The Herald Bulletin

April 18, 2014

'Big Joe' Clark: Understanding the risks within fixed income investments


The Herald Bulletin

---- — Retirement is a tricky proposition and sometimes downright confusing. Many assumptions have to be rendered before an individual can confidently leave the workforce.

Addressing life expectancy and forecasting your budget are two obvious areas to consider, but there are more than 23 major assumptions that have to be identified in order to provide reasonable confidence in a decision that will generate an income stream for the next 30 years of life after work.

The issue of understanding income — not to mention inflation, tax rate assumptions, etc. — can also be challenging. Many retirees associate the concept of taking “risk” with the equity markets. However, as 2013 demonstrated, there is also principal risk in the fixed income arena if an untimely liquidation requires you to sell bonds and generate income.

When fixed income matures (a bond comes due), you endure reinvestment rate risk. That is the possibility (risk) that the new bond may have a lower coupon than the one that just matured. This situation can be devastating to an income portfolio.

The year 1980 coincided with the peak of inflation. I wasn’t in the industry at that time, but if I were there is no doubt I would have heard a client state, “Joe, here is my million-dollar nest egg. Don’t lose it!” Had I put the money in certificates of deposit at the local bank in 1980, the return would have been $140,000 per year, as the annual yield on a longer- term CD at that point was 14%!

Before you begin reminiscing, “those were the days,” refer back to the annual inflation rate at that time. But that is another story.

By 1990, yields on CDs had fallen to 5.5% and your $1 million nest egg’s returns would have declined by almost two-thirds, to $55,000 a year. As the planner I could say I had done my job of protecting your nest egg, but it would have destroyed your expected income stream. By 1990 I was indeed in the industry and the fictional example became a living reality.

The turn of the century brought CD rates to 5%, so you went for a full decade with zero growth to your income even though inflation was present. You still had your million dollars.

Today the same CD rates are closer to 1.4%. The investment yield on your 1980 million dollar investment would have dropped by 90%. Had your focus been on preserving your capital — as so many retirees seem to do — your declining income would have sent you to the proverbial poor house. This in no way is directing you to ignore risk and lose track of your principal. Our hope is to open your eyes to one of the many other risks that exist in retirement planning. There are more than 10 other risks besides the loss of principal that have to be accounted for along your retirement journey.

Don’t get caught in making a decision that might feel good today and simultaneously wreck your financial journey.

Joseph “Big Joe” Clark, whose column is published Saturdays, is a certified financial planner. He can be reached at bigjoe@yourlifeafterwork.com or 640-1524.