You just retired
Along with a great career, you have built up a substantial 401(k) balance. It took a while, but you got the hang of investing in equities: never comfortable with the ups and downs, but always focusing on long-term growth.
However, now you need income, not growth. Over the years you owned some bonds with mixed success. Moreover, unlike your foray into equity investment, this time you cannot afford on-the-job training. You need the income now. Plus, you have less time to recover from any mistakes.
With interest rates close to zero, where do you go for income?
You’ve heard that the Department of Labor’s new Fiduciary Rule may result in more people keeping their 401(k)s with their former employers. However, you’re unsure whether you can get the income you need from yours, as many employers have yet to adapt to the new rule, and still steer their employees’ 401(k) choices toward stock funds to grow their accounts, rather than bonds funds to distribute the accounts.
Moreover, today, with the ten-year U.S. Treasury Bond yielding just 1.6%, bonds hardly seem to be the place to go for income, even though, so far this year, they have provided investors with decent total returns. (For example, the Barclays Aggregate Bond Index is up 5.6% for the year.) Total return combines the interest rate with the bond’s change in price: bonds go up in price when interest rates fall.
The opposite can happen with bonds
There is talk in the financial press that the Federal Reserve is itching to raise rates, maybe in September or December. This could push rates higher on any new bonds issued. It could also increase the rates at which banks pay savers.
But when interest rates go up, the value of existing bonds drops. This leaves retirees with a low-interest rate (1-2%) and a bond portfolio decreasing in value, so your total return is no longer 5%, but negative.
Diving into the stock market
Many retirees, frustrated by low rates, have put money earmarked for bonds into stocks, hoping the dividends plus growth will provide sufficient income.
The problem today is that the stock market, as measured by CAPE or the Q Ratio, is anywhere from 50-70% overvalued. This does not mean it cannot continue to go higher; it can, and it has. (It was more overpriced during the late ‘90s Internet boom and the roaring ‘20s than it is today.)
High stock prices do present more risk than, say, in 2008, when the stock market was at fair value. High stock prices also exasperate the problem with a stock-centric retirement portfolio. If the market drops and you withdraw principal as income, that money is no longer in your portfolio when the market rebounds.
The financial services industry has adapted to this low-interest rate environment
It has done so by building products for it, some of which provide you with income guarantees. But they come with restrictions on withdrawing your principal, as well as somewhat confusing terms and conditions.
Other products offer a higher yield but no guarantees of how much of the money you invested you will get back. Plus, many of them lack daily pricing, making it impossible to know the value of your account on any given day.
- has a keen understanding of interest rates and the bond market:
- has the knowledge that is imperative when one talks about income;
- has the access to the products necessary to help you transition from growth to income;
- will check your account and let you know if leaving it with your 401(k) is a good option;
- will work to keep your costs low—because, in a low yield world, the less you pay to someone else, the more you keep for income.
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Tim Hayes CRPS®, AIF®, AWMA®, CFS®