Build your own inflation-protected pension
An inflation-indexed or cost-of-living-adjusted pension or annuity can be purchased from an insurance company in order to convert a lump sum of cash into a steady stream of income whose value is adjusted to provide constant purchasing power. Depending on the terms, a pension may pay out until the end of your life, your survivor's life, or a fixed period. Some pensions provide a lower fixed income in return for a guaranteed minimum payment period, so that your heirs will receive some benefit if you die early on after purchasing the pension.
An alternative to these kinds of pensions or anniuties, is to cut out the middleman and do it yourself by purchasing a series or 'ladder' of bonds, carefully chosen such that they will provide the income you need at the time you need it. Some government bonds such as eTIBs in Australia or TIPS in the United States provide inflation protection similar to an inflation-indexed pension, in fact these securities often make up a substantial portion of what insurance companies offering such pensions invest in.
This tool will help you identify which eTIBs may be purchased to build an inflation-protected income ladder. You can then compare the cost and benefits of this ladder to a pension product offered by an insurance company. Further details on the mechanics of eTIBs are described below.
eTIBs, or 'Exchange-Traded Treasury Indexed Bonds' are securities issued by the Australian Government, whose Face value is adjusted for movements in the Consumer Price Index (CPI). They make coupon payments quarterly, a fixed a percentage of the CPI-adjusted Face Value, as well as paying the CPI-adjusted Face Value back to the investor at the time of the bond's maturity. A ladder of eTIBs allows an investor to overcome the problems of credit risk, inflation risk and interest rate risk normally associated with fixed-income investments.
Unlike corporate bonds, or term deposits purchased from a bank or credit union, Treasury Bonds do not suffer from Credit Risk, which is the risk that the issuer of the bond (the borrower), will default. The Australian Government guarantees the payments due to investors in Treasury Bonds.
Unlike Nominal Bonds, the standard type of bond, eTIBs have their Face Value adjusted according to inflation, as measured by the CPI. This eliminates one of the major risks in holding traditional bonds, which is that inflation will outpace the rate of return on your bond, decreasing the holder's purchasing power. There are very few securitised investment products available that prodvide such inflation-protection guarantees.
By purchasing a ladder, or series, of bonds, as opposed to a traditional bond fund, you also eliminate the effects of interest rate risk on your bond portfolio. A bond fund's net asset value (NAV) will decline in the case of a rise in interest rates, which might leave you unable to meet your income needs. Purchasing a ladder of individual bonds allows you to meet your liabilities precisely, so you don't have to care or worry about the bond's NAV, instead you hold each bond to maturity, and you know in advance precisely how much capital you will receie.
Two disadvantages of buying an eTIB ladder over a traditional pension are the lack of longevity insurance and mortaility credits. A pension may offer you inflation protected income for life, whereas a ladder can only provide that protection up to the maturity date of the longest bond in your portfolio. Conversly, by giving up a lump sum that pays only until your death, an insurance comapny may be able to offer you more income for your premium, since some insured persons will die earlier than others, and their unused preimums can be used to fund the survivors' incomes. If you are not concerned about passing assets on to heirs if you die early, a pension is likely to give you a better lifetime payout than a bond ladder.
eTIBs are available from any brokerage account with access to the Australian Stock Exchange (ASX), including Self-Managed Superannuation Funds (SMSFs).
This content is provided for informational purposes only and does not constitute financial advice. It does not take into account your individual objectives, financial situation or specific needs.
This tool developed by David G. Claridge. Source code on GitHub. Commentary on HackerNews.