Better than Bonds

Although bonds give a terrible return compared to stocks, the traditional advice has been to hold lots of them. A "traditional" portfolio contained 60% stocks, 40% bonds. Or you would be "lifestyled" into bonds gradually as you approached retirement - with some pension companies starting that process as early as your twenties (I'm looking at you, Nest!). 

That gives one hell of a dent to your performance. Why do it? What were people afraid of? Well, it comes back to the big problem with the stock market - its volatility, and the possibility that you retire right before a crash that then lingers for years with subdued prices and no returns.

The logic ran that bonds would tend to react in the opposite way to stocks. When stocks crashed, bonds would bounce up, providing a counterbalance which would smooth away your volatility.

The elephant in the room was this whopping 40% of your portfolio which was doing nothing the rest of the time. You needed far more stocks in order to be able to retire, which led to working for more years... a big mess, if you ask me.

Even worse, bonds now seem to be broken. That opposite action to stocks during a crash hasn't really happened during the most recent crashes. Ever since central banks took to printing money to get out of trouble ("quantitative easing") the bond markets seem wise to the fact that governments are trying to scam them, and bonds haven't bounced up as expected.

I think bonds are an awful thing to do to your portfolio (but then I am an avid owner), and this leads me to look for alternatives.

The Alternatives

There are three obvious alternatives to holding bonds continually.

1) Hold bonds short-term, whilst needed.

2) Go into retirement with a cash buffer.

3) Flex your spending.

The logic to each of these will become clearer if we have a look at the actual risk we're trying to manage...

Bonds are a blunt instrument to deal with "sequence of returns risk". This means the risk that a stock market crash comes along soon after you retire and wipes out enough of your portfolio that your drawings cause damage from which it will never recover.

We try to guard against this risk, to a degree, by applying a safety margin to our drawdowns. Earnings and typical growth are about 10% per year, and of that we start by leaving in 3% to cover inflation. We could theoretically go out and spend the remaining 7% each year forever, but in fact we play it safe and try to draw just 4%. This jiggle factor is an attempt to account for the stock market dips which come along all the time. And this'll work, with normal run-of-the-mill dips. 

If the big one comes along, and prices stay subdued for a number of years (instead of the more common profile of a crash which sees a recovery within months), then this may not be enough. We will spend years withdrawing an effective higher rate than our safe 4% and perhaps higher than our actual 7% of earnings.

Conversely, if we get a few "normal" years after we retire, the difference between those 7% earnings and our 4% spending starts to add up and our portfolio grows. Our withdrawals reduce, as a proportion of this now larger pot, and over time a 4% withdrawal rate turns into a 3.5% withdrawal rate. If we were to encounter a bad crash now, we are much safer. Few crashes would ever have wiped out someone using a 3.5% withdrawal rate.

Let's take a look at those three solutions.

Bonds - in the short-term. The usual way to do this is to create a "gilts ladder". Gilts are UK government bonds, and you can buy short-dated ones which will pay out in a matter of months. You still earn a little on them, but they're safe as houses. I could buy one which matures next January, another one which matures next April, and so on, to build myself a series of dollops of income which will drop every few months over the next couple of years. By using these I'll not need to dig into my main portfolio for income, or at least not much, and I'm still holding an asset which earns me at least some return in the meantime.

A cash buffer. This works in a similar way - I'd move a chunk of money from stocks and into cash, which earns me some interest but ultimately it's safely waiting there to be spent.

Flexible spending. This one works well if your retirement plan includes some excess over and above your core spending needs. With flexing you leave the money invested in nice productive stocks, and you say I shall reduce my spending whenever the market is badly down. If your original withdrawal rate was 4% and then in a crisis you are able to cut it to 3.5% or 3%, we're back in extremely safe territory where few historic crashes would have killed a portfolio.

Which is best?

I like any solution which only takes you out of a full allocation in stocks on a temporary basis. In practice, probably a combination of some of these approaches will appeal to most people. Flexing certainly fits with our natural instincts during a crash, to draw our claws in and halt unneccessary spending. A cash buffer or gilts ladder brings some certainty of income. (Though it is unclear whether continually topping up a buffer once retired would bring any further benefits.)

The main thing is that you don't feel that you must automatically abandon your stocks and buy bonds permanently. There are good alternatives which can be used instead.