How Rising Yields Should Affect Asset Allocation for Retirees, Preretirees

Our guest for the video, “How Rising Yields Should Affect Asset Allocation for Retirees, Preretirees” is Michael Kitces. He is a financial planning expert and the head of planning strategy for Buckingham Strategic Wealth, co-founder of XY Planning Network and AdvicePay, and is the Chief Financial Planning Nerd for the advisor education platform Kitces.com and the Nerd’s Eye View blog.

Key Takeaways

• From a pure asset-allocation perspective, higher yields don’t necessarily change the picture, in and of themselves.
• The bonds that do the best work of protecting against the sequence-of-return risk are the most boring, lousy-yielding bonds.
• I have some challenges with the laddered TIPS strategy in retirement. For much of the past 20 years that these strategies have been discussed, real returns were so low. The second challenge that crops up around building laddered TIPS portfolio is simply: How long do you want to build the portfolio?
• Why have investors without TIPS done fine through a range of inflationary environments? Inflation gets reflected in a whole bunch of other parts of the portfolio as well, in a way that still moves us at least reasonably in tandem over time.

Christine Benz: Hi, I’m Christine Benz for Morningstar. How should higher safe yields affect how investors are approaching their asset allocations? I recently had the chance to sit down with Michael Kitces, the financial planning expert, to discuss how he thinks investors and their advisors should approach that question.

Michael, thank you so much for being here.

Michael Kitces: Absolutely. My pleasure. Appreciate the opportunity.

Higher Yields and Asset Allocation

Benz: Many investors at this stage, especially where we have this relatively new phenomenon—newish phenomenon—of higher yields coming online, investors are really thinking about, “Well, how should that affect my asset allocation? If these higher safe yields are available, does that mean I should allocate more to safe assets?” And I guess, I would like you to focus especially on folks who are closing in on retirement or in retirement.

Kitces: At a high level, I would say, from just like a pure asset-allocation perspective, higher yields don’t necessarily change the picture, just in and of themselves, and really, that’s for two reasons. The first is, at the end of the day, it’s really not about just what we’ll call “the stated yield,” like the coupon on the bond. It’s what my yield is after inflation. And the reality is, my after inflation, my real returns on bonds are not particularly much better now than they were several years ago. I’ve gone from almost no yield with almost no inflation to a whole bunch of yield with a whole bunch of inflation. We’ve moved a point or two relatively on where those are in comparison to each other. But it’s not as though we can say, like, “Well, I went from near zero to almost 5% on yields. Look at how much more I’m making.” It’s like, “Well, OK, but when we look at how much more inflation went up as well, we’re not really making much ground here.”

And when we think about that from a retiree perspective, that’s especially impactful because what that means is, in terms of my ability to fund my retirement spending goals, my future retirement spending goals, I’m really not growing these dollars in any material way above and beyond inflation. I may or I’m hopefully at least keeping pace with inflation, but higher yields doesn’t mean I’m beating inflation more and able to fund my long-term goals any better—because I’m growing my money as much as I’m growing how much my future goals are going to cost because inflation is lifting up the expense.

The secondary reason why we don’t necessarily look at this as a material difference from an asset-allocation perspective for retirement is, if you want to get to the pure economics of how stock returns tend to come about, there’s usually two core components. The first is there’s some risk-free rate that just exists in the marketplace, like, what I can get if I just park my money somewhere and have it do nothing. There’s a second layer on top of that that is then, “Well, what do I actually get for taking some risk?” We usually call this the risk premium. In the context of stocks, we call it the equity risk premium or the stock risk premium. And stock returns, we can generally break down to, there’s some risk-free rate and there’s some equity premium that sits on top. So, when interest rates were very low, the risk-free rate was very, very small and the equity risk premium sat on top. When we put a bigger interest rate on top, the equity risk premium still sits on top of it. And so, we might even get higher returns out of stocks because it’s sitting on top of a higher risk-free rate in the first place, but the relative difference, like how much do my stocks tend to beat my bonds, isn’t necessarily materially different if the bond rate lifts higher because they move in tandem, one stacked on top of each other.

