Usefulness of Bonds in Retirement Accounts

[Vincenzo Corleone]

Hi,

With about 20 years before I can touch money in my tax-sheltered retirement accounts, I'm wondering what sort of benefit I receive by keeping a certain percentage of that money in bond funds. From what I understand, common advice is to keep a certain percentage in bonds / bond funds in order to reduce volatility (inverse correlation with stocks?). But with 20 or more years until one can touch that money, does it really matter, other than making me feel less bad when the stock market tanks? Are there additional benefits of keeping money in bonds in a retirement account that you can't touch for 20+ years? Would it not be more beneficial to put it all into (index) stock funds?

I'd appreciate your thoughts. Thanks.

 

[Chuckanut]

It matters if one is the kind of person who will panic when the next big market correction hits and sell out at or near the bottom.

Bonds, IMHO, buffer the fall and reduce the panic, thus possibly keeping one from making this tragic mistake.

OTOH, if one believes the market will eventually recover and go higher bonds, IMHO, should make up a small percentage of one's financial assets. Personally, I did very well with a GNMA fund for several decades. But, it made up maybe 20% of my assets during those years, and I held the GNMA fund following the double digit bond rates of the 70's. Not exactly today's environment.

 

[tulak]

I think it's helpful for rebalancing. If the market tanks, it's nice to have money outside of stocks to buy more stocks with.

But it's not for everyone. I did this in 2008, when I was 90/10. I went up to about 95/10 before I was done buying stocks. It sounds easy, but you really do feel like you're throwing money away. Or at least I did.

If you can stomach it, then go for it. The problem is that you really don't know if you can stomach it until you've gone through a big drop.

 

[CaliforniaMan]

FWIW I kept to 100% stock allocation in my retirement accounts throughout most of my working years with the rule to myself, that once bought could never be sold until retirement. Later I started adding in bonds to get to the allocation I wanted in retirement. I never panic sold in any downturn, so it worked out for me so far (finishing my first month of retirement now). It all really depends on if you can stick to the "rules" when all your friends and everyone on TV says the sky is falling.

 

[W2R]

Like CaliforniaMan, my asset allocation during the accumulation phase was 100% stocks, equity funds in my case. That was a gamble I was willing to make at the time.

About three years before I retired, I started buying bond funds. Bond funds are great in retirement because they reduce volatility, and produce dividends which I use for spending money.

 

[Free To Canoe]

Hi,

With about 20 years before I can touch money in my tax-sheltered retirement accounts....

The only problem is that you CAN touch these accounts. You can change allocation in bad times, like others pointed out. Also, many retirement accounts will let you take it out before 59-1/2. Will you take it out and suffer the 1,2,3,4 tax hit like I have seen many do this tax season? (1 fed tax, 2 fed tax penalty of 10% or more, 3 state tax, 4 local tax).

It is good to have emergency funds in non-retirement accounts.

 

[nash031]

I keep only a small portion (15%+/-5) of total savings in bonds:

1) I know my behavior such that I am not tempted to sell when the market tanks. I've gone through 2000s and 2008-9 without doing so, so I feel confident I can weather most any storm without making bad choices.

2) I have a pension coming (likely), so I intend to keep the bond portion relatively small throughout retirement since I have a significant "fixed income" already.

3) The small portion of bonds keeps my portfolio just stable enough to make absolutely certain I don't have a weak moment as my portfolio size grows and the potential losses in a -20% or more year grow to the 100,000s.

 

[walkinwood]

From the time I learned about AA until I closed in on ER, I had 20% in bonds. It worked for me. If you do the math, you'll see that you don't lose that much on the upside (or save that much on the downside), but there are advantages of having assets that are not correlated with equities.

In addition to the excellent points made before, a bond allocation (beyond your emergency fun) may help with your living expenses if you lose your job at the same time that the stock market tanks. In the 2008 crisis, may otherwise very employable people, were unemployed for a long time.

All the best.

 

[Vincenzo Corleone]

...a bond allocation (beyond your emergency fun) may help with your living expenses if you lose your job...

I really appreciate all of the responses. I just want to remind people that my original question related to bonds in a tax-sheltered retirement account not to be touched before reaching traditional retirement age. I agree, having money in bonds or some other safe vehicle that is taxable that can be easily tapped (i.e., non-retirement) is necessary.

 

[walkinwood]

I really appreciate all of the responses. I just want to remind people that my original question related to bonds in a tax-sheltered retirement account not to be touched before reaching traditional retirement age. I agree, having money in bonds or some other safe vehicle that is taxable that can be easily tapped (i.e., non-retirement) is necessary.

I didn't read that correctly..

If you do decide on bonds for a part of your portfolio, the tax-deferred accounts are the best place for them (tIRA, 401-K) since the dividends are taxed as income.

 

[sonomaguy]

One point sometimes overlooked for AA is how important your future earning power is...during accumulation and through your working years, you can effectively take more risk the more your future earnings will be...as your future earnings decline or go to zero (retirement)...your risk tolerance from the standpoint of being able to "rebalance" through savings, goes down. Of course there are many other factors, and aside from the AA part of the equation, keeping income producing assets in tax deferred can shield that income from taxes so often it does make the most sense to put that part of your portfolio in tax sheltered accounts.

