Constructing a portfolio that can withstand the uncertainties of retirement—unpredictable market conditions and inflation, potentially lumpy spending, and an unknowable duration—is one of the most complicated challenges in investing.
In this excerpt from my new book, How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement, I asked author and investment expert William Bernstein to discuss how retirees can craft a portfolio to meet their spending needs without running the risk of premature depletion. Bill is ideally suited to the task: Some of his best-known writing relates to asset allocation, and his first book, The Intelligent Asset Allocator, remains a modern classic.
Christine Benz: If we were to think of a base case of a 65-year-old with a spending rate of 4% and a self-professed moderate risk tolerance, how would such an individual approach constructing a portfolio for retirement?
Bill Bernstein: The single most important thing that a person in that situation should do, since they’re at risk of running out of money if they invest too aggressively, is to invest relatively conservatively. The bedrock of their portfolio should be something that approximates a TIPS ladder, a portfolio of Treasury Inflation-Protected Securities that matures in such a fashion that it pays off their liabilities every year.
Let’s say that you have a person who needs $70,000 a year to live and is getting $30,000 a year in Social Security. Social Security provides a real payoff because the amount you receive increases with inflation. So they have to pay off that $40,000 deficit every single year, ideally. I say “ideally” because it’s hard to realize perfectly in the real world. They want to have $40,000 worth of TIPS maturing every single year for the next 30 years, because that’s as far out as TIPS go.
They need $1.2m worth of TIPS—30 years times the $40,000 they need per year. That should be the bedrock of their portfolio. I’m not saying to put it all in TIPS. It’s not a problem to layer some stocks and nominal bonds on top of that as well.
Christine: Can you discuss why you’re so enthusiastic about TIPS? What are the key attractions?
Bill: The key attraction is that they protect you against inflation. It’s right in the name of the security. If you look at economic history and financial history, the biggest risk to any investor in almost any era in almost any country is inflation. Even the United States, which has done fairly well with inflation over the past 100 years, had some really scary periods after World War I and also during the 1970s, when nominal bonds came to be referred to as “certificates of confiscation.” You would buy your bond and then, when it matured in 20 years, you were left with only 35 cents on the dollar due to the impact of inflation.
Christine: Will there be times when it would not make sense to invest in TIPS? For example, real yields on TIPS were negative not so long ago.
Bill: One of the nice things about financial history is its cyclicity. From time to time central bankers will want to stimulate the economy, and so they lower real interest rates, which is what we saw until 2022, before which the five-year TIPS yield hit a low of minus 1.9%. I would not be buying TIPS at those yields. On the other hand, you almost inevitably run into periods when the central banks want to take away the punch bowl, during which you’ll see yields that are pretty darn attractive.
Christine: Not to get too in the weeds on TIPS, but I generally like the idea of using funds instead of individual bonds, especially for individual do-it-yourself investors. Funds are just so much simpler. Is a TIPS fund a reasonable alternative to the laddered TIPS portfolio?
Bill: It’s a reasonable alternative, but I don’t think it’s as appealing as having a ladder that matures every year. With TIPS funds you basically want the average maturity to be roughly half of your life expectancy. [Average maturity refers to the average amount of time in which the bonds in the portfolio will mature.] Let’s say you have a 30-year life expectancy. Well, you want your TIPS fund to have an average maturity of roughly 15 years. The problem with that is that most of the low-cost TIPS funds have maturities of about seven or eight years. The longer-maturity TIPS funds are expensive. The way to address that would be sort of a hybrid approach: Buy a long-term TIPS fund and a shorter-term one.
Christine: It sounds like you think addressing inflation and preserving purchasing power are the main jobs for retirement portfolios. You’re obviously enthusiastic about TIPS, but are there any other assets that you would suggest that retirees bring into their plans to help address inflation as a risk factor? Do stocks do…
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