How to (Actually) Shield Your Retirement From the Threat of Low Yields

Raise your hand if you love today's super-duper low interest rates: ultra-cheap mortgage and car loans! Refinancing boomed in this cycle! Businesses borrow cheaply! Even some student loans are getting cheaper. But on the flip side, bond investors are getting squeezed by the same low interest rates. Given fixed income is a widespread staple of retirees' investment portfolios, some suggest it's time retirees materially alter their investment approach to boost yields and reduce risk they run out of money. Proponents posit you should invest less in traditional fixed income and more in alternate asset classes that either have higher yields or generate guaranteed income. Some of this discussion is fine and more or less sensible. But in our view, much of the angst and resulting recommendations stem from an incorrect focus on how to generate income and construct portfolios for retirement in the first place. None of that is brought to you by low rates.

Much of the trouble seems to stem from conflating two investment terms: Income and cash flow. Cash flows are withdrawals to cover expenses, while income is a piece of investment return (dividend, interest payment, etc.). You can earn income and never withdraw a penny. You can take cash flow and never earn income. Income is one way to generate cash flow, but it is not a requirement.

Yet some believe otherwise, a misperception creating this whole low-interest-rate-squeeze concern by limiting the universe you are picking from. If you free yourself from the shackles of investing for cash flow with income-producing securities-instead correctly focusing on price movement and income (total return)-the universe of investible securities is wide open. When a total return-focused investor needs cash flow, he or she can sell securities. In taxable accounts, it can easily be a more tax efficient means of doing so, no less.

Perhaps that strikes you as blasphemy. We get it. Conventional wisdom says retirees who rely on their portfolio to help cover living expenses shouldn't invest-or should invest very little-in growth-oriented investments like stocks. Part of the reason is income fixation, but also, it's partly because stocks can decline in value, sometimes by a lot, and some think avoiding this risk is paramount to their successful retirement. This might seem sensible, but it ignores two quiet-but-insidious problems-inflation and rising life expectancy.^[i] While fixed returns are fixed, your expenses aren't. They tend to rise over time, and growth from stocks helps offset this. Yes, in the short run stocks are more volatile. But they also tend to rebound fast and are negative over longer periods far less often than bonds. People are living longer than ever-if you're retiring at 65, you may have three decades of retirement in which your money must be working.

Fixed income can play an important role alongside stocks, but not solely because bonds generate income. In our view, their purpose in a blended portfolio is more to mitigate stocks' volatility. While adding bonds to reduce volatility may not always be desirable, depending on your individual needs it can help to reduce the swings if you need relatively high cash flows.

This logic has no relationship to presently low interest rates. They aren't relevant if you view portfolios correctly-with the right mix of stocks and bonds your portfolio needn't materially change to make up for reduced bond income. Certain tactical tweaks will take the interest rate environment into account, like emphasizing corporate bonds over Treasurys to increase yield some, and more importantly, reduce pure interest-rate sensitivity. But this isn't a wholesale change.

Instead of proffering this sensible but (probably) boring advice, most of the punditry suggests you replace one income-bearing security with another, higher-paying one on the notion yield is all that counts. But veering from fixed income into high-dividend stocks or alternate assets classes such as Real Estate Investment Trusts (REITs) or Master Limited Partnerships (MLPs) introduces risks that can more than offset higher yields. High-dividend stocks are, um, stocks, and REITs and MLPs have more equity-like characteristics than bonds. In this context, we are using "equity-like characteristics" to mean volatility and correlation. Exhibits 1 & 2 illustrate this, showing the hypothetical change (in dollars) of a $1 million portfolio during 2007 - 2009's bear market. Exhibit 1 shows a 100% equity allocation and 50%/50% blends of stocks and bonds, stocks and MLPs, stocks and REITS and stocks and preferreds. Exhibit 2 shows the same combinations with a 70% equity component. As you can see, a bond mix helped weather the financial panic far better than these other mixes. Nearly all the "replacement assets" behave like stocks-there is too much correlation and similar return magnitude to argue these assets provide a real benefit.

Exhibit 1: 50/50 Blends, 9/30/2007 - 3/9/2009

Source: Factset, as of 5/20/2015. S&P 500 Total Return Index, BofA/ML 7-10 Year

Corporate/Government Bond Total Return Index, S&P MLP Total Returns Index, S&P US REIT Total Return Index, BofA/ML Preferred Core Fixed Rate Total Return Index.

Exhibit 2: 70/30 Blends, 9/30/2007 - 3/9/2009

Source: Factset, as of 5/20/2015. S&P 500 Total Return Index, BofA/ML 7-10 Year Corporate/Government Bond Total Return Index, S&P MLP Total Returns Index, S&P US REIT Total Return Index, BofA/ML Preferred Core Fixed Rate Total Return Index.

Jumping into these "replacements" is a sector decision, too. REITs, intuitively, move with the real estate market. MLPs are a form of an Energy-industry bet (though they are less directly exposed to oil prices than, say, stocks of drillers). Both these categories, too, trade like small cap stocks. And high-dividend stocks are concentrated by sector-when those areas see volatility or negativity, so will the high-dividend stocks. For example, Financials were one of the higher dividend-paying sectors leading up to 2008. The dividends weren't much help in offsetting the bear (and most dividends in that sector were obliterated).

Still others suggest getting out of the liquid capital markets altogether, recommending annuities because they offer a "guaranteed" income stream for life. But there are some caveats and asterisks. To receive a regular income stream, you must give up ownership of the assets to the annuity company, a process called "annuitization." You can't pass on any remaining funds or the income to heirs absent riders and added expenses. Payments, too, typically aren't indexed to inflation, so their purchasing power erodes over time (again, absent a pricey rider or specialized contract with its own issues). Oh and that "guarantee" is only as good as the insurer is solvent. Perhaps all this is why few annuity buyers ever actually annuitize.

Maybe it seems basic, but we'd suggest changing your thinking is the right start here, not radically swapping products and assets. In our view, the most sensible approach to investing in retirement is to start by identifying your goals, time horizon and projected cash flows. Then determine, based on many combinations of historical returns, which mix of stocks, bonds, cash and other securities maximizes the chances you reach your financial goals.