Beyond wishing for interest rates to bounce back to historic highs, what can you do to help your portfolio produce income into your golden years?
Retirement planning used to be simple: invest in a portfolio (of bonds?) that comfortably paid a steady stream of income for life while keeping the bulk of your investments (the principle) for the next generation but, unfortunately, in our current reality of lower interest rates, a comfortable stream of income has become far more challenging to achieve. #munKNEE/Money!
The chart below outlines the challenge. Today, we need to accept three to five times more volatility than we did before the 2007 credit crisis in order to generate yield targets of between 3 and 5 percent.
…so what can you do to help your portfolio produce income into your golden years?
1. Set an income target, and make sure it’s reasonable
Ideally your portfolio should provide the cash flow you need with some wiggle room but, with interest rates lingering well below historical norms, you also need to be realistic about the income your portfolio can deliver.
- A relatively safe bet is to set a yield target in line with the yields of core bonds. A good point of reference here is the yield of the Bloomberg Barclays US Aggregate Bond Index The closer you can stay to that level, the longer your portfolio can likely sustain you.
- If your income target depends on a market-beating yield, chances are you will need to invest in riskier assets and experience more portfolio – and income – volatility. Consider that reaching for higher yield now may result in losses that mean fewer years of retirement income later.
2. Focus on the purpose of the investments and the costs
Even if your current portfolio is consistently meeting your income targets, it is worth considering the longer term ‘costs’ or trade-offs of your investment choices.
- annuities are the poster child for highly reliable income products but they tend to be expensive and, depending on the type you choose and how long you live, there may be little or nothing left to pass on to the next generation.
- On the flip side, a standard investment portfolio has the potential to increase in value over time, but it lacks the guarantees of annuities, meaning you’ll likely have higher volatility and more variable income.
Your ultimate goal should be achieving your priorities, even if it comes with higher fees. If you most value steady income, , but if your highest goal is to build a legacy, an investment portfolio may be better.
3. Know that risk can take many different forms
History is littered with stories of investments that appeared to be low risk – until they weren’t. There are always trade-offs for the extra yield, even if they are not immediately obvious. Don’t be fooled by investments offering low-risk opportunities with market-beating yields or returns. Instead, make sure to ask “What’s the catch?”
- bank loans are a popular income investment because they have produced a nice yield and seem to have low risk. If we looked at the volatility for bank loans over the last five years, we’d expect to lose 3% or more once every 6 years. If we extrapolate that rate over longer time frames, we’d expect to lose 10% or more once every 330 years. How about losing 30% or more? Try once in a ridiculously large number that has 24 zeroes in it. Yet that’s exactly what happened in 2008 so it could be the case that the risk demonstrated over the past five years may not tell us enough.
You need to carefully evaluate the risks you’re taking, over realistic time horizons, to understand both how and when your investments can go wrong.
When it comes to income investing, I stand by the old adage: If it sounds too good to be true it probably is. Being realistic and well-informed about your income and risk goals today can better set you up to reap benefits well past tomorrow.
Editor’s Note: The above excerpts are from the original article by Patrick Nolan, and have been re-formatted, color highlighted, edited ([ ])* and abridged (…) by Lorimer Wilson, editor of munKNEE.com – Your KEY To Making Money! – for the sake of clarity, and brevity to provide a fast and easy read.
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