The Cambridge Safety Net: Laddered Treasury Strips
Capital preservation is a major concern of most people as
they near retirement. Clients tell us that they want to make sure they don’t run
out of money. This is the main reason many people avoid investing in the stock market
after they retire.
A key concept of the Cambridge Systems is Functional Asset
Allocation. According to this concept, the function of ‘interest earning’ investments
in a portfolio is capital preservation. Interest earning investments protect the
portfolio from deflation. The recommended proportion of assets in this category
depends on where the client is in the Cambridge Financial Life Cycle, and increases
in later stages of life.
One of the most popular investment approaches we use with
clients approaching retirement is to build a ladder of Stripped Treasuries. This
article will discuss how this strategy works, its advantages and disadvantages,
and alternatives when this is not appropriate from a tax standpoint.
What Is A Laddered Stripped Treasury?
First, an explanation of what ‘Laddered Stripped Treasuries’
are. Treasuries are I.O.U.’s (i.e., bonds, notes and bills) issued by the U.S. Government.
They are globally traded, and are considered to be the safest investment in the
world which is why they carry a very low rate of interest relative to other bonds.
They are available with maturities of one month to thirty years, and normally pay
out interest every six months. Denominations generally are available in $1,000 increments
starting at $10,000.
‘Stripped Treasuries’ are Treasury securities that pay out
no interest, but are sold at a discount from their face value and at maturity can
be cashed in at face value. This type of bond is sometimes called a ‘zero-coupon
bond.’ In effect, the interest earned is reinvested instead of paid out. The advantage
of this is that the interest doesn’t have to be reinvested every six months, but
automatically earns the rate of the original bond.
For example, at this time the ‘Long Bond’ (i.e. 30 year treasury
bonds) are paying just over six percent interest per year. Shorter term bond usually
pay a somewhat lower rate of interest. So for the sake of our example, say that
12 year bonds are paying exactly 6%. So, if you bought a regular Treasury bond for
$10,000, you would get $300 interest paid to you every six months (or $600 per year).
Since money invested at 6% doubles in 12 years, instead of
buying a regular bond, you could buy a Stripped Treasury with a face value of $20,000
due 12 years from now for the same $10,000. Although no interest will be paid, the
discount you get when you purchase the bond insures that you will earn a 6% compounded
rate for the life of the bond.
A ‘bond ladder’ refers to a series of bonds which are bought
with sequential maturities, so that a bond matures every year. Laddering stripped
treasuries provides a cash flow that is guaranteed by the U.S. government.
In designing portfolios for clients approaching retirement,
the most important thing is to make sure they will not run out of money. So we have
to determine how much they need to live on per year, and how much of this will come
from pensions and Social Security. The rest can be guaranteed by using strips as
part of a diversified portfolio.
Let’s Go Over An Example
For example, if a client needs $80,000 a year to live on,
and pension and social security payments will contribute $35,000, then we want to
have a 15 year ladder built by the time they retire which provides $35,000 per year.
At current (1998) interest rates, if the ladder starts in 2-3 years, it will take
about $350,000 to invest in the ladder today to provide this cash flow. This usually
amounts to 50-60% of a client’s investment portfolio, and the balance can be invested
in the stock market.
This combination of super-safe bonds and a well diversified
stock portfolio has averaged a combined return on average of about 8-9% over the
past 70 years. The key is that now the client has locked in an assured investment
horizon of 15 years. The ladder will be replenished during the period when the stock
market is good. Since the bonds are guaranteeing 5-6% (historical average), as long
as the stock market earns more than 5% over the fifteen year period, the client
will never run out of money.
Annual Review Is Important
Each year we determine whether to take the funds provided
from the bonds maturing in the ladder, or to take capital gains from the stock market.
In good years, the funds coming from the ladder are reinvested at the top of the
ladder where they will normally buy two years for every year that matures. When
the stock market is weak, the funds provided from the ladder are used instead of
selling stock. This assures the stocks in the portfolio are always bought low and
The critical part of this strategy is to make it tax efficient.
The best way is to invest money which is in a qualified pension plan (e.g. I.R.A.)
in the Stripped Treasury Ladder. This assures that the interest will be earned on
a tax deferred basis, and also that there will be adequate funds for minimum withdrawals
One of the key reasons to use Treasuries in the ladder is
that they are non-callable. While municipal or corporate bonds may provide a higher
yield to start with, they do not provide for long-term protection against deflation
since the issuer can ‘call’ the bond back when interest rates drop.
If a client does not have adequate funds in qualified plans
to build the total ladder, we can use insured municipal bonds up to 10 years out,
since many non-callable bonds are available for that short a maturity. Likewise,
we often recommend FDIC insured Certificates of Deposit for the first five years,
rather than Treasuries because they carry the same government guarantee and are
non-callable and pay a slightly higher yield because they are not negotiable.
When Is The Right Time To Start
We usually like to start building a client’s ladder when they
start planning for the Financial Independence stage, so that their marketable net
worth is 7-10 times their annual living expenses. At this stage, we start with a
ladder as small as 50% of their projected cash flow needs for as little as 5 years
out starting with the year they plan to stop working full time. Each year we grow
the ladder so that we have at least 7 years fully funded when the client may be
dependent on it, and continue to grow the ladder so that there is 15 years funded
when the client stops working entirely.
Over the years, this Cambridge Strategy has proved to protect
our clients in the most financially vulnerable part of their lives, while giving
them the peace of mind to really enjoy their golden years.