Retirees Need To Rethink Fixed Income

by: Eric @ SERVO


The days of acceptable returns on fixed income are long gone, but many retirees still act as if bond returns going forward will mirror the '80s and '90s.

A new framework for investing in bonds within the context of a long-term retirement plan is needed to prevent people from running out of money.

Using bonds as they were intended, as low-risk, return-on-investment assets that can stand in as an enhanced emergency reserve, is the most sensible retirement investing strategy today.

In 1982, you could have purchased a 10-year Treasury note that yielded 14.6% (in 1979, inflation was 13.3%; in 1980, it was 12.5%). Since 1985, you've earned +8.8% a year on the Vanguard Long-Term Investment Grade Bond Fund (just 1% less than the long-term return on stocks). Those days are long gone, of course, as interest rates on high-quality bonds of any maturity are below 3%.

Unfortunately, many people still invest as if bonds are priced to return 6% to 8% per year or more going forward. We continue to see significant inflows into bond funds and ETFs as well as balanced funds with a considerable allocation to longer-term bonds. These decisions are especially risky for retirees, whose greatest investment risk entails holding too much of their portfolio in assets that won't produce an acceptable long-term return, such as low-returning bonds.

But in the absence of a better approach or a new framework for retirement planning decisions, dollars tend to flow blindly towards investments with strong past returns. So let me propose a different way to think about investing in general and fixed income in particular within the context of a long-term retirement plan. Here are four investing principles that you can use to adapt your retirement plan to modern fixed-income realities.

#1 - If the goal is an ongoing income stream that rises with inflation, coupled with principal growth for unexpected spending needs and future legacy aspirations, you'll need to rely on stocks.

Let's look at all 20-year rolling periods since 1927 across a range of different stock and bond asset classes, net of inflation ("real").

Asset Class

Frequency of 20-YR REAL Returns < 0%

Frequency of 20-YR REAL Returns < 4%

1-Month T-Bills



5-YR T-Notes



20-YR T-Bonds



S&P 500 Index



Diversified Stock Index



Regardless of the maturity, bonds have historically produced extremely low inflation-adjusted returns. At the 1-month and 5-year maturity marks, bonds have failed to outperform inflation almost 30% of the time. For long-term maturities, that figure rises to almost 50%!

Setting the bar higher, at +4% annual real returns, 1-month T-Bills have never achieved that result, 5-year T-Notes failed 84% of the time and 20-year T-Bonds fell short over two-thirds of the time. If the goal is to achieve a satisfactory long-term return, investing in bonds is a risky bet.

Stocks, on the other hand, despite significant short-term ups and downs, have performed remarkably well at longer horizons. Neither the S&P 500 nor the Diversified Stock Index (a mix of large cap, value and small cap stocks) failed to achieve a positive real return over 20-year periods.

Even with a bogey of 4% more than inflation, the S&P 500 fell short just 24% of the time, the diversified index only 3% of the time. Clearly, stocks have a much higher probability of a satisfactory long-term return, and the more diversified the better.

#2 - The real purpose of bonds: they can buy you time

The chart above looks almost too good to be true: Who wouldn't want to own stocks? You wouldn't… in 2008, 2000-2002, 1973-1974, 1937 or 1929-1932. These are the five worst bear markets for stocks in modern history. And it is here where we see the primary advantage of bonds: They tend to hold their value when stocks are declining.

Bear Market

S&P 500 Index

Diversified Stock Index

1-Mo T-Bills

5-YR T-Notes

20-YR T-Bonds































While the bear markets don't last long, they are severe. Of course, we know these episodes are temporary, and historically, you have recovered fully within just a few years. But for the retiree who doesn't have an alternative source for cash flow while stocks are dropping, they might be forced to sell stocks at fire-sale prices, foregoing the opportunity to recover.

For that reason, it makes sense to keep a few years of future spending in bonds, at least enough to cover the worst bear market on record - the four-year stretch from 1929 to 1932. Once stocks begin to recover (the S&P 500 returned +31.6% per year from 1933 to 1936, the Diversified Stock Index returned +42.2% per year!), the retiree can resume taking periodic cash flows from stock dividends and proceeds from sales of shares.

