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by Jonathan Pond, October 7, 2010
With an economy that's barely recovering and concerns about stock, bond and real estate bubbles waiting to burst, it’s no wonder many investors are acting so conservatively. Yet interest rates on so-called safe investments — such as Treasurys, certificates of deposit (CDs) and bank savings accounts — are the lowest they've ever been. What's a retirement-focused investor to do?
First and foremost, keep in mind that those who flee to the security of safe investments are taking a risk just as those who put all their money into stocks. That's because there are two kinds of investment risk. The visible risk of losing money on your investments is uppermost on investors’ minds. But the second risk, the invisible one of losing ground to inflation, can be just as disconcerting, especially for a retirement portfolio.
When inflation outpaces investment returns, your money will earn so little that it will lose purchasing power — and that's not just true during hyperinflationary periods like the 1970s. Though inflation is quite low now, the interest paid on safe investments is even lower. This is a big problem, particularly for retirees who need income from their investments to pay the bills.
Here’s an example of how onerous low interest rates are on retirees. Say you want to keep your money absolutely safe in 3-month U.S. Treasury bills, but you need to earn $50,000 a year in interest after taxes for living expenses. How much would you need in 3-month T-bills to earn that much? Sixty million dollars. Really!
That doesn't mean safe investments are of no value. A portion of your portfolio certainly belongs in them. But safe is a relative term. There are ways to increase the income paid on your investments, though some additional risk is involved. Here are three options worth considering:
1. Shop for better yields on safe securities. You may be able to keep your money secure, yet earn a better yield, by comparison shopping among such securities as money market mutual funds, bank deposit accounts and CDs. For example, in September 2010, the average rate paid on a 6-month CD was 0.6 percent, yet several banks were offering 6-month CDs paying more than 1.4 percent. Each was FDIC-insured. Check with your bank or credit union, or search websites such as Money-Rates.com and Bankrate.com.
2. Invest in short-maturity bond funds. If you’re willing to take a smidgen of risk to boost your interest income, short-term corporate and municipal bond mutual funds and exchange-traded funds (ETFs) are well worth a look. The risk is that interest rates will rise, resulting in a small loss of principal, but I think it’s a risk worth taking. I’ve been using these successfully for my clients as a better-yielding substitute for money market funds and CDs.
3. Consider higher yielding securities. There are opportunities to earn higher interest (and dividends), but at the risk of possibly losing some principal. You can earn interest or dividends of more than 4 percent on Build America Bonds (these are taxable municipal bonds), high-yield corporate and municipal bonds, some dividend-paying stocks, preferred stocks, and some master limited partnerships. But the danger here is that you could end up losing a lot more principal on these investments than the interest or dividends they pay. Talk to your investment adviser, if you have one.
But you can reduce the risk of principal loss somewhat by investing in mutual funds or ETFs that invest in the aforementioned securities. Funds spread your money around among a large number of securities, so if one or a few of them go sour, your investment principal shouldn’t be badly impaired. But higher yielding investments are appropriate for only a portion of your investment resources. Always keep this uppermost in your mind with respect to securities that pay interest: The higher the interest, the higher the risk.
All the information presented on AARP.org is for educational and resource purposes only. We suggest that you consult with your financial or tax adviser regarding your individual situation. Use of the information contained in this website is at the sole choice and risk of the reader.
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