Thinking about bonds in retirement? Be careful
Many investors nearing retirement have been lulled into a belief that their investment risk should be reduced. There is even a “rule of thumb” that suggests your age should determine your percentage allocation toward bonds or fixed income. This general guideline may sound good but could be dangerous to the safety of income during your retirement. We believe bonds are one of the riskiest places for investors today.
Inflation is the major culprit. Some advisers think that fixed income or bonds are “safe” investments for retirees. When planning for income during retirement, however, you want to ensure that a portion of your income is growing. Unfortunately, most pensions do not increase, and Social Security has not kept up with the inflation rate.
With interest rates close to 30-year lows, investing in bonds nearly guarantees a loss in your purchasing power over a 30-year time frame. Imagine having a $100 bill, but it only purchases $50 of groceries. That is what inflation does over just a 24-year time frame.
Today, the 10-year U.S. Treasury bond is earning roughly 2 percent, which is less than the current inflation rate of 3 percent. Without taking any earnings for income, you are losing 1 percent per year on these bonds. If you are drawing or spending your earnings, you lose 3 percent per year. In just 24 years, you have lost half your purchasing power.
Safety of income means having the same purchasing power of income over time. For example, if inflation is growing at 3 percent per year, your income must be increasing at 3 percent per year. If not, your funds are not worth as much, and you are getting poor slowly.
Think about experiencing a fixed income this way: If you are age 60, the money invested in fixed income will be like living on the same dollar amount you earned at age 30. Ask yourself, “Could I live on that amount today?” Your answer is most likely no.
And, what about withdrawals? Some advisers recommend taking withdrawals from portfolios at a “distribution rate,” or a percentage estimated that you could “safely withdraw.” To do this “safely,” you would need to earn your distribution rate (for example 4 percent) plus the inflation rate (estimated at 3 percent) or a total of 7 percent net of all expenses to remain “even.” This is a tall order if you have any significant allocation toward fixed income or bonds.
Another concern with taking withdrawals is the risk of a prolonged period when investment returns are low, or below that 7 percent per year, and you are withdrawing your principal. What happens if you live an extra 10, 15 or 20 years beyond the estimated asset allocation rate and you run out of money?
What’s critically important in retirement investing is not the principal value, but the income derived from it. Over time, the price of nearly everything increases. Inflation as measured by the Consumer Price Index, over a 30-year potential retiree’s time frame, results in prices rising 2.5 times.
In our opinion, investing in solid American companies that have growing income with growing dividends has historically been one of the best solutions to hedge against inflation and loss of purchasing power. Stocks have historically risen with cost of living increases more reliability than bonds.
According to the Bureau of Labor Statistics, the cost of living increased 12-fold between 1946 and 2016. During that same time frame, Standard & Poor’s reports that the dividend of its 500 Stock Index increased 65-fold, outpacing the inflation rate by some fivefold. The price of the underlying investment also rose 150fold.
For all the reasons stated above, and that they are subject to market and interest rate risk if sold prior to maturity, we believe bonds are one of the riskiest places for investors today. The most important number to check is the income from your portfolio and not its value. Knowing that your purchasing power is growing during retirement buys a whole lot of financial confidence.