Yellowstone Financial, Inc.

New Ways to Secure Financial Independence

Do you worry about being able to pay for retirement? Going from the accumulation stage when you’re salting money away into your 401(k) to the distribution stage when you’re withdrawing funds is a stressful transition. Even those with ample financial resources have concerns about a disappearing paycheck.

A salve to this stress is a defined benefit pension that pays a fixed amount for the rest of the retiree’s life. In my experience, those with pensions have a noticeably higher level of security regardless of market conditions. Of course, most of us qualify for an inflation-adjusted pension called Social Security. Unfortunately, for most affluent retirees it only begins to cover living expenses.

If having predictable cash flow sounds appealing, there are a few new options to consider. While annuities may be the most traditional (and often costly) approach and high-yield stocks have their devotees, a bond ladder is ideal to provide steady income.

The concept is simple. Let’s say you want to guarantee 15 years of retirement income starting in 2014. You purchase individual bonds that mature in 2014, 2015 and so on. Each year you receive the face value of the bond if all goes well.

The issue is that purchasing individual bonds can involve concentrated credit risk with corporates or municipals. You could rely on Moody’s and the other ratings agencies for guidance, but that didn’t pay off so well for Mortgage Backed Securities holders that saw their AAA holdings quickly depreciate into nickels on the dollar a few years ago.

While munis have better track records, state and local governments have been under budgetary pressure. Also, corporates and especially munis can have high transaction costs passed on through a typically large bid-ask price spread.

Bond ladder believers would have to purchase many bonds for each rung of the ladder, an unworkable approach, for adequate diversification. The traditional answer is a Treasury bond ladder. Transaction costs are lower and diversification within each rung is not needed. Unfortunately, short to intermediate term Treasuries are yielding historically paltry rates — about 1.4 percent for a Five Year Note.

An important development is the spate of new diversified municipal and corporate bond mutual funds and ETFs with targeted maturity dates. Traditional bond funds generally try to keep a steady average maturity among their holdings. Each year the bond fund has holdings that mature and therefore is forced to purchase new bonds to keep its average maturity consistent with its target. If you seek a fund made up of bonds that mature in a single year, you have largely been out of luck.

Now one of the largest ETF providers, iShares, has released a series of ETFs made up of municipal bonds that mature in a given year. One example is the iShares 2016 Muni Fund (Ticker: MUAE) that holds munis maturing in that year. Given that munis generate tax-free income, even for those in the AMT, this beats Treasuries, albeit with more risk.

Guggenheim Bulletshares offer a similar product made up of corporate bonds, such as the 2016 Corporate Bond Fund (Ticker: BSCG). It yields almost 3 percent annually. Fidelity is getting into the game with its new series of mutual funds including Fidelity Municipal Income 2017 (Ticker: FMIFX).

Are these recommended? My take is to wait a bit longer for these products to mature. The ETFs generally trade at a premium and have high bid-ask spreads sometimes exceeding 3 percent as the market is relatively thin.

The Fidelity mutual funds don’t have this problem, but are brand-new. The funds are relatively small and may lack the diversification that we have come to expect from bond funds.

Nevertheless, targeted maturity bond funds and ETFs hold significant promise as a category. As they improve they could be a key part in building your secure retirement.

Dave Gardner, for the Daily Camera.