And so, when we think about this from an asset-allocation perspective, like why do I hold some stocks and some bonds, it usually comes down to two reasons. I own some stocks on top of some bonds because the stocks give me a risk premium that rewards me in the long run that I need to accumulate for my goals or fund my long-term goals or beat inflation to cover my long-term goals. So, I got some money there. And then, unfortunately, coming with that, they’re volatile, they move up and down and sometimes I need money at what is not exactly the best time to sell it, so I’ve got some bonds that serve as essentially kind of the ballast that balances out the ship that wobbles around with the stocks. And so, if my stocks are my growth engine and my bonds are my ballast, and stocks generally are going to give the same equity risk premium whether the base bond rate is high or low, the balance of how much stocks and bonds I own doesn’t necessarily really shift all that much. So, when we look at this from a pure asset-allocation perspective, I don’t necessarily think about stock/bond mixes as looking materially different in higher-yield environments versus lower-yield environments.

Now, I guess, the small asterisk that I would put to that is, when you get down to the purest sense of bonds trying to serve as a ballast to stocks—and that becomes especially important when we’re in early retirement stages—we have the infamous sequence-of-return risk, like, what happens if I need to withdraw from my portfolio in the early years and stocks are down in the early years, and if I draw too much from stocks in the early years while they’re down, by the time the market recovery comes, I don’t have enough stocks left to participate fully in the recovery, and then I start running out of money or have to curtail my expenses in the later years. The extent that the bonds are supposed to provide ballast, bonds that have more yield tend to provide more ballast, really for two reasons. One, outright if I’ve got more yield, just at least I’m clipping a coupon to generate some return while I’m putting some money in bonds in case stocks go down. And secondarily, while—we’ll see if it happens anytime soon—the higher rates are, the more room there is for rates to cut the next time, say, bad stuff happens in markets and the economy, and rate cuts create bond price increases, and bond price increases gives me even more ballast return out of the bonds.

And so, when I look at it from that perspective, there is I think more opportunity for bonds to provide that ballast against sequence-of-return risk to the point that some of the research even that we’ve published in the past is that you can hold higher bond allocations early in retirement to help balance that out. I sometimes call like a bond tent. Like, we’re going to build an extra allocation of bonds in the early years of retirement if you draw your allocation to bonds, it goes up in the first few years of retirement, then you spend down that extra bond reserve over the next few years of retirement, you get back to whatever your original balanced portfolio was that you hold from that point forward. If we want to build a bond tent to protect against sequence-of-return risk in the early years, and bonds provide a little bit more of a buffer when yields are higher and there’s more room for price appreciation if rate cuts come, it functions as an even stronger ballast in the early years of retirement. And so, I do view that as one plus to the environment of having a little bit more yield coming off of our bonds is that that function of bonds not necessarily to be the return driver—the return drivers at the end of the day is the stocks—but to be the balance when the returns in the stocks are not always coming when we wanted them to come, the bonds help a little bit more in this environment.

Credit-Sensitive Bonds

Benz: Just to clarify, though, Michael: You’re not saying, within the bond universe, the higher-yielding bonds tend to be more ballast. So, you’re not saying credit-sensitive bonds, they’d be worse ballast, right?

Kitces: Correct. And actually, what we find from some of the research that we’ve done around withdrawals and sequence-of-return risk, the bonds that do the best work of protecting against the sequence-of-return risk, I mean ironically, it’s the most boring, lousy-yielding bonds. They’re not there to drive the return. They’re there to be the thing that does well when everything else is going badly. So, if you envision an environment where there’s a horrible economic recession and companies are defaulting left and right and going out of business, which means stocks are cratering at this point, if you think of full-on recessions we’ve had at various points, get one or two every decade or so, when you think about those environments, what’s the worst thing that happens in the bond world? High-yield bonds get crushed, corporate bonds get slammed, and good old-fashioned, not terribly appealing yielding government bonds A) continue to crank along their yields and B) are often the one segment of the bond world that even goes up when everything else is getting slammed in a recession because there’s often rate cuts that are occurring and the classic math of bond—when rates are going down, prices go up, and you get that appreciation.

So, just remembering and bearing in mind the point of bonds in a retirement portfolio is not the return driver. It’s the diversifier for the return driver. And so, taking the risks on the bond side that you take on the equity side, which is, buying companies that pay better returns in the hopes that the company does well and doesn’t do badly, if you’re already taking that risk on the stock side, you don’t need to take it on the bond side, at least from a pure retirement management sequence-of-return risk perspective.

