Is There Still Income in Fixed Income Today?
By Joni Clark
March 23, 2012
Is There Still Income in Fixed Income Today?
By Joni L. Clark, CFA, CFP®, Chief Investment Officer, Loring Ward
Question: When it comes to investing for retirement, what is one of the biggest differences between today’s retirees and past generations of retirees?
Answer: While past generations of retirees could invest in bonds or other fixed income investments and live off the income, with the current low interest rate environment and the potential for increased inflation in the years ahead, it may be difficult for average retirees to sustain their income needs over their lifetime without continuing to invest in stocks throughout retirement.
The extraordinary performance of fixed income investments in the past few years resulted from a combination of slow economic growth, low inflation and aggressive intervention by the Federal Reserve. These unusual factors are unlikely to be repeated over the next 30 years, and these unexpected returns simply cannot reoccur.
“The rally in bonds is a once in a millennium event, but it’s absolutely mathematically impossible for
bonds to get any kind of returns like this going forward … If you missed the rally in bonds, well, then that’s it.” — Jeremy Siegel
Finance Professor at Wharton School at the University of Pennsylvania
One of the primary concerns with counting on fixed income to finance retirement is that long- and short-term fixed income investments do not provide significant returns once you factor in inflation.
Inflation also takes a significant bite out of investment returns.
The graph below shows annualized returns on stocks, bonds and cash from 1926-2010. The first bar for each asset class on the graph below represents the nominal, or unadjusted, returns of each asset class. The second bar illustrates the real, or inflation-adjusted, returns of each asset class — or the actual return you get once you account for inflation. Notice that with cash and bonds, after adjusting for inflation, you are left with very meager returns compared to stocks — cash and bonds real returns were only 0.6% and 2.4% while stocks real returns were 6.6%.
Inflation Risk: Will Returns Keep Pace with Inflation?
Past performance is no guarantee of future results. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. Stocks are represented by the Standard & Poor’s (S&P) 500 Index; Bonds are represented by the Ibbotson/SBBI Long-Term Government Bonds Index; Cash is represented by one-month Treasury Bills. An investment cannot be made directly in an index. ©2010 Morningstar, Inc. All rights reserved. 3/1/2011
It is important for those who are approaching retirement today to understand that portfolio growth may be essential in order for your money to last through a 30+ year retirement period.
This may be accomplished by balancing the account with a significant allocation to stocks in an effort to improve the probability of sustaining retirement income through your life expectancy.
With this strategy, the primary role of the fixed income portion of the portfolio is to dampen overall portfolio volatility associated with investing in stocks — not to provide income. Instead, income is provided through a combination of dividend and interest income and the harvesting of capital growth (gains in the portfolio).
In fact, drawing from capital growth may be more tax efficient than receiving a stock dividend or bond income. Long-term capital gains are currently taxed at the capital gains rates of 15%, instead of at higher income tax rates.
We believe the right approach to meeting retirement income objectives is an efficiently diversified portfolio constructed of fixed income and stocks to provide the maximum potential total return for a chosen level of risk. Even more important are the advice and guidance of your financial advisor, who can help you keep your retirement plan on track, as well as make any adjustments along the way.
Why Your Nest Egg Needs to Beat Inflation
Inflation is the reason that things cost more today than they did a few years ago. With inflation averaging about 3% a year over the last few decades, $1 this year will be worth 97 cents next year. That may not seem too bad, but it adds up over time. Assuming inflation continues to average 3%...
In 10 years, $1 will be worth 73 cents.
In 23 years, $1 will be worth just 50 cents.
That means your buying power will be cut in half in the next 23 years. Just look at how these prices have changed over the past 30 years.
Gallon of gas (note 1) $1.30 $3.62 278%
Postage stamp (note 2) $0.18 $0.44 245%
Movie ticket (note 3) $2.78 $7.89 284%
If your nest egg isn’t keeping up with inflation, your money is disappearing without you even realizing it!
1 Bureau of Labor Statistics
2 CostOfStamps.net & U.S. Postal Service
3 National Association of Theater Owners
Past performance does not guarantee future results and the principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. diversification neither assures a profit nor guarantees against loss in a declining market. Implementing a total return income portfolio cannot guarantee a gain or protect against a loss.
The risks associated with investing in stocks and overweighting small company and value stocks potentially include increased volatility (up and down movement in the value of your assets) and loss of principal.
Fixed income securities are subject to interest rate risk because the prices of fixed income securities tend to move in the opposite direction of interest rates. In general, fixed income securities with longer maturities are more sensitive to these price changes and may experience greater fluctuation in returns.
Loring Ward is not a legal or tax advisor. The information herein is general in nature and should not be considered legal or tax advice.
LWI Financial Inc. (“Loring Ward”)Securities offered through Loring Ward Securities Inc., member FINRA/SIPC R 12-098 (03/12)
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