Retirement Portfolio: The Bond You Forgot About
Before we worry about what bond you might have forgotten about (okay – this is a bit of ploy to get your attention), we should define how bonds work.
How Bonds Work
A bond is a loan made to a government or a company. We all know about loans – you borrow an amount of money and agree to pay it back over time. Bonds and loans have an original amount, payment terms for principal and interest, and interest rates even if that rate is zero. Beyond those basics, bonds can have a variety of structures and special features.
Consider this example of a bond. A company wants to raise some money to build a new manufacturing facility. They need $50,000,000, want 20 years to pay off the debt, and are willing to pay a 2.5% interest rate known as the coupon rate. Bonds are typically issued with a face amount of $1,000. When you buy 10 of these bonds you are investing $10,000 in the company that sold the bonds. For 20 years the company makes no principal payments, and you will wait get your $10,000 back as a lump sum.
Bonds you might invest in are rated for the ability of the borrower to repay you. You personally have a credit score that lenders rely on when they make you a mortgage or offer a credit card. The higher your credit score, the less risky you are as a borrower. Well, the same is true for bonds. Bond ratings use a different scale though the concept is the same. The higher a rating a bond carries, the less risk you have in a bond, which means you will get your money back. When you invest, you can measure the risk you are taking. By the way, the “Risk Free” bond is the 10-year U.S. Treasury Bond.
At this point you may be thinking this is not a great sounding investment. You give the company $10,000 and in 20 years you get $10,000 back. The reason you might take this offer is for the 2.5% coupon (also known as interest) payments. The standard bond makes a coupon payment semi-annually, say June and December. Twice a year, you get a payment of $125 which is $250 a year. A regular payment coming in like clockwork is a key goal of people planning to retire. People want a reliable and steady retirement paycheck.
Retirees and Bonds
Historically retirees allocated a relatively high percentage of their retirement portfolio to bonds. Why? Two reasons: 1) for the regular income stream generated by bond coupon / interest payments; and 2) for the perception that bonds are safer than stocks. In the discussion above, we have considered the regular income stream of a bond. Why are bonds safer than stocks? Naturally, its complicated. The simple take is that bonds do not lose as much value in a recession as stocks do in a concomitant market crash. Certainly going down less has a huge value.
Approaching retirement people commonly ask: “Shouldn’t I have more in bonds?” Other people will cite the ‘Subtract Your Age from 100’ guideline to set a bond allocation:
You are 65 years old. 100 – 65 = 35. Therefore, 35% in stocks and 65% in bonds/cash.
A simple rule of thumb is easier to follow. When interest rates are low, it becomes more of a challenge to create retirement income from bonds. We see that in the example above. To create $1,500 a month in income with a low risk bond paying 2.5%, you need to invest $720,000. For $720,000 to be 65% of your total investments, you need $1,107,700 in total investments (bonds and stocks). That is a lot of money to just get $1,500 per month!
Historically, stocks offer a higher total return than bonds. That seems too easy, and it is. Stocks are more volatile than bonds. Said another way, stocks are riskier than bonds. To get a higher return of investing in stocks, you have to take more risk. Which – going in circles here – takes you back to bonds. You invest in bonds for a regular interest payment and a lower level or risk. Perhaps you could allocate more to stocks for that higher return, IF you only had a good ‘bond’ paying you every month. Is that possible?
The Bond You Forgot
The bond you forgot is an investment you or your spouse made every month over a lifetime of working. What are you forgetting? Social Security. Social Security is an investment made over a working career. In retirement, the Social Security investment creates a monthly paycheck deposited into your bank account. Better yet, it is a monthly paycheck that adjusts with inflation.
In Social Security Land – a neighborhood with its own set of rules even more complicated than the average neighborhood association – there is the concept of Full Retirement Age. We all grew up thinking retirement came at age 65. But in Social Security Land Full Retirement Age is not age 65. Full Retirement Age depends on the year you were born and is between ages 66 and 67. We will use age 66 for Full Retirement Age which means you were born in 1954.
In January 2020, the Social Security Administration released a couple of interesting numbers.
$1,503 is the average monthly retirement benefit being paid
This is an average across all workers with 31% of women and 27% of men claiming Social Security at age 62 and getting a reduced benefit for claiming before Full Retirement Age.
$3,011 is the highest monthly retirement benefit payable at Full Retirement Age of 66
This is the maximum benefit at Full Retirement Age in 2020 which requires a
lifetime of maximum Social Security earnings.
You actually have a choice to wait until as late as age 70 to take Social Security. If you wait and do not take the age 66 benefit until age 70, then it could grow at 8% per year to $4,096 at age 70. Only 6% of women and 4% of men wait until age 70 to claim.
