Using A Bond Ladder To Provide RMD "Insurance"

Sep. 25, 2013 9:06 AM ETVTI, AGG2 Comments
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Contributor Since 2013

In my last post, I summarized the situation of Edna, a retiree in her early 70s who has just started making annual RMDs from her IRA. She does not have an immediate need for the income generated by these required distributions. Her very simple IRA consists of two ETFs: 50% Vanguard Total Stock Market (VTI) and 50% iShares Core Total Bond Market (AGG).

Two of Edna's concerns are the following:

  • Even under favorable assumptions, if she keeps the same asset allocation, she will be selling investments at an increasing pace, since required distributions will rise as dividend income falls.
  • Her assumptions are bound to be wrong. Markets cycle. If she is taking distributions in a bear market, she will have to sell ETFs that have already declined in value.

There are several things that Edna could consider at this point. She could reallocate her money to individual dividend paying stocks; she could purchase ETFs with an income tilt; she could just do nothing and hope that VTI is up in years that AGG is down, and vice versa; or she could increase her cash allocation, reasoning that even if her income doesn't keep up with her RMDs, she would be limiting her losses; or she could do any combination of these steps.

I believe that part of the solution for Edna might be something that I seldom read about on SA: a bond ladder. I was taught in school that you should match duration with the timing of expected expenditures; and that bonds, held until maturity, are good vehicles for intermediate term savings, which is what Edna needs.

Edna could purchase five bond issues, each with a principal amount of $20,000, with durations ranging from one to five years. The bonds that I selected have ratings of AA, AA+, and AAA. Average yield on this portfolio would be 1.54%. Each year, Edna can choose to do one of two things, depending on how her ETFs have performed over the previous year:

  • Sell one of her ETFs to provide funds for her RMD, and roll the expiring bond into a new five year bond.
  • Use proceeds from the expiring bond for her RMD (along with dividend and interest income earned during the year). Wait for a future opportunity to liquidate one of her ETFs.

This strategy would minimize the impact of really lousy markets by allowing Edna to meet most or all of her RMD needs without having to sell investments into a down market.

It is worth noting that a 65-year-old could implement the same strategy using bonds with durations between six and ten years (since the first RMD is five or six years away). I was able to select bonds with an average yield of 3.04% for this strategy; again, all were rated at least AA.

Here are the bonds that I found on the Schwab website a couple of days ago:

For the shorter maturity ladder:

Maturity date Issuer yield rating princ amt 2014 interest
1/9/2015 GE Capital 0.59% AA+ $20,000 $118.00
5/15/2016 J&J 0.85% AAA 20000 $169.00
1/31/2017 Berksh Hth 1.57% AA 20000 $313.20
5/3/2018 Apple 2.17% AA+ 20000 $434.60
3/15/2019 Pfizer 2.55% AA 20000 $509.00

For the longer ladder:

Maturity date Issuer yield rating princ amt 2014 interest
5/15/2018 GE Cap 2.66% AA+ $20,000.00 $532.00
3/15/2019 Pfizer 2.55% AA $20,000.00 $509.00
1/8/2020 GE Cap 3.44% AA+ $20,000.00 $688.00
1/15/2021 Berksh Hth 3.39% AA $20,000.00 $678.60
8/15/2021 Mobil Corp 3.15% AAA $20,000.00 $629.60

Comments are welcomed and appreciated.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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