How Investment Income Threatens Retirement

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Could more investment income negatively impact your retirement plans? There are steps you can take to avoid reducing your hard-earned nest egg.

Perhaps the greatest investment mistake I see retirees make over and over, sometimes with disastrous results, is the pursuit of higher income. With interest rates so low, I see it now more than ever. Though it's natural to search for more income, let me first explain why it can be a huge mistake. Then I'll suggest a better way to view your nest egg and investing.

The instinctual urge for income

Some people seem incapable of deferring immediate gratification and never save a dime. Others appear to be preprogrammed to save and build up a nest egg. From observing many clients, and my own behavior, I know it's very difficult for savers to suddenly give ourselves permission to spend down that portfolio. It's not that we don't understand the reality of "you can't take it with you," but rather that it's incredibly hard to see your nest egg get smaller after decades of growth. Retirees generally see only one option: Buy securities that pay higher income.

Why it's a mistake

There is no shortage of investment products promising high income. For example, here are a few that clients have come to me with:

• High-yield bonds. Otherwise known as junk bonds, these non-investment-grade bonds or bond mutual funds pay higher interest than safer bonds. In 2008, the average high-yield bond fund lost 26.4 percent of its value. One well-known fund became very illiquid late last year and lost more than 30 percent of its value.

• Master limited partnerships (MLPs) investments. These are typically publicly traded entities or funds that own MLPs that, for example, own pipelines and make their money from transporting petroleum products. I've been told it's like owning a toll road. Last year, the Alerian MLP ETF (AMLP) , which is an exchange traded fund of energy infrastructure MLPs, lost 25.7 percent, even after the income distribution.

• Non-traded real estate investment trusts (REITs). These are securities in entities that buy real estate and pay the leasing profits in dividends. You can't sell them on an exchange like you can a stock or a public REIT. They sound good in theory, but very high commissions and high operating costs have led to broken promises, with many drastically reducing both their dividends and their stated value, if they could be traded.

• High-dividend stocks. There have been many so-called safe high-dividend stocks. In 2007, banks and other financial firms fit that bill, only to see dividends slashed or suspended if they survived the Great Recession at all. More recently, many oil companies were considered "safe" high-dividend investments. . The lesson here is that high-dividend stocks can be riskier than a broad index fund of stocks.

A better solution

I advise viewing your portfolio as "stored energy" that gives you choices in life. Protecting that energy so it enables you to do what you want with your life is your No. 1 goal. Passing it on to your heirs is only a secondary goal.

View your portfolio in two parts. Part one is for growth and part two is for safety. I recommend very low-cost broad U.S. and international stock index funds for the growth part of your portfolio. A U.S. stock index fund like the Vanguard Total Stock Market ETF (VTI) is earning 4.5 percent net income per dollar invested, while the Vanguard Total International Stock ETF (VXUS) is earning 5.4 percent. They pay out some in dividends and reinvest the rest for growth.

The safe portion should go to high-quality fixed-income investments. These include certificates of deposit or high-quality bond funds, such as the iShares Core U.S. Aggregate Bond ETF, (AGG) that invest only in taxable fixed-rate investment-grade bonds. Most will be backed by the U.S. government. The goal of this part of your portfolio is just to keep up with inflation.

Neither the stock funds nor fixed income will pay much in the way of income, but your total return, counting price appreciation, is likely to be much higher. More important, that stored energy has a greater chance to last your lifetime, and you won't have to make the painful cuts I've seen others have to make when both their principal and income evaporated when they put money in "high income" but unsafe investments.

Allan Roth is the founder of Wealth Logic, an hourly-based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.