 

[RunningBum]

I struggle with this question sometimes too. I think the idea is that if you need cash but really don't want to sell stocks but that's all you have in taxable accounts (funds you can access without penalty), you can sell stocks in your taxable account and buy corresponding stocks in your tax-deferred account. Does that make sense?

Just be careful if you have a cap loss, because if you buy the same stock (or very similar mutual fund), it is a wash sale and since you now have the asset in a tax-deferred account, you will never get the wash back.

 

[veremchuka]

Hi,

With about 20 years before I can touch money in my tax-sheltered retirement accounts, I'm wondering what sort of benefit I receive by keeping a certain percentage of that money in bond funds. From what I understand, common advice is to keep a certain percentage in bonds / bond funds in order to reduce volatility (inverse correlation with stocks?). But with 20 or more years until one can touch that money, does it really matter, other than making me feel less bad when the stock market tanks? Are there additional benefits of keeping money in bonds in a retirement account that you can't touch for 20+ years? Would it not be more beneficial to put it all into (index) stock funds?

I'd appreciate your thoughts. Thanks.

Maybe I missed it but you don't say if you are working and contributing to those retirement accounts. With 20 years to retirement you should be at least 80-90% in equities IMO. You have time, lots of time. I was 100% in equity funds until 3 years before I retired. Of course as pointed out fixed income allows you to have the ability for rebalancing and studies show that even a low allocation to either equities or fixed income is better than 100% of either.

 

[clifp]

Hi,

With about 20 years before I can touch money in my tax-sheltered retirement accounts, I'm wondering what sort of benefit I receive by keeping a certain percentage of that money in bond funds. From what I understand, common advice is to keep a certain percentage in bonds / bond funds in order to reduce volatility (inverse correlation with stocks?). But with 20 or more years until one can touch that money, does it really matter, other than making me feel less bad when the stock market tanks? Are there additional benefits of keeping money in bonds in a retirement account that you can't touch for 20+ years? Would it not be more beneficial to put it all into (index) stock funds?

I'd appreciate your thoughts. Thanks.

LOL, I can't tell you how many times I've asked myself the exact same question. But I've never thought to post it here, I am glad you did.

I do have bonds in my retirement account, almost all of them are the much discussed ISM/OSM. The rational being is it is more tax efficient to hold bonds in IRA than in a taxable account, I don't know if Spain treats dividends differently than bond interest, but in the US they are.

During the financial crisis I had a significant amount of TIPs bonds in my IRA which I sold in order to buy stocks, so in that respect I'm glad I had them.

However, I will say that if it wasn't for the tax difference between capital gain/dividends and interest I'd keep all of my bonds in a taxable account since they are more stable and I can tap into them easier.

 

[Vincenzo Corleone]

Maybe I missed it but you don't say if you are working and contributing to those retirement accounts.

Both DW and I are working and contributing the max to the retirement accounts.

studies show that even a low allocation to either equities or fixed income is better than 100% of either.

Do you know where/how I can get my hands on these studies? I'd be most interested. Thanks.

 

[mathjak107]

while the studies show 100% equities has performed just fine the part missing is that was only true if you did not take any big hits the first 5 years in .

until you went through a good up turn to build up a cushion the first 5 years could hurt you badly.

in fact the first 15 years shape your entire retirement time frame.

can you imagine having 100% equities and retiring in 2000?

14 years of sluggish markets while you are reverse dollar cost averaging by spending down would have been killer.

hense the roll of bonds, cash and annuities are to provide a base to get you through the early years.

 

[clifp]

I really appreciate all of the responses. I just want to remind people that my original question related to bonds in a tax-sheltered retirement account not to be touched before reaching traditional retirement age. I agree, having money in bonds or some other safe vehicle that is taxable that can be easily tapped (i.e., non-retirement) is necessary.

I do think people are missing this point.
You are 40. You have $1 million in taxable accounts and $1 million in an IRA and you plan on withdrawing $60-70K/year depending on what happens.
For that early of a retirement the optimal AA is something around 75/25%.
It is most efficient to have bonds in a tax deferred account.

So you have $950K in index fund and $50K in cash/living expense in your taxable account
Your IRA has $500K in total bond and $500K in domestic/international total bond markets.

It is difficult in the US and perhaps even harder in other countries to tap into the $1 million in the IRA before age 59.5.

However, stocks always outperform bonds over a 20 years (except for 1990-2010 where there was virtual tie) period. So why bother having bonds in your IRA in the first place? The lower volatility of having bonds in your IRA is off little use since you can't easily withdraw them for living expense.

 

[Vincenzo Corleone]

...However, stocks always outperform bonds over a 20 years (except for 1990-2010 where there was virtual tie) period. So why bother having bonds in your IRA in the first place? The lower volatility of having bonds in your IRA is off little use since you can't easily withdraw them for living expense.

Yes, that's exactly my point. Thanks for making it much clearer than I did.

 

[RunningBum]

Like I said yesterday, you can sell stocks in your taxable account to raise cash, while at the same time trading bonds for stocks in your tax-deferred account. The net effect is that you've sold bonds for cash, with the tax advantage of keeping income-producing bonds in a tax deferred account.

