Look beyond bonds for sustainable retirement income

With the recent increase in interest rates, retirees or those nearing retirement might find it tempting to invest their nest eggs in longer-dated government bonds to secure a stable, long-term income. After enduring the "Great Financial Crisis," it's understandable why exiting the stock market might seem appealing. When you have only a few working years left or have already retired, the prospect of another market downturn can be quite daunting.

However, following this line of thinking could lead you into trouble!

Sure, bonds play an important role in your portfolio by protecting the money you need in the short term against losses and by mitigating the impact of stock market fluctuations. Nevertheless, don't lose sight of the reason interest rates rose in the first place: inflation.

Why is inflation such a big concern in retirement?

Inflation steadily erodes your money’s buying power year after year. If you invest $100k into a 10-year bond paying 4.25%, you'll receive $4,250 in interest every year, plus your principal back at the end of the term. This might sound appealing until you factor in a 3% inflation rate over those same 10 years. You will get a check for $100k after 10 years, but it will only have the buying power of $74k in today’s dollars. That’s a loss of over $26k of purchasing power!

In reality, most retirees cannot afford such a loss; they need their return to outpace inflation by more than 1-2% to avoid a significant decline in living standards later in life. Moreover, certain expenses, like healthcare or long-term care, have historically seen even higher increases than general inflation rates.

Inflation becomes an even bigger concern when you are no longer working and living off your assets. During your working years, inflation was often accompanied by rising wages. Given advances in healthcare and increases in longevity, your retirement could last almost as long as your career. To understand the cumulative impact of inflation over such a lengthy period, consider how much you paid for your first car or your first home.

So, what's the solution?

You may not like the answer, and you probably already know it: You’ll need to keep a sizeable portion of your assets in a diversified portfolio of stocks.

Bonds are great for the money you need in the near term (i.e., the next five years or less), but they are lousy at providing any real returns once adjusted for inflation. To achieve that, you need the growth potential that equities offer, which has outpaced inflation by 7.6% over the last 50 years (and by 10.8% over the last 10 years). On average, the 10-year Treasury Bond only exceeded inflation by 1.9% over the last 50 years while failing to keep up with inflation over the last decade, falling short by 1.9% per year.

But aren’t stocks too risky?

For instance, in 2022, the S&P 500 (an index comprising approximately 500 of the largest public companies in the U.S.) declined by 18%. It experienced roughly twice that drop in 2008 and plummeted by 44% in 1931 at the onset of the Great Depression. Yikes!

But, looking at the S&P500 over longer periods paints a very different picture.

Do you remember box and whisker plots from your 9th-grade math class? Well, this is a situation where they convey a powerful message. The darker blue chart on the left shows the range of one-year returns of the S&P 500. These returns are all over the map, spanning from a 44% decline in 1931 to a 53% increase in 1954.

However, as you focus on longer investment periods, the extremes smooth out considerably. There are only a couple of windows where the ten-year returns were negative (1928-1939 & 1999-2009), and even then it was only a modest annualized loss of 1%.

Now, if you examine any 20-year period, the worst performance would have encountered would have been positive 4%!

The key takeaway here is that the longer your investment horizon, the lower the overall risk of a well-diversified, low-fee stock portfolio.

So what are bonds for?

We’ve already touched on the answer. Bonds are the ideal place to park money that you’ll need in the near future, typically within the next five years or less. When you’re young, bonds may be where you put the savings that you’re earmarking for a downpayment on a home. When you’re retired, bonds are where you put the next five or so years of your income needs.

By securing your lifestyle in the short to medium term with bonds, you can comfortably embrace the risks associated with stock investments. You can have confidence that when the market inevitably experiences downturns (and it will, possibly multiple times during your retirement), you can exercise patience and stay invested. This approach avoids the panic-driven decision to cash out at the worst possible moment.

Implementing such an investment strategy can take various forms, and I tend to avoid one-size-fits-all approaches. It doesn't need to be overly complex, but your portfolio should align with your risk tolerance (you need to sleep at night), your anticipated income needs throughout your life, and your broader goals and objectives.

If this makes your head spin, reach out to a fee-only (or even better, a flat-fee) financial planner. They can help you crunch the numbers and talk through your fears and your needs, all while minimizing conflicts of interest.

There are no guarantees in life or investing, and the assistance of a knowledgeable and empathetic advisor can have substantial benefits, both quantitatively and qualitatively.

Bonds in Retirement: Build a Bond Ladder

One simple approach is to purchase treasury bonds that mature in 1, 2, 3, and 4 years to coincide with your income needs in each of the next five years. When the nearest bond matures, deposit the principal in your cash account.

This approach is known as building a bond ladder. Keep the rest of your investments in well-diversified, low-fee, equity funds. Each year, sell just enough of your stock holdings to purchase the next 5-year maturity bond. Rinse and repeat annually.

from schwab.com