The old formula for retirees to “live off of the interest earned from fixed income investments” is nearly impossible in today’s interest rate environment. A 10-year U.S. Treasury note yields about 2.5 percent. Said another way: If you agree to lend the U.S. government $10,000, they promise to pay you $250 per year (before taxes and inflation) for the next 10 years. At the end of the 10 years, you receive your $10,000 back.
These low returns have left retirees choosing to live off of less income or to invest in assets with a greater potential for loss. If you prefer a stable income without relying on interest earned or excessive risk, you need to invest for total return.
Total return is a measure of investment performance that accounts for two categories of return: growth and Income. Growth, or capital appreciation, occurs when investments go up in value (increase in stock price). Income could come from interest paid by fixed income investments, distributions or dividends. Total return combines both measures, and is the most important number to review for an honest look of your investment performance.
The best way to structure your investments to maximize total return is to split your assets into two different categories: growth and income.
Invest for growth. The average American will spend two decades in retirement. Using the 20-year average inflation rate of 2.4 percent over this time frame, you would need $161 in 20 years to purchase the equivalent of $100 worth of goods today. In order to combat the effects of inflation, a portion of your investments should be invested for a longer time horizon, and into assets that have the potential to appreciate.
You don’t need to be extremely aggressive, but investing a portion of your assets in equities will give you a better chance at having a longer-lasting portfolio. The annualized return for the Standard & Poor’s 500 index, from 1871 to 2013, is 9.07 percent. If you invest 30 percent of your portfolio in an S&P 500 index fund, you could have received a 2.72 percent return from just that portion of your assets, based on historic averages. Although the return is just over the interest paid on the 10-year U.S. Treasury note, it only accounts for 30 percent of your portfolio, leaving 70 percent of your portfolio to be invested elsewhere.
Historically, growth has come from sectors such as small companies, emerging market and technology investments. Although these sectors will likely continue to experience growth over the next two decades, they should not be your only investments. You still want to diversify your risk, so focus on spreading it across multiple asset classes and multiple companies. You can achieve this more efficiently through mutual funds or exchange-traded funds.
Invest for income. When investing for total return, the growth portion of your portfolio will tend to function in typical market cycles with peaks and valleys. In order to offset the volatility within these investments, income-producing assets can be used to provide predictable payments and lower your total portfolio risk.
Real estate investment trusts, or REITs, dividend-paying stocks and high yield bonds are examples of income-producing investments. However, just because an investment is paying a high dividend does not mean it is a good investment. I met with a client who said he had a stock that was paying a 9 percent dividend and he was very happy about that. So I looked at the stock he held, and it did in fact pay an 9 percent dividend. The only problem is that he only looked at the income side of the stock. When I looked at the investment’s statistics, I found out that the stock price actually decreased by 7 percent. So just taking the 9 percent dividend and subtracting the 7 percent price decline, he actually only made a 2 percent total return. He did not know this and actually thought he had made a great investing decision, when in actuality, he wasn’t even keeping pace with inflation.
The extraordinary measures taken by the Federal Reserve have placed retirees in a difficult position for producing stable income without taking low risk. Fortunately, investors who structure their portfolio for growth and income can achieve consistent income and potentially increase the longevity of their portfolio.
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Retirees Should Invest for Total Return originally appeared on usnews.com
