Questioning the Need for Bonds in Retirement

Conventional financial wisdom says that bonds should comprise an increasing percentage of a portfolio as the owner ages and heads into retirement.

In theory, a retiree’s need for income and a reduced tolerance for risk are the main drivers of the larger allocation to bonds.

A key consideration, though, is whether bonds are the best or “optimal” way to address lifetime income needs and the reduced appetite for volatility.

Circling-back yet again to a recent research paper from Wade Pfau, it turns-out that in certain instances bonds may not be needed at all during retirement.

Pfau’s research paper addresses the efficient frontier (optimal portfolio) for a hypothetical 65 year old couple. Pfau focuses on balancing what he considers the fundamental and competing retirement objectives of: a) supporting lifetime income security, and; b) maintaining some liquid reserves for legacy or unforeseen risks.

Pfau simulates and plots over 1,000 different product allocations to determine the efficient frontier for the hypothetical retirees. Readers are encouraged to have a look at the details of the case study through the link to Pfau’s blog that is above. That said, at the highest level the components of the 1,000+ product allocations consist of stocks, bonds, inflation-adjusted single premium immediate annuities (SPIA), fixed SPIAs (no inflation protection) and variable annuities with a guaranteed lifetime withdrawal benefit.

The results are very clear. The efficient frontier (the optimal portfolio for the retired couple) is comprised of stocks and fixed (again, no inflation protection) SPIAs. Stocks and partial annuitization through fixed SPIAs dominate all other portfolios.

Pfau acknowledges that the optimal product allocation is highly personalized, and that any changes in lifestyle goals, minimum spending needs, age or marital status would reshuffle the results.

Given the case study, Pfau concludes:

"there is no need for the retirees to hold bonds. SPIAS are like super bonds with no maturity dates and which boost retiree returns with mortality credits."

The conclusion makes sense since life annuities are a combination of interest (analogous to a series of zero coupon bonds), return of your own money and other people’s money.

The other people’s money part of the life annuity is the kicker in terms of the bond comparison. This is the mortality credit at work, and as Moshe Milevsky says, there is no other financial product available that guarantees such high rates of return conditional on survival.