Fixed Income Choices For Retirees: How Some Are Better Than Others

by: Ted Waller


Fixed income meets specific needs important to retirees.

Over time, duration risk and inflation have corrosive effects on fixed income that must be considered in any financial plan.

Two types of fixed income vehicles that address loss of buying power and duration risk are discussed, as well as two types that do not.

Fixed income has a number of characteristics that are particularly attractive to retirees:

  • It takes away the worry about where income will come from.
  • It doesn’t require any monitoring or other attention at a time of life when most people want to spend less time on their finances and more time on other things.
  • In most cases return of principal is guaranteed.
  • Fixed income vehicles can minimize the chances of severe financial loss at a time of life when there may not be time to recover.

In retirement, when things like reliability of income and capital preservation have a bigger role than in earlier stages of financial life, fixed income has a more prominent position. However, it is subject to two main risks: inflation and duration risk. Effective use of fixed income requires careful risk planning. Coupon clipping the old-fashioned way.

The Rule

For decades the general rule for asset allocation has been to have a percentage of your assets in stocks equal to 100 minus your age, and the rest in fixed income. As an example, a 65-year-old should have 35% in stocks and 65% fixed income. As interest rates have dropped in recent years, the contribution of fixed income to income and asset growth has become increasingly inadequate. Many advisors now recommend a formula using 110 or 120 minus your age, which reducing the fixed portion and relying more on historical stock market returns. Of course, this is only a starting point and asset allocation depends on each individual’s personal circumstances.

The Rule and Retirees

Interestingly, most asset allocation discussions are silent on an important part of the equation specific to retirees: The existence of large fixed income outside of the portfolio. Social security is the most obvious example, and individuals may also have pensions or annuities. When these are added to the fixed/variable asset mix it changes drastically. Consider, for example, at a 65-year-old who receives $25,000 a year from social security and $25,000 from a pension or annuity. Assuming a 4% interest rate, $50,000 of income represents an investment in fixed income of $1,250,000. If this person also has $300,000 entirely in stocks, he or she is already at 72% fixed income. If he has the advised 65% of his $300,000 in bonds, he is at 93% fixed income!

Type of asset or income

Asset equivalent

% total assets equivalent

$25,000 SS income represents a 4% yielding investment of:



$25,000 annuity income represents a 4% yielding investment of:



65% fixed portion of $300,000 portfolio equals



Total equivalent fixed income assets



35% stock portion of $300,000 portfolio equals



This exercise in arithmetic does not imply that everyone should use a dollar for dollar correspondence for their pensions or Social Security in calculating fixed/variable asset allocation. Rather, the message is that this type of resource should not be overlooked in the application of asset allocation guidelines, recognizing that individual circumstances and preferences vary widely. For many people fixed income in its many manifestations is a desirable counterbalance to the variability of stocks.

Fixed Income and the Passage of Time

Perhaps the number one virtue of fixed income for retirees is its long-term reliability. But within this virtue lies its greatest danger: inflation. In a modern economy, inflation ranks close to death and taxes in terms of certainty. Our central bank even has inflation as an explicit goal, saying some inflation is desirable and necessary for economic health. If true, the ability of the Federal Reserve to keep inflation levels in an acceptable range is highly questionable. In recent years, they have missed their inflation targets consistently. There’s no dispute that uncontrollable high inflation in the future would be a catastrophe for anyone relying on fixed income, and that possibility cannot be ruled out. But even mild inflation has a corrosive effect on fixed income over time and every retiree must consider inflation in their financial planning.

The table below, reproduced from Boomers, Retirement, Inflation, shows just how corrosive an inflation level considered acceptable by the Federal Reserve would be. Imagine the effect on your life if your buying power was cut 33% or even 45% from what you have today.

Duration Risk

Duration risk refers to sensitivity of a fixed income investment to interest rates. The longer an investment’s time to maturity, the greater the risk from higher rates. When interest rates rise, the amount of principal goes down to adjust the yield to new rates. When interest rates fall the principal goes up, but if interest rates trend higher in the long term, long term bonds and most preferred stock will in effect suffer a permanent capital loss. Whether interest rates will change in this way is unknown, but in light of the current historical lows in interest rates it is irresponsible not to plan for that possibility.

Can Fixed Income Account for Inflation and Duration Risk?

By their nature most fixed income instruments don’t offer direct inflation or duration protection. Treasury Inflation Protection Securities [TIPS] are the best known inflation hedge, but they currently offer a very low yield and have high duration risk. The current 10 year TIPS yield is .46% vs. US 10 year bond yield of 2.48%. An alternate strategy is to avoid instruments that lock up money for very long periods, and instead provide an opportunity to adjust to changed conditions in a reasonable time frame. The risks can't be eliminated, but they can be reduced. The following discussion highlight two investment types that have this option, and two that don’t.

Inflation/Duration Hedge: No

Long-term bonds (10+ years): The buying power of income from a bond with a maturity of 10 years or more will be significantly impaired by accumulated inflation. Duration risk is very high, and can’t be avoided by selling before maturity because as general interest rates rise to accommodate inflation the price of the bond will go down. Selling means a loss of capital, negating one of the chief advantages of bonds.

