exactly what each successive 5-year income bridge will cost. Market conditions will differ at each point in time. During 2003, bond yields dropped to near historic lows as the Fed cut its lowest lending rate to 1 percent, a rate that had not been seen since the 1940s. This low spot appeared to end the long, slow decline of interest rates that occurred during the 1990s and continued until 2004. But who knows what the future holds? The further out you go, the hazier it gets.
The important thing for the Browns is for their portfolio to stay above this critical path. It will then continue to supply the needed income over their lifetimes. They need not worry about financial problems so long as their portfolio stays in the Safety Zone shown in Figure 7.1.
If they have not yet done so, they must arrange their wills, trusts, and other legal documents to legally transfer their assets to their heirs. This is one of those life tasks that must be taken care of to make sure the transfer phase goes smoothly. If they have not done this by now, they need to do it because time is beginning to run out for the Browns.
MAINTAINING AND RELOADING THE INCOME PORTION
1. Yearly automatic reloading. Instead of waiting 5 years before reloading, the Browns could start out with a 5- year horizon, then update the portfolio at the end of the first year to extend it out to the full 5 years again. This may simply require them to buy a new 5-year bond. Or, if interest rates have dropped significantly, they may wish to sell the complete 5-year set of bonds and purchase a new set at a lower price.11If they do this every year, they will keep a perennial 5-year horizon in front of them at all times. They will have protected themselves with a 5- year buffer. A nice benefit is that each year the portfolio is recalculated, buying bonds with 5-year maturities usu- ally means that they will be getting higher interest rates.
This happens because the yield curve is usually posi- tively sloped, meaning that 5-year bonds generally have higher yields than 1-year bonds.
2. Yearly discretionary reloading. At the end of each year, the Browns can make a discretionary decision based on their evaluation of market conditions: Reload now or wait. If their growth portion has done well and bond prices are right, they can sell enough of their growth assets to extend the horizon. If these conditions are not met, they can wait another year or so, then review the sit- uation again to see how the market looks. For example, assume that the return on their growth portfolio has been good enough after the first year to allow them to extend the horizon to 6 years and still stay above the critical path. They would then protect their income for the next 6 years. Prudence may suggest locking in their gains by doing this.
3. Continuous discretionary reloading. With this option, the assessment is continuous. Gains in the growth portfolio are constantly balanced against the cost of reloading and/or extending the income portion. Extension of the horizon can become automatic, with an arrangement that more assets are dedicated to income by purchasing bonds whenever returns in the growth portion permit stocks to be sold to extend the horizon without dropping the growth portion below the critical path. This is active management of the portfolio based on what is happening now rather than on forecasts of what may happen in the
The Distribution Phase: Dedicating Assets to Do Their Job 151
future. This approach will be more expensive than the passive management afforded by the simplest fixed-hori- zon approach because conditions will have to be moni- tored constantly and transactions costs may be slightly higher, but for conservative investors, locking up their gains may provide a greater sense of security.
4. Tax swapping. Tax swapping is an active management strategy that takes advantage of losses within the income portion to offset gains in the growth portion and thus negate any capital gains tax. For example, assume that interest rates were to rise at the end of the second year of the Browns’ first 5-year horizon. Assume further that stocks have risen rapidly, and they want to sell some of their growth portfolio to buy bonds and extend their income protection. Their last 3 years of bonds will have decreased in market value temporarily, although this has no effect on the cash flow from interest that they generate.
It may be that if the Browns sold bonds out of the income portfolio, they would create a capital loss. They could then use this loss to offset the gains from their stock sale, thereby reducing their overall capital gains tax liability.
They might be able then to buy similar bonds with the pro- ceeds and reconstruct their income portfolio with essen- tially the same characteristics.12It is best to consult a tax expert before implementing tax-related strategies such as these, but the opportunities may be well worth pursuing.