This doesn't give you the green light to load up on bonds though. With 40%, 50% or more in low-returning fixed income, you run the very real risk of running out of money in retirement at even modest spending rates. What's the right amount to have in bonds? As little as possible.

#3 - Look to bonds for a return of principal, not return on principal.

Despite the logic of the above approach, most investors still purchase bonds for their coupons, with the interest rates matched to the current spending needs of the investor. But this ignores that future interest rates might not keep up with the growth in your spending needs. Consider the rise in inflation and interest rates that began in the early 1960s, which led to the early 1980s peak in interest rates I previously mentioned.

Asset Class

1964-1981 REAL Annualized Return

1-Month T-Bills


1-YR T-Notes


5-YR T-Notes


20-YR T-Bonds


S&P 500 Index


Diversified Stock Index


This 18-year stretch is another illustration of the risk of bonds in general, and long-term maturities in particular. How many investors have flocked to long-dated bonds recently because of their perceived bear market protection, not realizing how much inflation risk they are taking on to get it (or that, prior to 2000, long-term maturities provided no additional bear-market benefit compared to shorter maturities)?

If you put $1 in long-term bonds in 1964, 18 years later, your dollar (including coupons) was worth less than $0.50 net of inflation! If you are using bonds as an enhanced emergency reserve, you don't want to have to keep adding to them as their value (and spending power) continues to diminish in the face of rising inflation and interest rates.

It was only 1-month T-Bills and 1-year T-Notes that managed to keep pace with inflation over this stretch, providing a real return of principal. Even 5-year maturities lost about -1.0% a year in purchasing power. The lesson here is clear: Keep the money you might need to spend in the short run in maturities of five years or less.

Short-term bonds tend to perform just as well as longer-term bonds on average in bear markets and over time, but have far less volatility and inflation risk. Beyond five years in maturity, and you are taking unnecessary risks in what should be considered the "safe" part of your retirement plan.

#4 - Turn low-bond-return "lemons" into "lemonade"

If there is one advantage to low bond returns for retirees, it's when we get to the tax and legacy aspects of a retirement plan. If you put your relatively low-returning bonds in your Traditional IRA accounts or Traditional 401(k) plans, you will reduce their long-term returns. That might not seem beneficial now, but when it comes time to draw funds from these tax-advantaged accounts, you should realize that all dollars withdrawn are taxed at ordinary income tax rates.

And as many older retirees will tell you, even if you don't want the money, you have a mandatory withdrawal after the age of 70.5 that is a function of your overall retirement plan balances. With lower long-term account growth (from holding low-return bonds), your future balances will be smaller and your forced distributions at higher tax levels will be relatively less.

This frees you up to put tax-efficient stocks in taxable accounts, which qualify for long-term capital gains taxes on sales of shares held more than one year, and then only on the gains. If you never get around to spending all of your taxable assets in your lifetime, they currently qualify for a "step up" in cost basis at your death, which could significantly increase the amount of after-tax wealth you are able to leave behind as a legacy.

Historically, low interest rates and bond returns are making it difficult for retirees to plan for multi-decade, ongoing cash flow. But the solution isn't to stick your head in the sand and continue to do the same things that might have worked OK in a previous era when rates were much higher. Retirees need to rethink fixed income.

Portfolios with excessive amounts in bonds, or any allocation to long-dated maturities were never optimal, but should be completely ruled out at this point. Instead, looking at bonds as an enhanced emergency reserve, with a few years of future income allocated to short-term maturities as a strategy to weather unpredictable but inevitable bear markets, makes the most sense.

If you're able to locate your bonds in tax-advantaged accounts, it might even save you in taxes today and allow you to leave a larger after-tax legacy in the future. These aren't ideal solutions, but they are far better than most alternatives and should allow you to achieve your retirement goals and many of your aspirations.


Source of data: DFA Returns 2.0

Diversified Stock Index = 30% S&P 500 Index, 30% DFA US Large Value Index, 40% DFA US Small Value Index, rebalanced annually.

Past performance is not a guarantee of future results. Index performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , , Financial Advisors, Retirement Advice,
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here