In a brief published this month, the Center for Retirement Research claims investors must choose between return of capital and return on capital, and further claims that retired households should favor return on capital. Because the market value of bonds can fluctuate, some households are inclined to believe cash and short-term deposits are safer, but the Center counters this view is too simplistic.
By investing in short-term deposits, a household is assured the full repayment of its investment when it reaches maturity, but is subject to reinvestment risk, according to the Center. Not only that, but inflation can makes the investment unreliable. On the other hand, long-term bonds are subject to inflation risk, but guarantee a fixed income.
“The ultimate objective of retirement saving is to finance consumption. The standard of living of a household that invests in short-term deposits is at risk if short-term interest rates fall. In contrast, changes in interest rates and bond prices may have no effect on the standard of living of a household investing in bonds.”
The Center recommends investing in mutual funds or exchange-traded funds that invest in bonds, and with an average duration equal to the household’s life expectancy. It also recommends households that are worried about inflation look at Treasury Inflation-Protected Securities and Social Security.
“Households need to trade off the risk of loss against the costs, in terms of income uncertainty and reductions in yield, of holding an excessively large proportion of their wealth in the form of cash and short-term deposits. The right answer will vary from household to household, depending on their sources of retirement income and the extent of their health insurance coverage.”