This past week, the Federal Reserve made a significant change to its policy on interest rates and inflation. While this change has significant implications for all investors, the policy shift is particularly important for those in retirement.
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Before the new policy, the Fed set an inflation rate target of 2%. This meant, in part, that as the economy picked up and employment increased, the Fed would increase the federal funds rate. Under the new policy, however, the Fed will seek to “achieve inflation that averages 2 percent over time.” That may not seem like a big change, but it is.
It means, among other things, that the Fed could allow inflation to rise about 2%. It would take this action, for example, after a prolonged period of inflation well below 2%. The decision has several implications for our economy. Perhaps most significantly for retirees, it could mean an even longer period of interest rates near zero.
Given this change in Fed policy, here are four things those in retirement should consider.
1. Retirees Should Focus on Total Return Investing
Among retirees and even retirement experts, income investing is a popular strategy. This approach has an initial appeal. By living off of dividends and interest, a retiree can avoid selling stocks and bonds to fund retirement. This approach feels safe.
Even under a normal economic environment, however, it has significant shortcomings. Chief among them is that the overall return of such a portfolio almost always underperforms a total return portfolio.
And by total return, I simply mean a portfolio that does not seek out investments that pay higher than average dividends or interest. An example of a total return portfolio would be a portfolio consisting of a diversified group of index mutual funds that mirrors the overall market. Such a portfolio will certainly pay dividends and interest. It will not, however, pay a higher than average rate of dividends and interest.
I believe this is the best approach for most retirees in all economic conditions. In fact, the studies supporting the 4% rule of retirement spending use a total return approach to investing. Using an income approach, if it yielded a lower total return, could jeopardize a retiree’s use of the 4% rule.
Related: 5 ‘Safe’ Ways To Boost The 4% Rule Of Retirement Spending
Total return investing is even more important with interest rates near zero. It’s impossible for most retirees to live on dividends and interest alone where dividend yields are around 2% and bond yields near zero. By focusing on a total return investment approach, retirees can benefit from the capital appreciation of their investments, while also enjoying some level of dividends and interest.
2. Retirees Should Hold At Least 50% In Equities
For most retirees, an equity allocation of somewhere between 50 and 75% is ideal. This is what virtually every study concludes that looks at the 4% rule and its many variations. Even under normal economic conditions, a portfolio with less than 50% in stocks or more than 75% has a significant risk of depletion during retirement.
Given the low interest rate environment, a 50 to 75% stock allocation is even more important. Holding more than 50% in bonds, given their low yields, would present significant risks to a retiree. The low rate of inflation is certainly helpful, but bonds still have negative real yields.
Of course this shouldn’t be taken to extreme. Studies find that a 100% equity portfolio, for example, could easily be depleted in a retiree’s lifetime. But one should not go to the extreme the other way. Some mutual funds designed to produce income for retirees have far less than 50% in equities. That is a very dangerous approach, particularly given our current interest rate environment.
3. Retirees Should Use Online Banks
For cash reserves to handle spending over the next year or two, retirees would do better with an online bank than a short term bond fund. For example, the Vanguard Short-Term Bond Index Fund Admiral Shares (VBIRX) currently has an SEC yield of just 0.33%. In contrast, online banks offer just under 1% APY. While this is still an historically low rate, it’s better than bond yields and offers FDIC insurance.
4. Retirees Should Hold Some TIPS
Finally, consider holding a portion of your bond portfolio in Treasury Inflation Protected Securities. TIPS protect investors against an unexpected rise in inflation. While rising inflation doesn’t seem like much of a risk today, the Fed’s policy signals that it will tolerate some level of additional inflation. More importantly, the country’s growing debt and monetary policy could result in rising prices that are not so easily controlled.
I’m not one to predict gloom and doom. But it seams reasonable to hold a portion of a bond portfolio in TIPS just in case.