How to create a fixed income stream out of an IRA.
You want a guaranteed income for retirement? I have a neat way to extract $40,000 a year for 25 years out of your IRA portfolio. It will appeal to any investor who is both cost-conscious and conservative. It would function as a safe anchor in your retirement plan, enabling you to be more daring with the rest of your assets.
My proposed annuity consists of what’s called a bond ladder, a collection of Treasury bonds with staggered maturity dates. It acts something like a fixed immediate annuity you’d buy from an insurance company, but it has more security and much lower fees.
With an insurance company annuity you can put down a sum, like $100,000, at age 70, when your IRA has to start distributions. In return you’d get a fixed monthly amount, like $500, for as long as you live. There’s much to be said for annuitizing your retirement account, but there are several drawbacks to this insurance product.
The Portfolio That Spits Out $40,000 A Year
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One problem is that you might die young, long before you have recovered your principal. Insurance companies let you eliminate this risk with a refund feature that continues payments for your heirs until $100,000 has come out. But they don’t give you this feature for free. To pay fot it they cut your monthly payout.
The next drawback is a big one: lack of access to principal. Once you’ve started the monthly payments, you can’t get out of the annuity. Annuitize your whole wad and you can’t handle a financial emergency.
Another downside to a commercial annuity: the remote but palpable risk the insurer will go bust. Yet another: the significant chunk of your money diverted into overhead and sales commissions.
The Treasury portfolio bypasses all four of these problems. When you turn 70 you buy 25 bonds with maturities from one to 25 years away (see table above). The amounts are calculated to deliver, via coupons and maturing principal, a level annual payout.
The table tells you exactly what to buy in order to get 25 paychecks of $40,000 each. Total cost for this guaranteed distribution: $731,000. Start at 70 and you’ve got an income stream that lasts until you’re 95.
Let’s see how the objections to annuities are answered here. Die young? No problem for your heirs. They can sell the bonds. Access to principal? Excellent. You can change your mind the next day and sell the bonds.
Risk the federal government will default? Small, I’d say. There’s price risk in the bonds—a rise in interest rates will send the value of your portfolio down—but you can look the other way and just pocket the $40,000 a year you bargained for. Rising interest rates, by the way, do just as much damage to the value of an insurance company annuity, but you can’t see that because you can’t sell the thing.
Lastly, we have fees to contend with. For a Treasury portfolio they take the form of a markup over the value of a bond when you buy it. How much?
In the $14 trillion market for Treasury paper those markups are tiny.
I inspected the bid/ask spreads displayed by Fidelity Investments for the 25 bonds I’m recommending. Fidelity charges no commissions on Treasury bonds; your damage on a round-trip trade is the spread maintained by the market makers Fidelity deals with. For a one-way buy or sell, the damage is half that.
Most of the posted spreads at Fidelity are for trades of a minimum 200 bonds, which is to say, a single purchase or sale of a security with a $200,000 face value. They are low for recently issued coupon bonds (with coupons between 1% and 4%), somewhat higher for bonds that came out a while back bearing coupons of 4% to 7%, and considerably higher for zero-coupon bonds.
To keep your costs down, I selected the most liquid issues for the portfolio and resorted to zeros only for a few years that don’t have maturing bonds of the coupon variety. Result: For this portfolio the posted asked prices average a tiny 0.05% increment above the mid-point of the bid/ask spread.
Unless you’re a big spender, though, you’re not going to be putting $200,000 into each position. What happens to people who are investing less? To answer this question I opened up an order ticket for the last bond on my list, enabling me to look at the “depth of book” detail from the market makers.
That order book showed a price of 98.492 for a minimum 200-bond trade and 98.507 for a buy as small as 25 bonds. I put in an order for $38,000 worth of the issue with a limit price of 98.507. It was instantly executed at the quoted price. So I paid $5.70 above the posted ask price for my fling with the federal government.
I didn’t have enough uninvested cash sitting around to experiment with all 25 recommendations, but I am persuaded that acquiring Treasurys is cost-effective for retirees with wealth well short of Warren Buffett’s. Extrapolating to the full portfolio and converting price markups into losses in yield, I calculate that that this $731,000 portfolio has an annualized 1 basis point of cost built into it. (Meaning: $1 a year for every $10,000 invested.)
That’s damn good. A cheap bond fund is going to cost you five times as much. Remember, too, that a bond fund never matures, so there’s no guarantee you’ll be able to pull $40,000 a year out of it for 25 years. If interest rates go up and stay up you’ll run dry before 2042.
The cash stream from my portfolio is lumpy, with big checks usually coming toward the end of the calendar year. The year-to-year variation is small, with a low payout of $39,440 and a high of $40,763. The cumulative payout is $1,000,260.
The stream is quite adequate to keep the IRS off your back. Required minimum distributions from an IRA starting at $731,000 would peak at $28,400 if interest rates stay put. If rates fall the RMD would be a tad higher in some years.
That’s the bullish case for a Treasury ladder. What’s not to like?
One problem is inflation. You’re guaranteed $40,000 every year but not the ability to buy a cup of coffee with it. You have that problem with any fixed annuity. You have it with any bond fund that doesn’t own low-yielding inflation-protected Treasurys.
The other matter is that you may live beyond age 95.
Deal with these issues by investing other assets in a different fashion. Say you have a $1 million IRA. Put $731,000 into my ladder and $269,000 into growth stocks. If the stocks crash next year you can shrug because you have your guaranteed $40,000 for a long time. If you’re still alive in 2042 your stocks will probably be worth a lot more than $269,000.
And what if your IRA is shy of $1 million? The smaller your pile, the more you are going to pay, in basis points of lost yield, to assemble a bond portfolio. Retirees well short of the seven-figure mark should own a mix of cheap index funds.
Here are some good ones: Vanguard Total Bond Market (BND, 0.05% expense ratio); Schwab U.S. Aggregate Bond (SCHZ, 0.05%); iShares Core U.S. Aggregate Bond (AGG, 0.05%); iShares Core S&P Total Stock Market (ITOT, 0.03%); Vanguard Total Stock Market (VTI, 0.04%); Schwab U.S. Broad Market (SCHB,0.03%).
Note: The Fidelity site may or may not be the best out there for Treasury traders. I’d like to hear from readers about their experiences trading bonds. Post a comment on this story or send a note to williambaldwinfinance-at-gmail-dot-com.
Originally published at Forbes