrawing proportionately from each asset class as you need cash. We like to do something different. It sometimes goes by the term asset liability matching, time segmentation, bucketing would be another word for it, where we’re laying out the cash flows that you need by account—meaning, there might be his IRA, her IRA, a trust account, there might be a deferred comp plan. There is, of course, other things that are coming in. It could be Social Security and a pension. So, we have this timeline that ultimately tells us here’s how much needs to come out of each account in each year. And that gives us a job description for that account. Maybe I have one spouse’s retirement account and they might be the younger spouse and they’re not going to start taking distributions till 72, and they might be currently age 60. Well, that account could be allocated very differently than, let’s say, a spouse who is age 70 who is going to start taking distributions from their 401(k) or IRA in two years.

The first thing we do is lay out those cash flows by account. And then, we decide how many years of cash flow we want to have covered by stable, secure investments like a CD that would mature, a Treasury bill that would mature, an agency bond that would mature, something that’s very highly rated because we don’t want to take any risk with that part of the portfolio. We want the client to be able to enter retirement and look out and that word runway comes from—we describe it as you have this runway where you know for five to eight years if we got a bear market, you wouldn’t have to sell a single equity holding. You would have these safe investments maturing and your cash flows would be covered.

We’ve often heard this term bucketing. I think of this as a bucketing strategy. Just the technical term would be asset liability matching. You have a liability, the amount of cash flow that needs to come out of this particular account in this particular year to fund your spending, your lifestyle, and we’re going to buy a particular asset—a CD or a bond, or an agency bond—that matures that particular year in that amount so that we know that that liability is covered. So, to me, bucketing is a very similar term. It means the same thing. Some people think in simpler terms: you have your cash bucket, your midterm bucket, and your long-term bucket. We’re just getting more granular with it. We’re actually laying out the cash flows for life by each account and then matching up the assets, and ultimately, you end up with what might be called… Pimco calls it the paycheck replacement portfolio; we call it an income ladder. So, you have this safe part of the portfolio and then you have the growth part of the portfolio.

Along the way, there’s going to be years where the growth portfolio does really well. And during those years, we’re selling some of that growth and we’re refilling the paycheck replacement part of the portfolio. There’s going to be other years, this is certainly one of them, where the growth portfolio is not doing well and we’re going to leave it alone. We’re not going to worry about it because we have these safe investments maturing.

There’s of course no way to know over a long period of time that this particular strategy is going to outperform. We don’t know that. But there does seem to be some behavioral benefits to it. It does seem to be able to enable people to relax and to get less stressed during these market downturns, because they know that the cash flows that they actually need to live off of, that that part of their portfolio is secured, and they know they have usually five to seven years to wait out this market cycle. And of course, most market cycles are much shorter than that. So, we see some significant benefits in just the ability to relax a little bit in using a portfolio structure like this during the retirement phase.

Individual Bonds vs. Bond Funds

Ptak: I think you use individual bonds rather than bond funds as part of this runway approach that you’ve been describing. Do you also do that for behavioral reasons, or is there another justification that you found is useful for individual bonds instead of bond funds?

Anspach: I think, behaviorally, when you use individual bonds, which, of course, if you were to look at bond holdings today, on paper, if you sell them now, they are down in value. But when you have this maturity date, there’s this inclination to let the bond mature; you’re going to hold it to maturity. And so, this current valuation that you see on paper isn’t impacting you. With bond funds, I think, there’s a tendency to look at that bond fund and think, Oh my gosh, I’m in trouble. Now, if everything worked efficiently the way it’s supposed to, that bond fund would have a duration, and if you hold the bond fund for the length of the duration of the bonds, it should recover, it should have interest income and so on. So, it shouldn’t materially put you in a different place, but there is definitely that aspect of something with a specific maturity date that seems to enable people to hold that security for that intended time frame. We have used short-term duration bond funds at times also or low-volatility funds, but in general, our preference has been the individual securities.

Inflation Risk and Protection

Benz: How do you think about inflation protection with the fixed-income portion of the portfolio? What do you use there? And if you can generalize about within the fixed-income weighting, what percentage might be in assets that would specifically be there to help address inflation risk?

Anspach: It’s a great question. And the way we have addressed inflation risk is we have built it into the cash flows in the clients’ financial plan. And so, we’ve already accounted for the fact that, let’s say, we have a bond that’s going to mature next year that it’s going to have to be worth more than maybe a bond that matured two years ago because the client will need cash flows that have increased with inflation. We haven’t addressed it by picking a security such as TIPS that will adjust with inflation. We’ve already outlined, here’s the increased amount of cash flow that the client will need. We don’t know what the actual inflation rate will be. And that has worked really well for us.

In hindsight, if I were managing a total return portfolio, I’d probably be more inclined to use a different type of fixed income. But because we’re managing this asset liability portfolio and our cash flows are all near term, that’s not how we’ve structured it. But one of the things that I wrote about in my book in 2012 was I Bonds. And it’s interesting, because I’m a big fan of I Bonds, and yet, if you didn’t buy them consistently every year, putting the money in along the way, then you get to years like this where inflation is high, and it could be difficult for a higher-net-worth household to get any kind of meaningful amount into them. So, one of my takeaways this year—and Christine, as you know, I recently saw you at a conference and I mentioned this—is that us as advisors aren’t completely exempt from behavioral biases either. And because inflation was so low for so long, great tools like I Bonds that even I wrote about and I’m a fan of, we kind of forget about it. It’s not top of mind. And so, if you want to hedge against something like inflation, it takes consistent action. And so, if you have been funding those things along the way, you’d be well-positioned today. The problem is, I think as humans, it can be very difficult for us to consistently hedge against something when it hasn’t been an issue for 10 years. It just drops out of our top-of-mind awareness. This is something, as an advisor, that I really want to spend some time thinking about—what are the hedges that you would want to put in place and how do you consistently implement them so that when these market events that are unexpected come along that you’re well-positioned for them already?