Challenges of Fixed-income Investing
Your parents and grandparents may have known better about lots of things when you were younger. But you probably shouldn’t be following their example when it comes to managing your money in retirement.
“Most retirement income for [our] parents’ and grandparents’ generation came from Social Security and a defined-benefit pension plan,” says Drew Denning, Senior Vice President and Retirement Strategist at Wells Fargo Advisors.
No longer. Defined-benefit pensions, which pay a fixed amount, are fading into history. Social Security is seeing minimal, if any, yearly increases. And interest rates have been at historic lows for years.
Prioritization as a beginning
“Your expected returns in fixed income [investments] are lower than they have been in the past,” says Brian Rehling, Co-Head of Global Fixed Income Strategy and Managing Director at Wells Fargo Investment Institute. Therefore retirees, and those preparing to retire, may need to rethink their investment strategies.
Every investor is different, Rehling and Denning say, so every strategy will be different. Of the most important considerations — risk tolerance, the income needed in retirement, total assets, and long-term financial goals — the last one could be especially critical. Some retirees focus on maintaining a lifestyle. Others may want to leave a significant inheritance, make charitable contributions, or help children or grandchildren with college. Depending on your goals, it may be prudent to keep a slightly more aggressive strategy for a longer period of time to try to continue building wealth.
“I think investors need to have a diversified portfolio of equities, bonds, and cash, and the percentages are going to vary,” Denning says. “The No. 1 variable in how they’re going to invest is their risk tolerance.”
Risk and return usually are correlated. Bump up the risk and your returns might be higher — or dramatically lower. Clamp down on risk and you might minimize losses, but you may also reduce your returns.
One of the biggest mistakes investors make, Denning says, is assuming they can use a withdrawal rate — the rate at which they liquidate their assets to cover expenses — that’s actually too high.
Although an appropriate withdrawal rate for most investors will differ, the traditional rate is 4% per year, he says. That’s enough to provide someone with $1 million in invested assets potentially a $40,000 a year income stream (on top of Social Security or other sources of retirement income).
“Most clients assume they can withdraw higher than the 4% withdrawal rate,” he says. Financial Advisors often have to tell clients, “You can’t support a 7 to 8 percent withdrawal rate.”
Inflation can also drain your spending power. That’s why fixed-income investments, which have lower risks but also typically earn less, shouldn’t be the only type of asset in most people’s portfolios — even those already in retirement.
Rehling says there are other ways to potentially reduce risk in your portfolio without relying too heavily on fixed-income investments. For qualified investors, alternative investments, such as private equity funds, and real assets, such as commodities and real estate, may serve a similar purpose.
“Alternatives have historically been used to help reduce volatility in portfolios,” Rehling says. “You may give up a little of the upside, but then you may give up some of the downside, too.”
Commodities and real estate may act as a hedge against inflation because their value — and therefore the income an investor earns from them — has historically tended to go up as inflation rises.
Bear in mind, while investors may benefit from the ability of alternative investments to potentially improve the risk-reward profiles in their portfolios, it’s important to remember the investments themselves can carry significant risks. Government regulation and monitoring of these types of investments may be minimal or nonexistent; returns may be volatile and present an increased risk of investment loss.
Rehling and Denning both say that as important as it is to find the right investment mix, it’s just as important to actually start putting money aside. The biggest problem for many people doesn’t end up being how their projected lifestyle impacts their need for retirement income or whether they have the right combination of assets. It’s simply that they haven’t invested enough. Starting early, even with a small amount, can let you take advantage of compounding interest.
However, if an investor reaches retirement and finds that he or she doesn’t have enough money to support the lifestyle wanted, there are still options, such as cutting some living expenses or perhaps going back to work part time. But putting all your money into bonds and certificates of deposit — as your parents or grandparents might have done — may not be able to fund your golden years.
All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or specific security.
Alternative investments, such as private equity funds, are not suitable for all investors. Any offer to purchase or sell a specific alternative investment product will be made by the product’s official offering documents. You could lose all or a substantial amount investing in these products. These funds are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and risks associated with the operations, personnel and processes of the advisor.
Real assets are subject to the risks associated with real estate, commodities and other investments and may not be suitable for all investors. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Real estate investments have special risks, including possible illiquidity of the underlying properties, credit risk, interest rate fluctuations, and the impact of varied economic conditions.
Investments in fixed-income securities are subject to market, interest rate, credit/default, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and/or principal. This risk is heightened in lower rated bonds. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Wells Fargo Investment Institute (WFII) is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.
Opinions represent WFII and WFA opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. WFII and WFA does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.
This article was written by/for Wells Fargo Advisors and provided courtesy of Carl M. Trevisan, Managing Director-Investments and Stephen M. Bearce, First Vice President- Investments in Alexandria, VA at 800-247-8602.
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