How Does Inflation Affect Asset Allocation?

Benz: You referenced earlier on the role of inflation in all of this. And I’ve been hearing in some quarters, especially among academics, that forget all the complicated in-retirement portfolios. Just buy or build some sort of a laddered TIPS portfolio, Treasury Inflation-Protected Securities, and call it a day, basically. What’s your take on such a strategy, setting aside that I don’t think most investors do this? But do you think it’s a good approach?

Kitces: I will admit. I have some challenges with the laddered TIPS strategy in retirement. One, just practically speaking, at least for much of the past 20 years that these strategies have been discussed, real returns were so low, TIPS just literally didn’t pay that much. And so, to actually build what essentially is a retirement portfolio that gets no benefits from the equity risk premium, you have to generate all of your return from a fixed income world when fixed income real returns were at or near 0, you would just need so much money to do that that the irony is like if you had a big enough nest egg to actually fully fund a laddered TIPS portfolio out that long, you may as well just buy a bunch of stocks and ride out the volatility because you would have so much money that your withdrawal rate might be down to 3% or 2%, in which case, I can just ride this out with stocks. I don’t actually need the bonds.

Now, if real returns get high enough, I think it does get interesting and will be an area that we’ll be looking at from the analysis end. If you run some of these numbers, say, back in the 1990s when real returns were much higher, you could get some laddered TIPS portfolios that were at least reasonably competitive to what you could build with, I’ll call, “traditional 4% rules.” Although ironically, even back then, nobody wanted to buy TIPS and do that with TIPS because they were getting 10%-plus returns out of stocks, which again is part of the point—stock returns tend to stack on top of bond returns—and so, if TIPS yields are great, stock returns tend to be powering off forward much better as well because it just means the whole real return environment is higher.

So, the first challenge that I just tend to find in practice when we sit down and do the math on it is the amount of money you would have to have to fully insulate a laddered TIPS portfolio for an entire retirement time horizon embeds such low real returns and takes your withdrawal rate so low that if you had enough money to do that, you would have enough money to ride out the stock risk.

The second challenge that crops up around building laddered TIPS portfolio is simply, of course: How long do you want to build the portfolio? You plan on being on this earth for 20 years or 25 years or 30 years or 35 years or 40 years? Because if you’re literally going to build a laddered bond portfolio where you spend each sleeve, there’s nothing left at the end. So, if you build a 30-year laddered bond portfolio and you’re alive in year 31, you’ve got a problem. Now, sometimes we can insure against that by saying, “Well, then I’m not going to put all the money in the laddered bond portfolio. I’m also going to hold some in equities.” It’s like, well, cool. But then, we’re really just building good old-fashioned diversified portfolio again that have bonds and stocks. We’re right back in that realm because part of the nature of building retirement portfolios that have mixtures of stocks and bonds is just the fact that when stocks tend to yield more than bonds over long time periods, we don’t need as much of a nest egg to retire in the first place because literally the growth engine of the stocks means we don’t need as much money to be able to retire, and then the bonds smooth out the volatility of the stocks in case the returns don’t come in the desired order. So, the bonds get us through the short-term time horizon. The stocks get us through the long-term time horizon. And the combination of the two means, hey, even if I end up living a little bit longer than I’d expected, most of the time stocks go up a lot more than they go down, particularly if we can ride out the sequence-of-return risk, and by the time we get to the out years, the ironic effect of sequence-of-return risk is if you survive the early years—like, if bad things happen in the early years, good things tend to happen after that. And the returns that come in the later years means if you live longer than you’d expected, there’s money left over. If you live longer than you expected on a bond ladder, there’s nothing left at the end of the ladder.

It’s that combination of the factors that—just putting the whole portfolio into real returns that are relatively low with TIPS often means we need so much money, especially if we’re going to do this for 30-year time horizons that if we really have enough money to do that, we would also have enough money to ride out the stock volatility in the first place. And coupled with, I always still have the risk that I’m going to outlive my TIPS ladder, or if I’m retiring younger, like I literally can’t buy TIPS for as many years as I’m expecting to be in retirement, which means I have to start putting some stocks back in there anyway, and once I do, then we’re really back to diversified portfolios again in the first place.

