The Baby Boomer Bond Dilemma
Today’s record low bond yields could not come at a worse time for many baby boomers.
Owning U.S. Treasuries, the undisputed safest bond for retirees, means signing on for next to nothing in earnings for the next five to 10 years. That’s because the current yield of a Treasury bond is a solid estimate of future annual returns, and Treasuries that mature in 10 years or less currently have yields below 1 percent.
“I start all my presentations saying, ‘I am sorry but this is going to be super depressing,’” said David Blanchett, head of retirement research at Morningstar’s Investment Management group. While the historical long-term average annual return for intermediate term Treasuries is 4.5 percent, Mr. Blanchett says that based on current yields, a return below 2 percent is more likely.
And that’s before factoring in inflation. The 1.3 percent annual rate of inflation through August, the latest information available, was higher than the 0.3 percent yield for a five-year Treasury note and the 0.7 percent yield for a 10-year Treasury.
Expected low returns for the next five to 10 years come at a crucial time for households near retirement and those who have recently crossed the retirement Rubicon.
“What matters most is what happens to your portfolio in the first 10 years or so of retirement,” said Mr. Blanchett. “If you’re not generating enough growth, it can have a big impact on whether you have what you need later on.” In an article he wrote for financial advisers, he also suggests that continuing to assume higher historical bond returns when running retirement income forecasts is “almost malfeasance.”
“It’s superdangerous to be investing in fixed income right now. But I don’t know where else you go,” he said.
High-quality corporate and municipal bonds may be tempting because they pay more interest than Treasuries. But once you’re retired, they can come up short when the stock market falls. “If you need to use money from your portfolio, you want to have some money in places that don’t go down when equities are down,” said Jonathan Guyton, principal at Cornerstone Wealth Advisors in Edina, Minn. “That leads you to Treasuries, because every other type of bond doesn’t hold its value when stocks are down.”
When there are more bond sellers than buyers, bond prices fall and yields rise. Total returns for traditional mutual bond funds and exchange-traded bond funds are the combination of the interest payment and changes to the price of bonds in the portfolio.
During the coronavirus bear market this year, when stocks fell nearly 35 percent in a four-week stretch through March 23, already-low bond yields did not offset price declines for most types of bonds. The Vanguard Total Bond Market Index Fund, the largest core bond fund, lost 1 percent. The Vanguard Intermediate -Term Corporate Index Fund, which focuses on high quality corporate debt, fell more than 11 percent. The iShares National Muni Bond E.T.F. lost 10 percent.
Rattled investors seeking safety flocked into Treasuries, pushing prices higher. The Vanguard Intermediate-Term Treasury Fund gained 4.7 percent. The Schwab Short-Term U.S. Treasury E.T.F. gained 2.1 percent.
Further Treasury price gains in another stock market decline could certainly happen. But with Treasury yields now close to zero, they would soon enter negative territory to generate positive returns. Countries including Germany and Japan have already experienced negative yields on government bonds.
All that said, there are plenty of strategies retirees can consider to generate reliable income without undue risk.
“Step 1 is to decide on the optimal Social Security claiming strategy,” said Wade Pfau, director of retirement research at McLean Asset Management and founder of the Retirement Researcher website for consumers. “Typically that means having the highest earner in a household delay until age 70 to claim the highest possible benefit,” said Mr. Pfau, who is also a professor of retirement income at the American College for Financial Services.
Every year you delay starting Social Security from age 62 up to age 70 entitles you to a higher benefit. A benefit at age 70 will be 76 to 77 percent higher than the payout if you start at age 62. You can’t replicate anything close to that with Treasuries or any other high-grade bond.
If Social Security won’t be enough to cover your essential living costs, the next step is to decide how much you need to add to close the gap, Mr. Guyton says. Retirees are typically focused on what he calls vertical risk, asking questions like, “How much is my portfolio up? How much is it down?” But the real risk, he says, is horizontal: How many years could you make withdrawals solely from bonds, if your stocks were down for an extended period of time?
Focus on horizontal risk and you may find that you don’t need to invest more than 30 percent or so in Treasuries.
As an example, let’s say your strategy is to start withdrawing 4 percent of your retirement portfolio a year. Right now you can assume that your bond interest income and dividend payouts from stocks will generate at least 1 percent. That means you would need to withdraw 3 percent of your portfolio each year to get to your 4 percent goal.
“If you want to know you don’t need to touch your stocks for 10 years, that would suggest you want 30 percent of your portfolio in Treasuries,” said Mr. Guyton, who has published influential research on how a flexible approach to annual withdrawal rates can support an initial target withdrawal rate above 4.5 percent.
You might want to own more bonds than that to moderate your overall volatility, but if your goal is a 10-year runway where you won’t need to touch your stocks, starting with a Treasury stake equal to 30 percent or so of your portfolio will suffice. For the record, since World War II, the longest time it took for the S&P 500 to recoup a bear market loss was the nearly six years after the 1973-1974 stock sell off, according to CFRA, an independent research firm.
Historically, a portfolio of Treasuries with a duration of five years has delivered the best risk-reward trade-off for retirees, said Jon Luskin a certified financial planner at Define Financial in San Diego. He recommends splitting a Treasury portfolio between classic Treasuries and Treasury Inflation Protected Securities, or TIPS.
Cash can seem like a legitimate option given that intermediate- and short-term Treasuries currently don’t yield much more than an FDIC-insured savings account. Mr. Luskin cautions that while holding cash indeed means you won’t lose value when stocks fall, “you also aren’t going to make any money, either. Treasuries tend to rally when stocks fall. Cash can’t.”
Another strategy is to ditch bonds altogether, Professor Pfau said.
Right now, the biggest bond headache is their paltry yields. Another risk is that from these very low yields, any increase in rates would cause a different headache: negative total returns as the fall in prices would most likely be greater than the rise in yields. Eventually, higher yields are indeed a very good thing. It’s just that when a retiree is relying on bonds for income, the ride from low to less-low will be a bumpy road where returns could be disappointing.
So Professor Pfau suggests that if you need more guaranteed income than you will get from Social Security and a pension, if you have one, that you use money you have in bonds to buy an annuity. A plain-vanilla income annuity delivers a lifetime payout that is not affected by interest-rate changes.
“You can still keep your stocks,” said Dr. Pfau, “But now you don’t have to be as nervous about the stock market because you have all your basics covered by guaranteed income.”
Such an annuity would require that you irrevocably hand over a big chunk of your retirement savings to an insurance company, however. As an alternative, there are income annuities that offer a guaranteed payout for a fixed period, even if you were to die a month after buying the annuity.
Other more complex (and more expensive) options, such as variable annuities, can also address concerns about irrevocably losing control of a big part of your retirement savings. But the money you will pay for additional features like these can reduce your net return.
Fine tuning investment choices will take you only so far. You may need to take action outside of your portfolio.
If you’re still working, for example, delaying retirement as long as possible — and continuing to save as much as you can — reduces the time you will need to rely on your investments, while increasing your nest egg. And there’s a silver bullet that can solve plenty. “If you can spend less, there’s no plan that won’t work,” said Mr. Luskin.
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