Beware of Fixed-Income Risks
As you sketch out your retirement income plan, you often hear that stocks are risky and fixed-income instruments, like bonds and certificates of deposit, are safe. That simplistic formulation ignores how devastating inflation is on fixed income.
Retirement is a tricky proposition and sometimes downright confusing. Many assumptions go into planning how you can confidently leave the workforce. Addressing life expectancy and forecasting your budget are two obvious areas to consider. But there are more than 23 major assumptions that go into constructing a portfolio designed to generate an income stream for the next 30 years of life after work.
The issue of understanding income – not to mention inflation, tax rate assumptions, etc. – can also be challenging. While many retirees associate taking risk with the equity markets, 2013 demonstrated the hazards of fixed income. According to Barclays Capital, long-term Treasury bonds had a total return (price and interest) of minus 12.7%; rates rose, which hurt bond prices. There is also principal risk in the fixed income arena if, to raise cash suddenly for whatever reason, you need to sell the bonds, whose value shrank.
When fixed income matures (a bond comes due), you endure reinvestment rate risk. That is the possibility that the new bond may have a lower interest rate than the one that just matured. This situation can be devastating to an income portfolio.
The peak of inflation was 1980. I wasn’t in the financial services industry at that time, but if I were, there is no doubt a client would state, “Joe, here is my million-dollar nest egg. Don’t lose it.” Had I put the money in certificates of deposit at the local bank in early 1980, the year-end return was $140,000.
The annual yield on a longer- term CD at that point was 14%. Before you begin reminiscing, “those were the days,” refer back to the annual inflation rate at that time: 13.6%. In other words, in 1980, your real return (interest minus inflation) was a mere 0.4%.
By 1990, yields on CDs fell to 5.5% and your $1 million nest egg’s returns declined by almost two-thirds, to $55,000 a year. As the planner, I could say I had done my job of protecting your nest egg, but it would have destroyed your expected income stream. By 1990 (when I was indeed in the industry), the fictional example became a living reality.
The turn of the century brought CD rates to 5% so you went for a full decade with zero growth to your income even though inflation was present. You still had your $1 million.
Today, the same CD rates are closer to 1.4%. The investment yield on your 1980 $1 million investment dropped by 90%. Had your focus been on preserving your capital, as so many retirees wish to do, your declining income sent you to the proverbial poor house.
This in no way is directing you to ignore risk and lose track of your principal. Our hope is to open your eyes to one of the many other risks that exist in retirement planning.
There are more than 10 other risks besides the loss of principal that you must consider along your retirement journey. Don’t get caught in making a decision that might feel good today and simultaneously wreck your financial journey.
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Joseph “Big Joe” Clark, CFP, is the managing partner of the Financial Enhancement Group LLC, an SEC Registered Investment Advisory firm in Indiana. He teaches financial planning at Purdue University and is the host of Consider This with Big Joe Clark, found on WQME and iTunes. He is a Registered Principal offering Securities and Registered Investment Advisory Services through World Equity Group, Inc, member FINRA/SIPC. Big Joe can be reached at firstname.lastname@example.org, or (765) 640-1524. Follow him on Twitter at @Big Joe Clark and on Facebook at http://www.facebook.com/FinancialEnhancementGroup.
Securities offered through and by World Equity Group Inc. Member FINRA/SIPC. Advisory services can be offered by the Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated.
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