 

[veremchuka]

Do you know where/how I can get my hands on these studies? I'd be most interested. Thanks.

Gosh I can't easily point to them. I read about 10-12 different blogs per week and any of them could have had articles about this over the past 10+ years. Daunting for sure to find. Same for books I have read, studies show that a 20/80 and 30/70 e/fi perform better than 100% fi and when the markets get hit 100% e takes it hard. Larry Swedroe, Rick Feri, Allan Roth, Vanguard, the BH site Wiki are all good places to look for this info re AA.

 

[clifp]

Like I said yesterday, you can sell stocks in your taxable account to raise cash, while at the same time trading bonds for stocks in your tax-deferred account. The net effect is that you've sold bonds for cash, with the tax advantage of keeping income-producing bonds in a tax deferred account.

Let's dig a bit deeper and continue my example.
You are now 41. You spent 50K in cash plus dividends from the $950K portfolio. We had another 2008. Equities dropped 37% leaving you with $599,000 in your taxable.
In your IRA. The stocks are $315,000 and the bonds are up %7 or $535,000 Leaving you with $1,449,000 in total assets

For 2009
You decide to decrease spending $50K + ~2% dividends from the portfolio.
At the start of 2009 your taxable portfolio 50K cash $549K equity
IRA 500K equity, 340K bonds.
Overall 75/25

But here is the problem you are planning on withdrawing ~$60K a year for the next 17.5 before you can easily tap into the IRA. While your overall withdrawal rate of 4.1% is a bit high for long retirement. The 60K withdrawal (10.9%) from a $549,000 taxable portfolio looks downright crazy. The Firecalc success rate is 14.4% for 18 years

At this point I'd be heavily researching 72(t), I know I did back in early 2009.

I'd think that any tax advantage of having bonds in your IRA would be more than negated by needing to use a 72(t)

So in theory I can understand why have bond in your IRA is good idea, in practice I think it doesn't make much sense a lot of time.

 

[Animorph]

I'd be happy with today's low income bonds in a taxable account. A perfect fit for the OP case?

http://www.early-retirement.org/for...account-or-tira-spreadsheet-answer-71548.html

 

[RunningBum]

So in theory I can understand why have bond in your IRA is good idea, in practice I think it doesn't make much sense a lot of time.

I don't know about "a lot of time", but yes, it can happen, and 2008 would've been scary. As it turns out, we've probably bounced back well enough from 2008 that as long as you stayed the course you'd probably have been ok, but it would've been gut check time.

Just out of curiosity, what does Firecalc say if you put bonds in the taxable account instead in that situation? It's a pretty interesting question, does keeping bonds in tax deferred only optimize a winning hand (meaning it helps when returns are decent), but bonds in taxable help in more extreme (bad) situations when you want to survive on taxable for a number of years? I'd be willing to sacrifice a bit of gains on ideal situations to insure against a bad run. In my own case though, I've got a lot more than 50% in my taxable accounts, and just 7 years to go.

 

[clifp]

I don't know about "a lot of time", but yes, it can happen, and 2008 would've been scary. As it turns out, we've probably bounced back well enough from 2008 that as long as you stayed the course you'd probably have been ok, but it would've been gut check time.

Just out of curiosity, what does Firecalc say if you put bonds in the taxable account instead in that situation? It's a pretty interesting question, does keeping bonds in tax deferred only optimize a winning hand (meaning it helps when returns are decent), but bonds in taxable help in more extreme (bad) situations when you want to survive on taxable for a number of years? I'd be willing to sacrifice a bit of gains on ideal situations to insure against a bad run. In my own case though, I've got a lot more than 50% in my taxable accounts, and just 7 years to go.

I think you analysis is probably exactly right. Reversing it and having bonds in the taxable account has you start 2009 with 50K in cash, 410K equities 347K bonds. This gives a 55% chance of success for 18 years at 60K. Not wonderful but hell of better than 15%.

You are right 2 great, 2 good and one flat year after 2008 meant staying the course is was just fine and probably this year he could start moving spending back to $70K+

I started off at 40 with twice as much in taxable as IRA. A modest amount of GNMAs in the taxable, and 35% bonds in the IRA. Now I am 47/53 taxable/IRA and with 5.5 years to go and I don't care so I am happy to have all my bonds in my IRA and just CDs in taxable.

I think the moral of the story is that folks retiring before 50 with significant tax deferred assets, really need to treat the pools separately. Make one run until 59.5 and make sure it is reasonably survivable before loading up the bonds in the IRA. Be prepared for some mid course corrections.

 

[pb4uski]

Like I said yesterday, you can sell stocks in your taxable account to raise cash, while at the same time trading bonds for stocks in your tax-deferred account. The net effect is that you've sold bonds for cash, with the tax advantage of keeping income-producing bonds in a tax deferred account.

That's exactly what I do. I sell bonds in my taxable account to increase my cash and then sell bonds and use the proceeds to buy stocks in my tax-deferred account. The net effect is to sell bonds and generate cash since the stock trades offset.