Retirees typically look for bonds to provide two things in retirement: income and inflation protection. But bonds are not what they used to be.
Rates today are too low to comfortably address just one of those issues, let alone both. The "conventional wisdom" of having bonds dominate a portfolio in retirement is outdated and was based on past market conditions and philosophies.
To that point, 30 years ago the retirement and bond market landscape looked quite different from the one we're currently experiencing. In 1988, the 10-year Treasury yielded between 8 percent and 9 percent, and the inflation rate was about 4 percent. Additionally, many people who retired in the 1980s had pensions that covered most of their living expenses so they could afford to take a conservative approach with their retirement portfolio. They could invest their portfolio in 10-year Treasurys, live on 4 percent of the bond income and still keep up with inflation, all while many had the security of multiple guaranteed income streams via Social Security and a pension.
High guaranteed incomes and a high-interest bond market are two comforts that today's retirees do not have. Here in 2018, pensions are disappearing at an alarming rate, the 10-year Treasury is yielding around just 3 percent, and inflation is about 2 percent. Safe to say, it is a very different environment. Yet despite these low rates, the "conventional wisdom" of overweighting bonds in a retirement portfolio has not changed.
Sticking with this outdated retirement strategy in such a low-rate environment all but requires retirees to invest in lower-quality, longer-term bonds to have any chance of providing the income and inflation protection they're seeking. I've observed this is increasingly the case.
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Unfortunately, this approach exposes their portfolio to additional credit and interest-rate risk while also increasing the correlation to their equity portfolio. The more your fixed income portfolio acts like equities, the more you are taking the exact risk (albeit a little less) that many retirees are trying to avoid without even realizing it.
As you've probably surmised, I believe many retirees are looking at bonds and their overall portfolios all wrong. I think bonds, especially in this interest rate environment, should be viewed solely as a safe harbor in the face of significant market declines rather than an income stream through all stock market environments. This being the case, I believe the use of high-quality, short-term bonds held in less quantity than conventionally discussed is a better overall approach to retirement income planning.
The goal of fixed income in a retirement portfolio shouldn't be total return, but stability and this is where many retirees are missing the boat. In retirement, when the market goes south, there needs to be a dependable asset class to provide the income needed. And generally, short-term high-quality bonds are more likely to provide that stability.
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So how much of your portfolio you should invest in these high-quality short-term bonds is entirely dependent on your personal financial situation and risk tolerance. Estimate the annual income needed from your portfolio and establish multiples of that amount while ensuring that the equity portion of your portfolio can hypothetically support the needed withdrawals, as well.
I've seen retirees with anywhere from about four to 10 years' worth of expenses in this asset class, depending on the investor.
The larger your portfolio is relative to your income needs, the more flexibility you have to hold more or less than others in a similar situation. Having this safe harbor is often what gives retirees the confidence and patience required to ride out the inevitable storms that accompany their equity investments.
"Striking the proper balance between stocks and bonds is where the rubber meets the road for true retirement planning, as every retiree's situation is different."
This approach encourages retirees to look at their portfolio as two separate portfolios with two distinct purposes. The purpose of the equity portfolio is to continue growing your wealth and to provide an effective hedge against inflation over an average 30-year retirement.
The fixed-income portfolio is there to provide the income needed during market corrections and recessions. Striking the proper balance between stocks and bonds is where the rubber meets the road for true retirement planning, as every retiree's situation is different.
I have found that the retirees who embrace this purposeful "two portfolio" approach feel more confident during times of market volatility and are more comfortable spending in retirement. Because when the market falls, they have years to let it recover without sacrificing their lifestyle while they wait.
— By Ashby Daniels, retirement planner at Shorebridge Wealth Management
