| 30 December 2011
Retirement income is almost an oxymoron. With interest rates this low, it is not your grandparents' retirement anymore. Gone are the days of living off the interest/dividends of a portfolio and never touching the principal – at least for now. This is a huge paradigm shift for retirees; so much so that I still hear plenty of people talk about finding a great rate on a bond or CD, and all I can do is shy away.
Implicit in the statement above about finding a good rate on a bond is the understanding that in order to get a better rate, an individual must take on one of two risks (or both). First, longevity risk – buying a bond with a longer maturity than you would otherwise want to. This could be a highly rated bond but in order to get higher interest rates you would need to buy something that matures in 10 or 20 years, or even longer. This can be risky because as interest rates rise, the value of that bond will fall – no big deal if you wait until the bond matures at its full value, but if something in life happens and you need to sell early, you would take a loss.
The second type of risk someone could take on is quality risk – buying a lower quality bond (even one with a junk bond status) that pays a higher interest rate. These bonds have higher default risk, so there is the chance – however small – that you might not get your money back. In my book, bonds are to ensure you get your money returned more than a return on your money.
The problem with interest rates is that they can move in broad swaths – since interest rates peaked in 1981 at 14%, they have fallen. That is 30 years of falling rates, which in the world of bonds is 30 years of bonds appreciating in value. So you can guess what happens if we now start moving in the other direction – if interest rates start moving up for decades (due to inflation), bond prices drop in value.
If you looked at the title of my article and guessed "Bond Fund Manager" you were right. If I were a bond manager that had spent the last 30 years posting stellar returns in my portfolio and now was looking down the barrel of horrible returns, I just might retire. Irony being what it is, that bond manager might not have the interest off bonds necessary to retire themselves. Yet, in our daily lives, we are all bond managers as we try to buy CDs, money market accounts or any other fixed investment. If the pros have a tough future, what is ours like?
Part of the answer is that those retiring in the next five to ten years will need to rely on more of a "total return" approach. They will need to have enough cash and bonds to spend up during the first five years of retirement so that the equity portion of their portfolio has some time to grow. That is a profound statement since many just assume they will lower their risk as they enter retirement by buying bonds. Ironically, they might be increasing their risk as interest rates start rising and inflation eats away at that purchasing power. Then, longevity risk has less to do with bonds and more to do with how long you live.
There are a lot of moving parts to this, but the overall point is that interest rates are not going to help savers for quite a while and therefore, the methodology of how income is derived from a portfolio will also need to change. All of this needs to be balanced with one's ability to take risk. Take heart, at least you are not the bond fund manager.
Jon T. Meyer, CFP® is the President of Boeckermann, Grafstrom & Mayer Wealth Management, LLC, a Minneapolis-based Registered Investment Advisory firm. Jon specializes in working with retirees and individuals nearing retirement to help them create the income they need in retirement by utilizing advanced social security planning, tax planning and investment strategies. For more information visit www.bgmwealth.com.