The total value of what you are paid by Social Security over your lifetime is based on your income history, the number of years you worked, how long you live, when you start your monthly benefit, and if you are or were married. The analogy to a bond is not perfect because Social Security pays only until you die. If you have an actual bond, then someone can inherit the bond. The point is not so much is Social Security a bond.
The point is that having a regular Social Security payment is valuable and worth more than you think. Having a Social Security payment is a stable, secure element in planning retirement. Yes – it is stable and not at risk for people nearing retirement. Younger people, like Millennials, will likely see programs changes that affect their benefits in future decades. For people nearing retirement, Social Security will pay you the benefits you have earned. Congress has a history of shoring up the program. The current projection that by 2035 the program can only pay 80% of benefits requires some relatively small tweaks to payroll taxes to resolve the problem. Historically, Congress has tweaked payroll taxes to keep Social Security fully funded with the burden of tweaks falling on people who are still working. All to say, do not overly fret about getting your Social Security payments.
If you did NOT have Social Security, then what would you have to have invested in a conservative investment portfolio on your 66th birthday to replicate a Social Security payment of $1,503 a month, goes up with inflation, and lasts until you die? Here are a couple of more numbers to round out the calculations: you will live 20 years, inflation will average 2%, and your conservative portfolio will have an average return after costs of 5.5%.
The Answer Is: $260,740
A monthly Social Security check replaces $260,740 of savings you would need to have saved over your working career.
Now, let us rerun the numbers above, and use the highest Full Retirement Age monthly payment of $3,011 with the same return assumptions for 20 years.
The Answer Is: $522,345
Let us say, just for fun, you are a couple with one person getting the high benefit and the spouse getting the average benefit. The value of Social Security to you as a couple in the scenario above is $783,085. That is a lot of money.
The Argument Against
Recognizing that Social Security has value is important. Should you really drop all bond holdings because you have Social Security? Probably not entirely. The reason is investor behavior. If you say to yourself, I do not need any bonds because I have Social Security, life will go well until there is a stock market crash.
Remember stocks are more volatile. If an ‘average’ stock market crash is 35%, that means if you have $100,000 invested totally in stocks when the market crashes, the value of your investment falls to $65,000. Pretend you are 81 years old and have been retired for 15 years. And suddenly your investment portfolio drops like a rock. The typical person does not say, “Oh, that is okay because I’ve got Social Security.” The average person freaks out. At 81 you probably are not planning to go back to work because the stock market crashed. You are not worried about dying next year, but rather worrying you might live to 95 and run out of money.
We are never rational when stock markets crash. A stock market crash of 35% leaving you with $65,000 means your investments must rise 53.8% to get back to $100,000. Wow! A rise of 53.8% can take time. Time is not something the average 81-year old person thinks they have in abundance.
What happens to bonds when stocks crash? It depends. To keep this simple, we’ll talk about three broad types of bonds. In recent history, many U.S. government bonds lost nothing or even rose in value. Good corporate bonds will lose 5% of their value. Junk bonds can lose as much as stocks because a junk bond, by definition, is issued by a financially weaker company. A mix of U.S. government bonds and good corporate bonds will off-set some of the sting of a stock market crash depending on your allocations to stocks and bonds. Bonds are not guaranteed to protect you in a stock market crash though that is a role they have traditionally played for investors.
Nuanced Approach
The answer lies in the middle. Recognize the stability Social Security income augments your retirement plan. Social Security adds a bond-like element to your income. A steady regular payment that adjusts for future inflation is valuable. Social Security gives you an option to stay with a higher allocation in stocks in the first decade or more of retirement.
While stocks will crash from time to time, over time stocks have a positive return. In a ten-year rolling period from 1950 through 2019, stocks could have an average return ranging between (1%) to 19%. If you go out 20-years, the average return ranges between 6% and 17%. Time is your friend. If you are a relatively young and healthy retiree with a longer life expectancy, then a higher allocation to stocks than bonds may make sense when you factor in Social Security.
The original structure of Social Security was created when life expectancy was 61 for men and 65 for women. Today, if you are 65 years old, the average life expectancy for men is 83 and for women it is age 86. Planning for 20-years or 30-years in retirement is a long time. You will need to leverage all of your resources to build a strategy providing income for decades. Long gone are the days most of us died before we even collected a penny from Social Security.
While opinions vary on whether or not to think of Social Security as a bond, no less an investing guru than Vanguard Founder Jack Bogle repeatedly stated he saw Social Security as a bond.
As you consider your retirement allocations – don’t forget the bond (umm… Social Security).
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