The topic of retirement income is on the top of most advisors’ minds these days. With large percentages of investors moving into their retirement years, advisors are wondering how they’re going to meet their clients’ needs for consistent and rising income.
While bonds are traditionally thought of as a good source of retirement income, in today’s markets, you’ll likely find much better income opportunities on the stock side of the market. Ten years ago, however, this wasn’t the case. But market metrics have changed substantially, and you’ll have to change your strategy if you want your clients’ money to last 30 or more years.
Retirement Income From Bonds
In general, I’m a big fan of bonds. In today’s markets and for the next decade or more, bonds will provide an important element of principal protection and some modest income payments, but they won’t solve your clients’ needs for meaningful and growing income.
At the time of writing this article, 10-Year U.S. Treasury notes are yielding about 2.3%, and 20-Year U.S. Treasury bonds are yielding about 3.3%. If you had a client retiring today, with a $1 million portfolio, and you laddered the bonds between 10 and 20 years, you’d have an average yield of about 3%, give or take a tenth of a percent. I don’t expect your client would find a fixed $30,000 taxable income stream a workable solution, especially since the client had to commit a good percentage of the portfolio to longer term bonds.
With the longer term nature of the bonds, the portfolio could look really ugly if inflation picks up. While you can’t predict future inflation rates, if we have inflation of just 2% over the next 20 years, that income stream is reduced to only about $20,100 in today’s dollars. If inflation ran at 3%, the income stream is reduced to $16,600 in today’s dollars.
With interest rates this low, the best you can hope for is low to no inflation. Otherwise, the rising cost of living will ravage the income stream, and if interest rates increase, the portfolio could get hammered by declining values. On the one hand, that’s not a big deal if your client is willing to hold the bonds to maturity, but on the other, it is a big deal because your client can’t do much to adjust to higher interest rates. Given the history of volatile interest rates and inflation cycles, the odds are that your client would experience one or both of those scenarios.
The Cost of Liability Matching
There is another option available with bonds called liability matching that would require you to buy a fixed income security today that will match your client’s anticipated spending needs in the future. For instance, let’s say you think your client will need $75,000 of income 15 years from now. If you wanted to fund that obligation with a zero coupon U.S. Treasury bond, it would cost you about $45,000 in today’s dollars. A 15-year zero coupon bond has a yield to maturity of about 3.5%, so if you invested $45,000 in the bond, it would be worth about $75,000 in 15 years. You could do this sort of matching for every year of your client’s anticipated retirement.
The problem is you can’t be sure how much income your client will need in 15 years. Why? Because you can’t predict inflation rates, and you probably can’t accurately predict your client’s lifestyle needs. If clients need to plan for 30-year retirements, the odds of predicting inflation and lifestyle needs 30 years into the future are pretty small. Plus, who knows how long your clients might live? If they live longer than anticipated, you may well have fully depleted their assets because you didn’t expect to have to match liabilities that far into the future.
Since inflation is an issue, you might think, “Well, I’ll use TIPS to help protect against inflation.” In a normal interest rate environment, that might be helpful. But today, 10-Year TIPS actually have no yield and on some days a negative yield, meaning your client will lose money in TIPS over the next 10 years, excluding the inflation adjustment. So if we were to have low inflation over the next 10 years, the return would be paltry.
In general, the fixed income market is so expensive that trying to fund your client’s unknown, future retirement liabilities with fixed income assets is a gamble on a number of fronts. So an asset that looks safe, poses lots of risks for investors in need of an inflation adjusted income stream.
The next question is, are there better opportunities today? In my opinion, yes; and they are found in the equity markets.
Retirement Income From Dividends