We are seven years into the wave of Baby Boomers turning 65 at the rate of roughly 10,000 per day. Many of these soon-to-be, or new, retirees use an increasingly flawed rule of thumb for investing and retirement income.
The basic thinking is that they should subtract their age from 100 and that will indicate the amount of stocks to hold in their investment portfolio — essentially 35 percent stocks, 65 percent bonds for a 65-year-old with the weight of bonds growing over time.
This rule of thumb has been successful for the past 35 years but may now unintentionally direct these investors toward a long-term financial shortfall.
Historically, retirees have tended to increase the weight of bonds in their investment portfolios to generate income to supplement Social Security and replace their paycheck.
The zenith of bond returns, however, is in the rearview mirror.
From the current environment of low, but rising, interest rates, many types of bonds are challenged to contribute much income or any growth to a diversified investment portfolio.
Through February, U.S. government bond indexes are negative over the past year, and the Bloomberg Barclays U.S. Aggregate Bond Index, which includes corporate and mortgage-backed bonds in addition to Treasuries, had a negative year-to-date return (-2.1 percent). It’s certainly early — and calendar year measuring points aren’t all that relevant — but this bond index has had negative calendar-year returns only three times since 1976. It’s so uncommon that some people think that it’s not possible for bonds to have negative returns. It happens when the current value of a bond, or an investment fund of many bonds, declines enough to offset the income paid out by the bonds.
It is rarer to have a negative return for the broad bond market over one year than to have a 20-percent decline in stock value — the technical definition of a bear market for stocks. There is no equivalent definition of a bear market for bonds, but the environment we are in now just might qualify.
Recently, the broad U.S. bond market has provided less-than-normal diversification benefit by preserving value during periods when stocks fall. As stocks have experienced increased volatility over the past month, there were several days when stocks traded downward that bonds did as well.
It’s periods like these that prompted Warren Buffett to address the stocks-versus-bonds decision in his recent annual letter to shareholders of Berkshire Hathaway.
“I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier — far riskier — than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates. It is a terrible mistake for investors with long-term time horizons — among them pension funds, college endowments and savings-minded individuals — to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio will increase its risk.”
To put this in the context of an individual trying to protect financial security both for short- and long-term needs, if you have obligations you need to cover in the short-term (out to even a few years), that money shouldn’t be invested in stocks.
Longer-term, stocks offer stronger likelihood of growth that can generate real financial security.
So, what is the newly retiring Baby Boomer to do during a potentially low-return environment for assets that have historically been critical for retirement income?
Here are ideas to consider:
▪ Understand what kind of bonds you own. Corporate, mortgage-backed, government, high-yield, investment grade, emerging markets. There are different risk/return profiles for each type of bond. It may be best for now to stick with short-term, higher-quality bonds. There’s not enough extra compensation in lower-quality, long-term bonds to make it worthwhile to reach for higher income.
▪ Think in terms of total return, not just income paid by investments. Get used to the idea of taking withdrawals from principal in addition to income from interest and dividends. This is especially true if your portfolio needs to be rebalanced to adapt to changing market conditions. You can capture gains where you’ve had growth and create needed cash at the same time.
▪ Become more comfortable with fluctuations in stock returns. Stocks certainly have a riskier downside profile. But as long as the money you’ll need to fund the next few years of retirement income aren’t exposed to stocks, your overall portfolio should benefit from their inclusion over time.
There is more money invested in bonds globally than in publicly-traded stocks. They are an important investment for many people. But it might be quite a while before income from bonds becomes as compelling as it has been for much of the past generation.
Gary Brooks is a certified financial planner and the president of BHJ Wealth Advisors, a registered investment adviser in Gig Harbor. Reach him at firstname.lastname@example.org.