With the lowest interest rates in decades, many investors are now coming to the harsh realization that re-investing their fixed income securities as they mature means a substantial reduction in investment return (the interest rate earned from a specific debt security). Rates just aren’t where they were even a couple years back, and if you’re relying solely on fixed income to retire on (which isn’t a recommended strategy) it’s disappointing at best – and financially devastating at worst. Financially devastating – primarily because you either have to suffer with a dramatically reduced retirement income, OR extend out your fixed income maturities to pick up a bit of yield (a VERY risky and in my opinion poor strategy in this low interest rate environment).
Even worse – these low rates lead many retirees to search for higher yield. There is no free lunch… higher yields mean higher risk to your principal AND/OR if it’s in the form of an annuity can completely lock up your funds in high commission-based insurance products (not that all annuities are bad, for example they’re perfect for a spendthrift who can’t control their own financial plan). Chasing yield is a mistake, but many retirees incorrectly think it’s a low risk strategy to bolster their retirement income.
So just what is a retiree to do in this low interest rate environment? Invest for total return through a diversified and balanced portfolio. The fact is, most investors think they need bonds and other fixed income investments to live off of the interest during retirement. That’s just not the case and really couldn’t be further from the truth. Retirees can benefit from a diversified blend of income sources.
Just what do I mean by a diversified blend of income sources? Most certainly the fixed income component is a must. Your portfolio needs bonds to produce interest and reduce your personal investment volatility and risk. That’s a given. How much to allocate to fixed income in your portfolio is a factor of your financial risk tolerance for portfolio volatility to a point, but it’s also a factor of how much income you need!
Many retirees don’t fully understand the planning factors that go into a retirement lifetime. Some investors think a portfolio allocation is solely based of some risk tolerance profiling questionnaire – that may be the case for PART of your investment portfolio planning. But it’s also based on your current and projected financial income needs.
For example, some clients need to be coached and educated on the financial costs of having too much fixed income. Too much fixed income will lower your overall long term investment returns, putting your retirement nest egg at risk. Not necessarily loss of principal, but loss of effective principal due to a reduction in purchasing power from inflationary pressures. Let’s face it, a stamp is 44 cents today. Stamps were 3 cents in the great depression, and it takes well over $16 today to buy what $1 did in 1933! If you’re not keeping pace with inflation, you’re falling behind financially.
Yet other investors need consultation and education on reducing their equity exposure because it’s not needed to achieve their retirement income goals. Many clients have conservative retirement budgets, and live off less income from their portfolio than they could. In this case, it may not make sense to allocate a greater portion of a portfolio to equities for growth – as it’s not financially necessary!
There is FAR MORE than simply a risk tolerance profile to consider when creating an investment portfolio suited to your specific financial needs, goals and risk tolerance!
Assuming you fall somewhere in the middle of an extremely conservative all income producing fixed income portfolio and an all equity aggressive growth portfolio – you’ll experience “income investing for total return”. Income doesn’t need to be generated solely from portfolio interest. Rather you can experience longer term higher returns to help offset inflationary pressures, as well as a solid current income through a diversified portfolio of equity, fixed income, and alternative investment assets.
Total return income investing means your income will be derived from interest payments, dividend payments, capital gains and other distributions (such as return of principal for example). The key is to consider ALL sources of distributions and income that your portfolio generates when creating your investment portfolio allocation. Focus more on total return, rather and interest income!
To be successful at income investing for total return however, you must be absolutely prepared for the inevitable market downturns. The worst possible time to liquidate portfolio assets to create cash flows for your retirement income is in a bad market environment – such as the one in 2008 and early 2009. There is no catch-up for liquidating principal investments at lower levels during retirement. The fact is, in retirement you’re not typically adding to your investment portfolio, you’re utilizing it for income. Selling shares of anything at lower prices can’t be recovered from.
An effective and well-constructed retirement plan is far more important than the investments you choose to allocate the plan with. Missing something simple like leaving enough reserves in short term fixed income investments and money market type instruments means more of your balanced portfolio is at risk for liquidation at lower values if the market turns sour again. It’s pretty clear – have enough liquidity on hand to cover a reasonable amount of monthly income cash flows or risk your portfolio to the whims of the capital markets!
I typically recommend anywhere from 9 months to 1 year of income on hand and accessible in money markets or highly liquid high quality ultra short duration fixed income funds or securities. This depends on the client, on their plan, and on their personal risk tolerance of course. There is no clear cut answer for the masses in retirement. But enough liquidity to help you weather a typical 12 to 18 month bear market is a great starting point, after which the amount becomes a factor of how aggressive or conservative the remainder of your portfolio balance is, and your personal risk tolerance.
Managing income investing for total return in a bear market presents it’s own challenges. It brings on a whole new set of decisions, for example when to re-balance your portfolio and does it make sense to shorten the amount of cash reserves in order to maintain your core long term retirement strategy. These decisions should be monitored and managed closely with your financial advisor.
If you’re a fixed income investor, think carefully before you choose to chase yield. Think even more carefully before you choose to extend your bond or CD maturities. And most importantly think carefully before locking up any of your retirement in an annuity. While annuities may be right for some investors, they’re typically not highly efficient retirement planning vehicles. I’m sure that assessment will draw substantial criticism from the ranks of those in insurance sales – but I’m not paid commissions to sell investment products – I’m compensated to develop a sound retirement income strategy for those who need it!
Tags: annuities, bonds, cash flow, cd's, income strategy, low interest rates, managing income, retirement income, retirement plan, total return investment
