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The “Three Lines of Defense Strategy” is a retirement income planning framework developed by Nested Interest. It involves breaking down income needs over three different time horizons, and matching these needs to an appropriate financial vehicle to meet them.
The three time horizons, and financial products to meet their associated income need, are as follows:
“First Line of Defense” – 1 Year – Needs for income over the next year require highly liquid investments with minimal risk of principal. This “first line of defense” is typically backed by a combination of income from annuities, pensions, social security, and wages; to the extent that these sources of income are not sufficient to provide for anticipated spending during this period, the different is funded by cash.
“Second Line of Defense” – 2 to 5 Years – Income needs for this period require some degree of liquidity, but are also in high need for inflation protection. TIPs, purchased under a ladder arrangement so that the timing of maturities are aligned with your income needs, are a preferred investment for this period.
“Third Line of Defense” – Years 6 and later – Your income needs for this later period can accommodate more investment risk than the income needs associated with the first two lines of defense; in addition, longevity risk is associated with this time period. Financial products used to meet this income need include immediate annuities, growth oriented stocks and bonds, possibly with some degree of market protection from put options or a collar.
The Dynamic Nature of Three Lines of Defense
The three lines of defense strategy is NOT a static, buy and hold arrangement. Each year, the portfolio is re-calibrated to reflect the change in future needs – for example, what was previously a need in 5 years a year ago is now a need in 4 years, etc.
As a result, the strategy should be thought of as a fluid arrangement, involving the periodic movement of funds from one line of defense to another. For example, funds that were at one time held in the third line of defense will gradually be brought into the second line of defense, and eventually to the first line of defense. In addition, market losses that impair the third line of defense may require a reallocation of funds from the second line of defense to better position the portfolio for long- term success.