3 Ways To Incorporate Bonds Into Your Retirement Strategy

Incorporating bonds into a retirement strategy is far from a one-size-fits-all solution. Bonds can serve as both a stabilizing force within a portfolio and a reliable source of income during retirement, yet their role depends on how they are used to align with specific retirement goals. The discussion here will focus on using bonds specifically to meet budgeted retirement expenses.

Bonds can be incorporated directly into a retirement strategy in three broad ways:

1. An assets-only approach to build a total returns investment portfolio.
2. Matching the duration of bond funds to the duration of the retirement liability.
3. Holding individual bonds to maturity to generate the desired cash flows to fund expenses on an ongoing basis throughout retirement.

The two latter methods put the retirement liability (meeting an ongoing spending goal in retirement) at the forefront and try to choose bonds to best protect the spending plan from interest rate volatility.

Assets-Only Approach

The first approach is the standard investing philosophy for accumulation, which does not really consider how the nature of risk changes upon retirement. In short, it uses Modern Portfolio Theory to choose an asset allocation strategy that includes bonds as part of a total returns investment portfolio.

Bonds, with their lower expected returns and volatility, provide a way to reduce the portfolio’s overall volatility to an acceptable level while still maintaining a sufficient overall portfolio return. Asset allocation in this framework is generally determined in terms of assets-only considerations to build a diversified portfolio with the highest expected return for the accepted level of risk. To the extent that retirement income needs were considered, it was generally to identify an asset allocation that would minimize the probability of failure for the financial plan.

Duration Matching

A bond’s duration is essentially the effective maturity of a bond: an average of when the bond’s payments are received, weighted by the discounted size of those cash flows. For example, a zero-coupon bond provides one payment at the maturity date, so its duration is the same as the time to maturity. The further away the maturity date, the higher the bond’s duration, making it more sensitive to interest rate changes. A bond fund, which is a collection of bonds, also has a duration equal to the average duration of each holding weighted by its proportion in the fund.

The second approach aligns a bond or bond fund's duration with the retirement liability's duration, effectively immunizing interest rate risk.

Laddering Bonds for Cash Flows

The third route involves holding individual bonds to maturity to provide the desired income to fund annual expenses continuously throughout retirement. In this method, maturing bonds and bond coupon payments provide a steady and known stream of contractually guaranteed income to meet planned expenditures.

The difference between a traditional bond ladder as an accumulation tool and a retirement income tool is that with a traditional ladder, you would reinvest the cash flows received into new replacement bonds. With a retirement income ladder, the cash flows received are spent on planned expenses. As a result, a retirement ladder will naturally wind down without additional funding from other assets.

When used thoughtfully, bonds can play a vital role in a well-rounded retirement strategy, offering stability, predictable income, and a hedge against volatility.