One of the biggest threats clients face in retirement is chasing higher investment income. I’ve seen people go back to work because they concentrated on income and lost their principal. Income is the wrong goal, particularly since much of so-called income is just a ruse allowed by regulators.
Don’t get me wrong, I certainly understand the desire for income. Our clients are savers who have spent their entire lives squirreling away a part of their income to build a nest egg. The thought of spending it down is terrifying to savers, even though clients understand they can’t take the money with them after they pass.
I’ll address two mistakes: income illusions and income that risks principal. Then I’ll propose a better strategy for our clients.
Income that isn’t
It’s illegal to sell something for even a trivial price claiming it will extend your life expectancy if there is no data to support the claim. Yet, it’s completely legal to take people’s life savings and trick them into thinking the return of their own money is income. Here are a couple examples of trickery:
- Individual muni bonds. The most common and, in my opinion, egregious trickery comes in the muni-bond market. I’ve examined well over a hundred client statements that appeared to show handsome income from owning individual muni bonds. The trick goes like this – the broker buys an AA-rated muni bond at $110 that pays a $5 coupon or yields 4.45% ($5 / $110). That’s so much better than a muni bond fund such as the Vanguard Intermediate-Term Tax-Exempt Bond Fund (VWIUX) yielding 2.60% as of September 21, 2018.
The trick is that the bond is going to mature or be called in four years at $100 par so, over that period, $10 of that income proudly displayed on their brokerage statement is just return of their principal. Thus, in simple terms, half of that $5 coupon is return of their own money and the actual yield is closer to 2.23% before the broker charges 0.50% to “manage” the bond portfolio. I’ve had several conversations with the regulator, MSRB, on why this is allowed and its executive director, Lynnette Kelly disagrees with me that this is trickery. Of course the MSRB is a self-regulatory agency and this trickery benefits the industry.
- Single-premium immediate annuities (SPIAS). Why buy a CD yielding 3% when a SPIA yields 6% income, depending on the client’s age? Fork over $100,000 into a SPIA and that $6,000 income is attractive and guaranteed for life. The problem here is simple to explain – at a 6% payout, the client must live 16 years and 8 months (1/.06) just to get their principal back. It’s like buying a bond with a duration of the rest of the client’s life at a time when interest rates are near an all-time low. So that “guaranteed income for life” not only isn’t income, it guarantees the client will have maximum exposure to inflation risk. Sadly, a SPIA is the least ugly of annuities – guaranteed returns from variable annuities are far worse since the return comes in the form of an annuitization later on, at below-market rates rather than cash.
Safe income that isn’t so safe
A different type of mistake is something we all want to believe but is rarely true: We can get both high income and safety. Here are some examples of costly beliefs:
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Master limited partnerships (MLPs). A few years ago, I was constantly hearing statements like in this 2014 article: MLPs – safe income for seniors. It notes, “today, however, we are focusing exclusively on how MLPs can produce a healthy and steady income without exposing clients’ nest eggs to unwelcome risks.” Yet in 2015, MLPs lost an average of 35% according to Morningstar, including that so-called healthy and steady income.
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High-yield bonds. A much better name for high-yield bonds is “junk” and junk bonds lost an average of 26% in 2008, just when we needed bonds to be a shock absorber. By contrast, a high-quality bond fund like the Vanguard Total Bond index fund gained over 5%. Now the “experts” are again saying bond indexing has failed, citing the fact that they had below average long-term performance, according to Morningstar. Morningstar correctly points out those active funds in the peer group take on more default risk. In 2008, people lost a ton of money trying to earn an extra 1% on bonds and today we are repeating this same mistake. This trend is proof that human beings aren’t efficient learners.
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Safe-dividend stocks. What can go wrong with a blue-chip dividend payer? The easy answer is everything. Consider that General Motors and Eastman Kodak were two of the 10 most valuable companies on the planet a quarter century ago. Their dividends were safe, many thought. Want a more recent example? The General Electric dividend was considered safe until last year when it was cut by 50% and investors cut the price of the stock by 60%.
While not as catastrophic, a diversified dividend fund strategy is also flawed. For example, the iShares Select Dividend ETF (DVY) turned in a good five-year annualized return of 12.31% through September 21. But a more diversified Vanguard Total Stock ETF (VTI) clocked a 13.26% return and was far more tax-efficient. After taxes, Morningstar estimates VTI bested DVY by 1.68% annually during the five years. And if you didn’t want dividends and bought the Vanguard Large Cap Growth ETF (VUG), you got a 14.79% with even more tax-efficiency.
A better way
Tell your clients that total return and principal protection are more important than income.
I advise clients that money is simply stored energy. Over the years, they worked hard and lived below their means to save and convert human capital (ability to earn money) to investment capital. I say “spend your money, you earned it.” By keeping costs low and diversification high, our clients can accomplish what should be their ultimate primary goal – having enough money to enjoy their retirement years. Then I throw them the bonus that it also happens to maximize the legacy they can leave to their children.
Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisor. He has been working in the investment world with 25 years of corporate finance. Allan has served as corporate finance officer of two multi-billion dollar companies, and consulted with many others while at McKinsey & Company.
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