April 21, 2010 / 6:12 PM / 10 years ago

PersonalFinance: Building your own annuity

WASHINGTON (Reuters) - Need retirement income? You can create your own annuity with a carefully crafted mix of bonds that will “immunize” your income against market change, say experts at Asset Dedication financial consulting company.

Asset Dedication, which uses technical computer modeling to “engineer portfolios” for financial planning clients, has been working with a variety of bonds and stocks with the aim of allowing retirees to get the income they need in the short run while protecting their assets in the long run.

The theory behind their work goes something like this: Retirees need to be able to count on an income stream from their investments, but they also need to be able to grow their investments by more than they withdraw, so that their nest egg will last them a lifetime. Many advisers recommend that retirees split their money into two pots, keeping some of it in stocks that would be expected to grow over time. The other pot is often put into an immediate annuity that will guarantee a monthly payout for life. Some experts suggest foregoing the annuity and instead peeling off three to five years of spending money and keeping it liquid in a bank account or money fund.

The Asset Dedication plan, devised by company president J. Brent Burns and investment strategist Steve Huxley, builds on this theory. But instead of keeping the three-year to five-year funds completely liquid, they build a portfolio of Treasury bonds and CDs from it. The portfolio is stretched out over that time period; some of the bonds are very short term. When those first bonds mature, in six months or a year, the owner can use the proceeds as part of their spending money. That allows the investors to set aside less of their portfolio in bonds and keep more in stocks.

The longest bonds in the portfolio would not mature until the end of the three-year or five-year period. Every year the investor could take one more year’s worth of spending money and put it into the longest bonds, grabbing the highest possible safe returns for the longest amount of time.

The plan works similarly to what’s called a bond or CD ladder. Using a ladder strategy, investors start with a mix of bonds that have varying maturities. There might be a one-year, two-year, three-year, four-year and a five-year bond in the mix. As the short-term bonds mature in a laddered portfolio, they are rolled over into the long-term bonds. The Burns/Huxley plan is different because they are counting on clients actually using some of their proceeds as spending money. And because they use computer models to optimize the size and maturity of the portfolio needed to accommodate the owner’s spending needs, the maturities of the bonds in the plan might never be equally spread out over the life of the plan. It might be more likely for some very short and very long bonds to dominate.

It sounds like it all makes sense, but there are some “buts” and some considerations to this plan.

— It isn’t actually guaranteed, as an actual annuity sold by an insurance company would be. “But the risk is very, very, very, very — that’s four veries — low,” Burns said in a recent interview. The idea that the stocks could ride for 5 years or so does add likelihood that their returns would be great enough to keep buying more bond income for as long as the portfolio’s owner would live.

— Don’t try this with bond funds. Burns and Huxley stress that individual Treasury bonds are the foundation of their strategy. That’s because bond prices fall when interest rates rise. If you’re holding a bond fund and interest rates rise, the value of your fund shares could fall below the level you’d need to sustain your retirement budget. If you’re holding individual bonds and interest rates rise, the value of those individual bonds will fall, too. But you won’t have to sell them.

— You may want to wait. The higher interest rates rise, the cheaper you can buy the bond income you need, says Burns. And many economists are predicting a big increase in interest rates as the economy recovers and the Treasury has to charge more and more to finance deficits. So if you’re not already in retirement, or extremely close to it, you may want to put off buying your bond portfolio for a while.

— Certainty is good, but so is flexibility. Retirees who annuitize too much money find they have lost the ability to easily switch up the amount they spend. And while some retirement expenses, such as electric bills and rent payments, may stay the same month after month, others do not. It’s a good idea to keep enough cash on the back burner so that you can buy your next car, take that trip, or pay for long-term care needs down the road. The DIY plan outlined here would allow you more flexibility than a fixed annuity.

— Immunity only goes so far. Putting aside enough cash (or Treasuries) for the next five years does “immunize” your cash flow as Huxley points out. But not forever. If you don’t calculate the right amount to set aside in the first place, you might spend your money down faster than the stock part of the portfolio can keep up with your demand for cash in your later years. Live lean now and you can cruise later.

- Linda Stern is a freelance writer. Any opinions in the column are hers. You can follow Linda Stern's financial notes on Twitter at www.twitter.com/lindastern

Editing by Gunna Dickson

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