Last Updated Sep 21, 2009 9:25 AM EDT
Low Rates. Many retirees are sitting on the sidelines in cash afraid to invest their money because they don't want to get whipsawed by inflation down the road. While this is a big concern, by sitting in cash, you're forfeiting the chance to prudently earn more income in today's markets.
- If you're in cash, you're probably making somewhere around 0.25 percent on your money.
- But if over the last year you'd been invested, for example, in a bond portfolio that was designed to track the Barclay's U.S. Aggregate Bond Index, you'd have received a little more than 4 percent interest on your money. This index is a mix of intermediate term Treasury, U.S. agency and high-quality corporate bonds.
- While 4 percent isn't great, it's 16 times more than what you may have been earning in cash.
- Let's assume you sit in cash for two years waiting for inflation, and the interest rate environment doesn't change. Well, you've earned about 0.50 percent from your cash over two years when you probably could have earned about 8 percent if you were more fully invested. So that's a real opportunity cost.
- But if you were more fully invested and earned more interest, you could distribute the income payments, which would lessen the need to touch the principal.
- If you're retired, you need to balance the risks of generating current income to feed distributions versus the threat of inflation down the road.
Flexibility. As long as you keep your fixed income holdings flexible, you should be able to respond to inflation by eventually buying bonds that provide higher income, while still earning more income today.
- One of the best methods is to simply ladder your holdings, meaning you have some bonds coming due every few years. This way if rates rise, as your bonds mature, you can reinvest at higher rates. But in the meantime, you're getting paid more today.
- You can ladder with individual holdings or also look into using some high-quality, passively managed bond ETFs. Many bond ETFs are targeted to a certain maturity range, such as short or intermediate term bonds.
- Remember, the return you want on bonds is the income return from the interest payments. Laddering provides a very simple and effective method to capture those interest payments without requiring you to time interest rate changes.
- While dividend payments are not guaranteed, there's a reasonably high probability that your dividend payments will outpace inflation through your retirement years.
As with all financial matters, consult your individual financial advisor prior to making any decisions.