TIPS and the Bond Market

Benz: Getting back to diversified portfolios, for people who don’t want to take that sort of absolutist all-TIPS portfolio approach but they want to have some inflation protection in the fixed-income piece of their portfolio, do you have any thoughts on how to approach that? How much, and also, how much to be disappointed about how TIPS funds behaved in 2022 where we saw them really behaving more in sympathy with the bond market and interest rates than they were an expression of inflation protection? Maybe you can talk about how investors should think about that.

Kitces: I draw this back to relative to sequence-of-return risk and just what our bonds versus our stocks are trying to do in the first place. My bonds aren’t necessarily there to be my return driver or, even to some extent, my inflation hedge. Because the reality is, look, I can buy good old-fashioned short-term government bonds. While it’s not perfect from day-to-day and month-to-month, when I look back over the span of several months and even a year, like what’s happened over the past year: Inflation went up, Fed raised rates because inflation went up, and all of my bond yields went up. So, even if I didn’t have TIPS to be indexed to inflation, if I go and actually look at what’s happened with short-term bond funds, my yield moved with inflation anyway. It’s actually still there. From that perspective, it doesn’t have the guarantee of TIPS literally indexed to inflation, but bond yields tend to move relatively in lockstep with inflation anyway, particularly if you get toward the shorter end of bonds. If you buy very long-term bonds, you’ve got some different dynamics.

The second thing that I tend to look back to when we think about it from this perspective is if I’m concerned about inflation, I don’t only need to hedge inflation on the bond side of the portfolio; my stocks function as an inflation hedge. Now, in today’s environment, some stocks are getting maybe some bad press around this but the reality is, when inflation crops up, it generally means, almost literally means, the prices of things are going up. So, when I buy it, this is not good news. When I sell it, it is good news. So, we see companies that have record revenue, that are generating record profits, because when everything gets more expensive, more money flows on the top of the company, they got to pay their staff more hopefully as well as inflation lifts wages. But if my prices go up, my revenue goes up, and if my expenses go up in lockstep, I still end up with more profits, at least moving up at the pace of inflation. And when we look back to other high inflation environments like the 1970s, we very much saw the same kind of pattern where the real return on stocks actually did a pretty reasonable job over time of keeping pace with inflation—volatile in the short term, as it always tends to be, but stocks overall did a pretty good job of keeping pace with inflation.

When my return driver comes from stocks and my inflation hedging comes from stocks and my short-term bonds already tend to move at least reasonably in the neighborhood of where inflation is going—again, the Fed is not always in lockstep, it’s not always in perfect synergy, but when you look over any moderate period of time, interest rates tend to move with inflation up and down because that’s just the Fed literally responding to inflation to try to keep it in the zone and try to keep it on their mandate—that we don’t necessarily need TIPS to serve that function. It’s not that I’m necessarily negative on TIPS. I don’t want to bash the TIPS market or anything of the sort. But I do find a lot of investors seem to put a lot of faith in, like, “This is the one thing that I can rely upon that will be like my perfect hedge for inflation” when in part, as we’ve seen in the short term, bonds prices at least can move for other factors besides just inflation. So, you see some of the TIPS fund price volatility that we saw in 2022. And in the meantime, a whole bunch of other things actually end up moving in lockstep with inflation anyway, as we’ve seen with short-term interest rates and in equities.

While we certainly want to make sure in the aggregate that something is able to track with this, like I want to be careful about buying 30-year bonds that tend not to move with inflation and they tend to respond to interest-rate sensitivity, or if they’re corporates, responding to economic sensitivity as well. But when I drill down to: Do I need TIPS to keep pace with inflation? The answer is, it’s an answer, but it’s not the only answer to this. And frankly, that’s why I just, when I look back at decades of research that we’ve done around retirement spending and just decades of investors retiring, a whole lot of retirees have done fine through a whole lot of inflation environments prior to TIPS having existed or without any material allocation to TIPS, and it’s gone fine. And when I draw back and said, well, why have investors without TIPS done so fine through a wide range of inflationary environments? The answer is because inflation actually gets reflected in a whole bunch of other parts of the portfolio as well in a way that still moves us at least reasonably in tandem over time.

Benz: Michael, this has been such a helpful discussion. We’ve covered a ton of ground. Thank you so much for being here.

Kitces: Absolutely. My pleasure. Thank you.

Watch “Where Should Investors Stash Their Safe Money Today?” for more from Christine Benz.