It goes without saying – I’m a bond guy. Fixed income has literally filled each one of my days for quite some time now. That’s why I may seem to be the most unlikely person to admit this, but it must be said: Just because you’re retiring does not necessarily mean you should put all of your money in bonds.
There are two things you need to consider when it comes to deciding when and how to be invested in bonds: growth and inflation.
Growing your wealth in retirement
When you’re moving into your next life stage, you typically want your investments to provide you with income to replace your paycheck and also to preserve wealth. The unfortunate reality is that many retirees may also need their wealth to continue to grow in retirement. Bonds aim to provide you with income at regular intervals. But they aren’t the best choice when it comes to growing your bottom line for a long retirement – especially in today’s rate environment. Worst case scenario: you retire, you put everything in bonds the first year to build a bond ladder, and you don’t earn enough income to meet your expenses. This means that you need to sell down some of your bond holdings, which reduces income further. If this cycle continues a retiree can see their portfolio shrink at an alarming rate.
Of course, different strategies work for different people. A person who has saved enough for retirement doesn’t have to be as concerned with growing their wealth, unlike someone who still has a ways to go in building their nest egg to a point where they can maintain the lifestyle they want in retirement.
Keeping inflation top of mind
Even if you’ve saved and invested for retirement, and your income needs are met, costs are going to rise over time. Why? Because of a phenomenon called inflation. The prices of goods and services rise over time and purchasing power diminishes. This means that in the future $1 is not going to buy you as much as it can today. Most of us can recall our grandparents discussing how much a candy bar cost at the dollar store when they were kids (and for some of our grandparents, they were called “dime stores” back then, a testament to inflation in itself).
Think of it this way: A 65 year old man today is expected to live to age 84. To keep the numbers even let’s say he needs to fund 20 years in retirement. And let’s say that our savvy investor has saved well and has a $1,000,000 nest egg. The average annual rate of inflation over the past ten years (2004-2014) has been 2.1%. If this rate of inflation continued over our investor’s 20 year retirement, his $1,000,000 today would be worth only $640,000 in 20 years. Essentially 1/3 of his wealth would have been wiped out, even without any losses in the market.
ChartMT Assuming an annual rate of inflation of 2.28%. For illustrative purposes only.
The tricky thing about inflation is that it is sneaky. A bank or brokerage statement shows you how much you have in assets, but it doesn’t tell you what you can buy with that money. Our retiree may think that he still has his $1,000,000 as he ages, without realizing that the value of that money is declining. And not only is the value declining, but the amount of income it generates is also declining in inflation adjusted dollars. If inflation is not countered our investor may find himself in the situation above, with not enough income to support his spending needs.
Bottom line: Bonds can play an important role in providing income during retirement, but may not provide a significant source of portfolio growth. This means that if you still need to build that nest egg in retirement, consider blending bonds with other asset classes that have higher expected returns. And above all, don’t forget about inflation. If you are not earning the inflation rate, your portfolio is actually declining in value.
Matthew Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.