How to Use Bond Ladders for Retirement Income

Bond ladders are a form of asset-liability matching.

Bond ladders can work well for retirement cash flow needs. Martin Barraud/Getty Images

To build a bond ladder, you purchase bonds (individual bonds not bond funds) in your account so that the maturity dates of the bonds are staggered, or laddered, across a specified period of time. Sometimes this is called asset-liability matching, meaning you have an expense coming up (such as a year's worth of retirement spending) so you buy an asset (a bond) that will be available to meet that expense when it occurs.

Bond Ladders to Meet Cash Flow Needs

In retirement, bond ladders can be used quite effectively to provide the funds needed for retirement expenses each year. For example, a conservative person might take their entire portfolio and buy individual bonds so that bonds mature each year for the next thirty years to meet their cash flow needs. This would be a thirty year bond ladder. A less conservative person might use a bond ladder to meet only the first five to ten years of expenses as described in the next section.

Bond Ladders as Part of a Balanced Portfolio

Suppose you are an investor with a moderate risk tolerance, retiring with $1 million. You might take $400,000, or 40% of your portfolio, and buy eight bonds with a face value of $50,000 each. The first bond would mature in one year, the next would mature in two years, the next in three years, and so forth, thus laddering the bond portfolio over an eight year period.

This is a simplified example, but it gives you a general idea of how it works.

The remaining $600,000 would be invested in stocks (equities preferably in the form of index funds) to make up the growth portion of your portfolio. Eight years later, if stocks averaged an 7% rate of return, the $600,000 would grow to just over $1 million, allowing you to sell $500,000 of stocks to create another bond ladder.

The Practical Application of a Bond Ladder

There are several practical aspects that must be considered when using bond ladders such as:

  • the credit quality of the bonds you buy
  • the tax characteristic of the interest income
  • what account you buy the bonds in (IRA, non-IRA for example)
  • within your portfolio, how to account for and use the interest the bonds produce before their maturity year
  • the brokerage service or account that can facilitate the purchase of the bonds
  • when to harvest the growth portion of your portfolio

Because of the complexity of the items above, many experienced investment professionals consider bond buying much more challenging than buying stocks. I agree. When building bond ladders for my clients I work in partnership with a firm that has this expertise.

As far as harvesting the growth portion of your portfolio, using our example above, it is not likely you would actually wait eight years before selling off stocks to ladder out more bonds. Instead, in years with strong stock market returns, you would sell equities, and add bonds to the end of your bond ladder.

In years with poor stock market returns, you would not sell equities. If you had several years of poor stock market returns, you may get down to a point of having only two to three years of laddered bonds left.

That’s ok, as the point of creating the bond ladder is so you have safe investments to meet near term cash flow needs and thus are not forced to sell equities in a down market.

What About Bond Prices When Interest Rates Go Up?

Existing bond prices typically go down when interest rates go up. This is a fact. When thinking about this, keep in mind that owning an individual bond is different than owning a bond mutual fund. If you are using individual bonds to form an asset-liability matched portfolio then when the bond matures you will spend the principal value. Although the price of the bond will fluctuate prior to maturity, as long as you hold it to maturity, those fluctuations are not relevant to you. When the bond matures you know the amount of money you will receive regardless of the movement of interest rates.

If you sell the bond before its maturity date you may get more or less than the initial price of the bond.

Alternatives to a Bond Ladder

In lieu of a bond ladder, you could create a CD ladder, with certificates of deposit maturing each year to meet cash flow needs. It may be beneficial to price both CD’s and bonds for any given time frame to determine which would give you the highest yield.

You could also use a fixed annuity, instead of a bond or CD, as part of your ladder. Again, you would want to determine which investment, or combination of investments, would provide you with highest yield for any given maturity date.