Why Bonds Are the Best Asset Class to Hold in Retirement Accounts
While there is no shortage of ways you could prepare for retirement, it’s tough to argue that there’s a better asset class for your money than bonds.
Below, we’ll explain why and how to begin using them to ensure you have comfortable golden years ahead.
A Distinction Between Bonds and Bond Funds
Before we go any further, I want to be clear that I am talking about bonds in this article. Bond funds are a completely different asset class, and I do not hold them in the same esteem as far as retirement (or any kind of savings) goes.
The main reason for this is that this asset class may take losses to the principle amount invested. That’s because the majority of these funds never mature.
While bond funds are a great asset class for diversification and they come with some degree of oversight from professional investors (this can also lead to greater flexibility regarding changing funds), bond are a much better choice for retirement accounts, as we’re about to illustrate.
Bonds Are a Great Asset Class for Control
There are a number of benefits I could list for bonds as a retirement asset class. However, for the sake of this piece, let’s begin with the issue of control.
With individual bonds, you can control coupon payments in terms of how much and when they happen. You can also control the timing regarding the return on principal.
Even more important, you can ladder individual bonds. Bond ladders are something I’ve brought up before. It’s a big reason I love this asset class for retirement accounts.
Basically, while you can sell individual bonds whenever you want (an advantage that could lead to gains), laddering gives you an ongoing source of income that continues to build until you’re ready to retire.
Essentially, this entails having a set amount of bonds that will expire every month over an established set of years. Each time bonds mature, you roll them forward automatically.
The two primary benefits of this approach are that, first, you never get locked into a single type of bond for any extended period of time.While I’m obviously a big fan of this asset class, that doesn’t mean blindly holding onto the same choice no matter what happens.
Doing this will greatly limit your potential for liquidity and security. If the market shifts, you’ll be unable to capitalize on this opportunity.
Second, using a ladder with this asset class gives you the advantage of flexibility. A lot can change between now and retirement. As your financial needs change, you can adapt accordingly.
Access to greater liquidity also means that if something unforeseen were to happen – like you lost your job or were sued – you could quickly access the required funds from this asset class.
Using Bonds as an Anchor
The potential benefits that can be realized by using a bond ladder are hopefully clear, but there are even more reasons to love this asset class as a retirement vehicle. Another is that bonds work well as anchors.
In the event of deflation – which is a definite possibility between now and when you retire – bonds will most likely come to your aid. When deflation occurs, most investors flee from stocks and look for much safer places to keep their money, namely, bonds.
Amongst other things, there’s the possibility of getting paid out a fixed income stream which will actually increase in value as prices fall.
Using an IRA to Hold Bonds
By now, it should be clear why this asset class is perfect for those looking to save for retirement. However, don’t go out and start putting your money into bonds before you know what you’re doing.
One major consideration is how you’re going to hold these bonds. As we’ve already covered, bond funds leave a lot to be desired where the purpose of this piece is concerned.
Instead, we recommend IRAs. For one thing, they’re tax-deferred. Otherwise, any income that you earn from bonds will take a much bigger hit from Uncle Sam.
For example, if you’re in the 25% tax bracket, an investment that returns 4% will actually only pay out at 3%; that’s a significant loss. This is why you want an asset class with returns that are taxed like ordinary income to be held in IRAs.
Otherwise, you’re throwing money away – money that should be used on your comfortable retirement.
Due to this and other reasons, a fixed income IRA to buy bonds makes a lot of sense for your retirement savings.
Understanding Asset Allocation
Finally, let’s end with the next step you should take to put this asset class to work for your needs. Simply put, you have to begin by thinking about asset allocation. As Sam Dogen at Market Samurai puts it:
“There is no “correct” asset allocation by age. But there is an optimal asset allocation I’d like to share in this post. Your asset allocation between stocks and bonds depends on your risk tolerance. Are you risk averse, moderate, or risk loving?”
For most people, the younger they are, the more risk-tolerant they’ll be. This is because, worst case scenario, they have time to rebuild their savings. Those who are closer to retirement have more to lose and less time to make it up.
Dogen later goes on to advise putting oneself through the following questionnaire before deciding on what kind of asset allocation you’ll take with bonds:
“I encourage everyone to take a proactive approach to their retirement portfolios. Ask yourself the following questions to determine which asset allocation model is right for you:
- What is my risk tolerance on a scale of 0-10?
- If my portfolio dropped 50% in one year, will I be financially OK?
- How stable is my primary income source?
- How many income streams do I have?
- Do I have an X Factor?
- What is my money strength?
- What is my knowledge about stocks and bonds?
- How long is my investment horizon?
- Where do I get my investment advice and what is the quality of such advice?”
Again, the relative merits of bonds will be different for everyone depending on where you’re at with your finances. However, if retirement is your primary focus, then they should become a priority. You should only use the above to help inform your decision about how much to invest in them.
It’s never too soon to begin thinking about retirement. Don’t make the mistake of simply buying stocks, though. For that matter, blindly throwing money at bonds is no better. Use the above to help properly plan for this important time in your life.