Preferred stock: Preferred issues are a way to get higher income than bonds or common stock. Unlike even the longest term bond, though, the potential duration of the normal preferred issue is forever, with an accompanying level of duration risk. The high income that preferreds offer makes it tempting to disregard the possibility of buying power erosion, but many investors cannot afford to do this in the long term. Likewise, they cannot or do not want to take a capital loss by selling holdings before maturity when principal has been eroded by higher rates.

Note: Most preferred issues have a call date but redemption is solely the decision of the issuer. Redemption will not happen if it is not to the issuer’s advantage, which means the duration is potentially forever.

Inflation/Duration Hedge: Yes

Intermediate bonds (2-10 yrs): Inflation and the added ill effects of compounding have less time to operate before maturity than long-term bonds, and duration risk is lower. Even if the funds from redemption at maturity are used to redeployed in bonds, the investor will be able take advantage of the future investment climate, getting a higher coupon if inflation and rates have increased. In other words, these bonds allow an investor to change course in a more reasonable amount of time, as opposed to being locked in for ten or twenty years by a decision made today. Given the historically low interest rates today, it odds of higher future yields are great enough to merit serious consideration.

Fixed-to-variable rate preferred stock: In this variation of preferred stock, the dividend is fixed for a specific period, usually 10 years, after which it is reset to a formula that is pegged to a benchmark interest rate (usually LIBOR). If the new yield is significantly higher than other preferreds, the issue will be called and the investor can move on. If the new yield is lower, stockholders will get a lower dividend. However, as shown in the examples below, there is a yield floor that enables holders to still get a decent yield regardless of how low prevailing rates are.

Goldman Sachs 6.375% Fixed to Float Non Cum

Morgan Stanley 5.85% Fixed to Floating

Two Harbors 8.125% Fixed to Float Preferred





Issue price




Current price




Current yield




Yield to Worst




Call date




Moody’s rating




Reset formula

3 mo. LIBOR +3.55%

3 mo. LIBOR + 3.491%

3 mo. LIBOR + 5.66%

The 3 month LIBOR rate is currently 1.7%. This is historically very low. For a more complete discussion of fixed-to-variable preferreds, readers can go to this article, A Better Type Of Preferred Stock Investment.

Weighing the differences

The flexibility of intermediate bonds and fixed-to-variable preferreds has a cost, as shown in this comparison with long term bonds and regular preferreds. ETFs and mutual funds are used in the example to include a larger number of issues for comparison.




Long term bond

Vanguard Long-Term Bond Index Fund (VBLTX)


Long term bond

Vanguard Long-Term Bond ETF (BLV)


Intermediate bond

Vanguard Intermediate-Term Bond Index Fund (VBIIX)


Intermediate bond

Vanguard Intermediate-Term Bond ETF (BIV)


Perpetual preferred

iShares U.S. Preferred Stock ETF (PFF)


Perpetual preferred

PowerShares Preferred Portfolio ETF (PGX)


Fixed-to var. preferred

PowerShares Variable Rate Pref Portf ETF (VRP)


Fixed-to var. preferred

mean of 10 randomly selected issues


The last entry uses individual issues to show the results of going farther down the bond rating scale. Most of the individual issues are rated BB, whereas at least 60% to 100% of the ETF and mutual fund holdings are investment grade.

Each investor can weigh the higher current income of the long bond and regular preferreds against their shorter duration cousins which allow adaptation to future conditions that are likely to be very different. Perhaps the higher paying instruments are chosen when every bit of income is needed right now. Retirees comfortable with their current income may choose to forego some income now for more flexibility later. In either case, it helps to be mindful of the loud, incessant message from the media that everyone must make as much money as possible right now, that something is wrong if colleagues and neighbors are getting more in dividends or interest than you. This is a destructive distraction from thinking about the longer term, where success truly lies.

Summing up

Fixed income fills a specific need for those past their working years. Inflation and duration risk are threats to fixed income that no retiree can afford to ignore. The destruction caused by high inflation or interest rates is easy to comprehend, but even milder manifestations have a corrosive effect on the value of fixed income over time. The relatively high income offered by long term bonds or perpetual preferred shares is a necessity for some and an attraction to others, but the value of that income and principal will be less as the years proceed. This is a particularly important concern for retirees, who do not have the same ability to increase income as working age people, or time to replenish assets after a setback.

Fixed-to-variable preferred stock and intermediate bonds provide a means to minimize risks to fixed income over time. Risk cannot be eliminated, but it can be attenuated. At maturity the bonds give the investor the ability to reallocate assets under future conditions with no loss of capital. Depending on future interest rates, fixed-to-variable preferreds can either do the same or reset yield to a higher level. Every investor looking for fixed income through bonds and preferreds should consider these variations in preparing his or her financial future. Flexibility is an essential consideration in every financial plan.

Disclosure: I am/we are long GS.

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.