Today’s very low bond yields have changed the investment landscape enough that traditional retirement income investing strategies need to be reconsidered. Retirees are generally concerned with drawing a steady income in retirement and bonds have traditionally been a good income producing investment but they just don’t yield enough today.
Over the past 50 years the ten year US Treasury bond has produced an average yield of 6.7%. The steady income is important for retirees but the fixed yields don’t rise with the cost of living. As a result most retirees would include some stocks in their portfolios as dividends and stock prices tend to rise over time. The trade off, though, was that stock dividends only produced average yields of 3.1% over the past half century, less than half the income yield from bonds.
Younger retirees considering the impact of inflation have traditionally allocated a larger portion of their portfolio to stocks. One of the old rules of thumb was to subtract your age from 100 and invest that percent of your portfolio in stocks with the rest in bonds. Thus a 60 year-old would have a 40% stock/60% bond mix while a 70 year-old would increase the bond allocation to 70%. Unfortunately with interest rates near record low levels this strategy doesn’t produce enough income today.
“Today’s retiree can earn a higher income from stock dividends, have it taxed at a lower rate, and expect the income to rise at least with the rate of inflation over time.”
The yields on the ten year US Treasury bond fell to record lows in 2012 and remain at just 1.9% today. Stock dividends, on the other hand, are much closer to their historical average and today the dividend yield of the Dow Jones Industrials’ stocks is 2.6%. While bond interest is fixed, dividends generally increase and have grown at an average rate of 5.4% over the past fifty years, nicely ahead of the rise in the cost of living. In addition, current federal tax laws tax dividend income at rates up to 23.8% while bond interest is taxed at rates up to 43.4%!
Stock prices, though, can be volatile and most retirees can’t afford to live on just the dividend income. At 2.5% the dividends would only amount to $25,000 per year on a $1 million portfolio. The problem then becomes finding other types of investments that generate better yields with less volatility. That’s a major challenge today but REITs, high yield bonds and other less traditional asset classes can diversify the stock market risk and produce better income yields for today’s retirees.