CONCLUSION
Figure 7.1 represents the culmination of the asset dedication process. It traces the projected value of the Browns’ portfolio from age 56, when they set their target retirement portfolio, to age 102, when it finally reaches a zero balance. The portfolio has done its job: It supported them to age 100.13The asset dedication strategy covered them for as long as they wanted to be covered. They took responsibility for their situation when they were 10 years from retirement by looking ahead and setting reasonable targets based on reasonable goals. By knowing the critical path that their portfo- lio should follow, they will be able to monitor their progress at each point along the way. The essential lifetime balancing act for finan- cial independence will have been accomplished.
The next chapter provides a detailed description of how the Asset Dedication web site (www.assetdedication.com) performs the asset dedication process. By answering nine simple questions (which include the six questions in Table 7.1), it will allow anyone to purchase the correct bonds to initiate an asset dedication strat- egy. Private individuals who prefer the “do-it-myself” approach should find this web site easy to use after reading this book through Chapter 8. Those who prefer the “do-it-for-me” approach can refer their financial adviser to this book or to the site.
Before leaving this chapter, we should say a word about the transfer phase, the final investment phase of life. This falls under the name estate planning. Planning what will happen to your money after you die requires legal counsel. Without proper guid- ance, taxes can devour the results of brilliant investing and make the government the primary beneficiary of your estate rather than your true heirs. Setting up your affairs correctly requires the help of attorneys who specialize in wills and trusts. If you fail to do this, you will have made a strategic blunder that will penalize your ben- eficiaries by far more than the cost of the attorney.
NOTES
1. The authors of the study were professors at Trinity University in Texas.
2. The Employee Benefits Research Institute compiles an annual Retirement Confi- dence Survey that tracks the public’s attitudes and actions regarding retirement planning (www.ebri.org).
3. Actually, recall from Chapter 6 that if the 10 years had been 1993 to 2002, they would have reached their target 4 years ahead of schedule because the 1990s aver- aged a higher rate of return than 11 percent. By following their critical path and knowing their target, they actually had multiple opportunities to sell and lock in their retirement. If they had obeyed the first signal, they could have purchased Trea- sury bills in 1998 and actually had $1,040,177 in the portfolio on the day Bob retired in 2002. If they had held on, however, as a result of ignorance or greed, they would have lost. The market decline of 2000 would have ultimately dropped their portfolio to $733,606 by the end of 2002, well below their target.
4. For this example, we assume a 2003 retirement date to make use of the prices of bonds at the time this section was written rather than the 2002 retirement date used in Chapter 6.
5. The most efficient portfolio of precision-guided bonds for asset dedication can be found at www.assetdedication.com.
6. The mathematician Dr. George Dantzig conducted research on how mathematics could be applied to help with the logistical problems of the war. His particular research unit dealt with linear equations, which were referred to as the “linear pro- gram.” The optimizing algorithm that he discovered became known as linear pro- gramming. Later scholars extended his work to nonlinear and other forms of The Distribution Phase: Dedicating Assets to Do Their Job 153
equations and variables, calling it generically mathematical programming. It con- tinues to be one of the most widely applied branches of mathematics because of its ability to find the optimal solution for problems that have trillions of possible solu- tions.
7. William F. Sharpe, Gordon J. Alexander, and Jeffery V. Baily, Investments, 5th ed.
(Englewood Cliffs, N.J.: Prentice-Hall, 1995), p. 478.
8. In fact, zero-coupon bonds with the right maturities, ratings, and denominations are sometimes hard to find.
9. Most experienced financial planners report that procrastination is the biggest enemy of sound financial planning. A lot of energy may be expended on formulating a plan, but unless the plan is implemented promptly and correctly, it will become stale and represent little more than a waste of time.
10. To keep the calculations simple, this assumes that the other pensions also adjust for inflation like social security. If they do not, then a slightly higher inflation rate may need to be factored into the withdrawals.
11. Selling the bonds may create a taxable event and the tax code forbids certain types of security swapping to generate taxable losses, so it is necessary to consult with a tax expert before taking action.
12. See note 11 above on the need to consult with a tax expert before doing this.
13. Actually, it supported them slightly past age 102, but this is merely an artifact of the prevailing interest rates at the time the example was constructed. This is an idealized version, of course, but it serves as a guide to what people can expect.