Living on a fixed income has gotten a lot harder

At one time, living on a fixed income meant you were retired, received a pension and social security, and got some extra income from your savings. For our parents and grandparents, certificates of deposit, otherwise known as “CDs” were a guaranteed source of no-risk income. Back in 1981 you could put your savings in the bank and get nearly 18%. That was a period of high inflation when prices were also going up. But CDs and bonds paid investors high enough rates so that retirees were comfortable with putting their money into CDs or bonds.

But interest rates have been on a downward path since then. CD rates have dropped from about 11% in 1984 to 1% or less today.

CD rates history


Today, CDs and bonds, once the go-to choice of the thrifty retiree, pay a small fraction of what they once did, and provide very little income to supplement their other retirement income sources.
The Federal Reserve has been keeping rates close to zero for years to try to jump-start the economy, with limited success. But while it’s been good for businesses and home buyers who have have been able to borrow money at rates that we have not seen since the 1950s, the traditional saver has seen their income dry up, collateral damage of Federal Reserve policy.

Charles Schwab, in an article published in the Wall Street Journal states that:

U.S. households lost billions in interest income during the Fed’s near-zero interest rate experiment. Because they are often reliant on income from savings, seniors were hit the hardest. Households headed by seniors 65-74 years old lost on average $1,900 in annual income over the past six years, according to a November 2013 McKinsey Global Institute report. For households headed by seniors 75 and older, the loss was $2,700 annually.
With a median income for senior households in the U.S. of roughly $25,000, these are significant losses. In total, according to my company’s calculations, approximately $58 billion in annual income has been lost by America’s seniors since 2008.
Retirees depend on income from their savings for basic living expenses. Without that income, many seniors have taken on greater risk to increase the potential yield on their savings, or simply spent down their nest eggs. After decades of playing by the rules, putting off spending and socking away money, seniors have taken it on the chin. This strikes a blow at the core American principles of self-reliance, individual responsibility and fairness.

What’s a retiree to do? Let’s look at some of the alternatives that people on fixed incomes are being offered and what to watch out for. All of them involve risk that may not be readily apparent. There are traps for the unwary.

Reaching for yield in the fixed income market.

The fixed income market offers several ways that people can get a higher interest rate. But there are risks in all of them.

The most common way of getting a higher yield is to invest is long-term bonds, bonds that may not come due for 30, even 40 years. If you are willing to tie up your money for a long time, you can buy bonds that pay more than ones that come due in 6 to 12 months.

But there are a couple of risks that you should be aware of. The first one is that when interest rates rise, you will be locked into today’s low rates. A second risk is known as “market risk.” If you need to sell a bond before it comes due, its value depends on the current interest rate (assuming all else remains the same). When rates go up, the price of existing bonds goes down. That means that you may lose money if you sell when rates are higher than they are today. Investors in bond funds should be particularly wary of this because bond funds advertize yield, not the fact that they may be buying long-term bonds that will decline in value as rates rise.

A second option is investing in high yield (otherwise known as “Junk”) bonds. These are issued by companies and municipalities that have a poor credit rating. They are forced to pay higher interest rates than more financially secure issuers. It is possible to get a higher interest rate by investing in these bonds, but there is a greater risk of default. Bond fund investors need to be cautious here also. A bond fund should never be bought simply because it has a high yield. I could be filled by high risk “junk.”

Buying dividend paying stocks

Many stocks today pay a higher dividend than the yield on a 1-year CD. The current dividend yield on the S&P 500 is 1.88%. The “Blue Chip” Dow Jones Industrial Average has 30 stocks; 23 of them pay dividends that exceed 2%. For someone seeking income, buying stocks that pay good dividends has a great deal of appeal. Many of these companies are actually raising their dividends regularly.

Keep in mind that stocks are riskier than bonds. Unlike bonds, stocks never mature. Most companies try to pay a regular dividend, but they are not guaranteed. If a company does well, the dividend goes up. In times of financial stress they can be reduced.

Stock prices fluctuate constantly. There is no guarantee that if you need money you will be able to sell your stock for as much as you paid. Experienced stock investors create diversified stock portfolios to reduce the risk that any single stock will have a major negative impact on their net worth. Investors buying stocks for income should study the dividend history of a company carefully and should be especially careful about buying a stock that pays out too much of its income in dividends as this may be a sign that the dividend is not safe.

Income via Total Return

While buying stocks for their dividend income has a certain appeal, the strategy can have negative consequences. Before the stock market crash of 2008, many of the stocks with the highest dividends were banks stocks. As a result of the financial crisis, many banks either went out of business or had to be rescued by the government. This led to enormous losses and the elimination of the dividend many were paying. People who owned these stocks lost not just their money but also their income.

That is why the total return strategy is preferred by many professionals. Instead of buying individual stocks for their dividends, the total return investors create a portfolio of mutual funds. The funds can include stock funds as well as bond funds. They can cover the globe, investing in the US as well as the rest of the world. The object of this strategy is to grow the value of the fund from a combination of income from interest and dividends, plus capital appreciation from the growth in the value of the stock funds. From these funds we “harvest” an annual income designed to allow the portfolio to last our lifetime. The amount that can be safely withdrawn depends on one’s age and income needs.

Principal risk vs. purchasing power

There is also a risk of staying with CDs and bonds. While this may appear to be the “safest” thing we can do, there can be negative consequences.  The most obvious risk is that if current income is not sufficient, the retiree on a fixed income will begin dipping into his or her savings. Over time, these savings will be depleted.

The second risk is less obvious, but perhaps even greater. Even with today’s “official” low inflation rate, the purchasing power of our money is declining. What this means is that – after taxes and inflation – people who put their money in CDs are able to buy less and less with the money they have saved.

Retirees who need income from their savings to supplement their pension and social security income have a problem in today’s low interest rate environment. The Federal Reserve’s low interest rate policy has created a problem for them. It’s a problem that has been a long time in coming and will take a long time to fix.

For those wishing to look into some of the alternatives, we suggest find an unbiased financial advisor, preferably an RIA (Registered Investment Advisor) who is also a Certified Financial Planner, who can help come up with a solution that meets the retiree’s income needs while minimizing the risk that he or she will run out of money before running out of time.

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