Are Fixed-Income Investments the Solution?
After Sally sees my bear market scenario, she's ready to dump her stocks and buy bonds. A bond offers the investor a fairly straightforward relationship: You give a government, corporation, or some other institution your money for a predetermined period of time, during which you'll receive a fixed rate of interest. At the end of that stretch, you get your money back. Case closed, more or less.
The primary trouble with bonds, at least in recent years, is that the yields they offer are substantially lower than the long-term returns provided by stocks. The yields on bonds and their close cousins, bank certificates of deposit, change all the time, but these days you can't get a government-guaranteed yield greater than 5 percent, even if you're willing to part with your principal for 30 years.
Looking at rates available on long-term Treasuries, Sally figures she could pour her 401K into 30-year bonds and generate a 5 percent yield, or $25,000 worth of income a year. That would require her to trim her budget by $5,000 annually, but the extra security alone would make this trade-off worthwhile.
Unfortunately, there's another problem with fixed-income investments, and it's right there in the name: The income they provide is fixed; it doesn't grow. There are a variety of ways to tinker with a bond portfolio and increase its yield, but from a big-picture point of view, the only way to get a bond portfolio's income to grow is to reinvest a portion of its income in additional bonds. Of course, those reinvested dollars aren't available for living expenses.
So now Sally faces a very difficult choice. She can either spend all $25,000 of her interest income, knowing this figure will never rise, or she'll have to live on even less so that this income can grow.
Choice 1
Let's say Sally withdraws all of her interest income every year, and, as a consequence, her income doesn't grow. Figure 1.4 illustrates how the purchasing power of her income will change under several inflation scenarios.
At even a 2 percent rate of inflation, the purchasing power of this income stream will drop 9 percent in 5 years, 18 percent in a decade, and 33 percent in 20 years. At a steeper 5 percent rate of inflation, the purchasing power erosion is significantly faster--Sally's effective income would drop 22 percent after 5 years and a whopping 62 percent after 20. Spending all of one's earnings from a fixed income portfolio points the way to a steadily eroding standard of living.
Choice 2
Sally could withdraw less than $25,000, leaving some of her interest income available to buy additional bonds. How much? That depends again on the rate of inflation.
Here we can call on a useful concept known as real return. Investment returns are usually expressed in nominal terms--percentages of dollars and cents--but nominal returns fail to take inflation into account. By subtracting the inflation rate from a nominal return, we can see what the real return is--that is, the net gain in purchasing power.
A good rule of thumb is that an investor should withdraw no more than the real return on a fixed-income portfolio. Withdrawals in excess of this figure will deplete the future purchasing power of the portfolio's income and value. Instead, the portion of the nominal return that represents inflation should be held back and reinvested, to keep the portfolio's real value stable.
For Sally's bond portfolio, Figure 1.5 demonstrates the (ugly) figures.
If inflation manages to hold to a 2 percent rate, Sally should withdraw no more than $15,000--just half of her original target. If inflation runs even higher, her allowable withdrawal drops further. At a 5 percent inflation rate, she technically shouldn't withdraw anything at all; at even higher rates of inflation, she'd have to add dollars to the account just to keep its real value stable.
