The Challenge of Long-Term Income: Part 1

Portfolio Income: The Trouble With Treasury Bonds

The current economic environment is making it very hard for investors to generate reasonable levels of income through traditional means such as bond ladders.  While it is always dangerous to suggest that ‘it’s different this time,’ I believe that we are facing some unprecedented conditions that require new approaches.  Income-seeking investors with low risk tolerance—those who have traditionally favored government bonds—are in the most difficult situation.

The problem of low savings and investment rates in the U.S. is huge.  I have written about this in the past, along with many others.  Every study on retirement savings notes that Americans need to save more.  Having the ability to support yourself from a portfolio of savings is not, however, just about the amount that you save.  There is also the issue of how much income you can derive from each dollar in your portfolio.  Today, with historically low yields on government bonds, retirees and others seeking to live on the income from low-risk investments are faced with an enormous challenge that compounds the savings rate problem.  To be able to live on the income provided by very low-risk investments, the necessary savings rates increase dramatically relative to savings rates when investors are willing to bear some risk.

In this two-part article, I explore the current environment for conservative income-seeking investors and what it means (Part I) and look at the range of plausible alternatives (Part II).

The Standard

The standard conservative approach to generating income in retirement is that people should hold a large proportion of their assets in low-risk Treasury bonds.  Holding a portfolio of bonds with varying maturities, a bond ladder, provides the core of long-term income for retirees.  Bill Bernstein, for example, in a recent interview in Money magazine (September 2012 print edition), suggested the following advice for retirement and beyond:

…you should save 20 to 25 times your residual living expenses—that is the yearly shortfall you have to make up after Social Security and any pension.  This portfolio should be in safe assets: Treasury Inflation-Protected Securities (TIPS), annuities, and even short-term bonds.

In today’s interest rate environment, the yield from a Treasury bond portfolio is very low.  The intent of very low interest rates is to stimulate borrowing and investment and thereby helping the economy to grow faster, which should benefit all Americans; however, the impact of those low interest rates on investors trying to generate income from government bonds is devastating.  The yield on ten-year Treasury bonds is 1.65% (see chart below).  Prior to the current economic crisis, the lowest yield over the last fifty years was about 4%.  Your income from bonds is determined by yield.  If you buy ten-year Treasury bonds with a 1.65% yield, you will receive less than half as much income as you would receive if you got a 4% yield.  In other words, a person retiring today and investing in 10-year Treasury bonds would have to have saved more than twice as much as a person retiring in the early 1960s to be able to generate the same level of income.

Yield on Ten-Year Treasury Bonds (^TNX, Source: Yahoo! Finance)

In theory, the very low yield on government bonds means that the consensus opinion of the market is that we are not facing substantial risk of inflation.  When inflation expectations are high, investors demand a higher yield from government bonds.  The very high yields on Treasury bonds in the early 1980’s reflected concern about ongoing inflation.  If inflation risk is low, investors should find low Treasury yields acceptable because the purchasing power growth provided even at low yields can be attractive.  The immediate problem, however, is that investors need current income and a 1.65% yield is vastly below most peoples’ expectations based on history.  To put it bluntly, almost nobody has enough money to live on a bond portfolio yielding 2%.

 The introduction of TIPS (Treasury Inflation-Protected Securities) was intended to provide a simple baseline asset class for retirees.  TIPS are government bonds that increase in value with the CPI.  Professor Zvi Bodie has long championed the idea that TIPS are the single asset class that should comprise most or all of investors’ portfolios.  Bodie proposes that investors create and manage a TIPS ladder that will provide a certain amount of income per year in retirement.  While I find Bodie’s analysis compelling, the most recently issued five-year TIPS have a negative yield (-1.29%).  It is hard to rationalize holding large allocations to TIPS with a negative yield.  If inflation surges, the aggregate yield to investor could become attractive, but I don’t think that buying bonds with negative yields makes sense for income investors, in general.

What Is The Market Telling Us?

The very low yields on government bonds today are the result of a number of factors.  First, investors are scared of taking any kind of market risk and discount the risk of inflation.  Second, the market as a whole is betting that either (1) inflation will remain low or (2) that they are nimble enough to get out of bonds when inflation starts to become evident.  Third, investors are betting that U.S. Treasury bonds will continue to be viewed as a safe haven as compared to sovereign bonds issued by other nations.  I do not place much faith in market forecasts, so I am left with the current state of yields and the fact that (1) yields are currently unattractive and (2) the only way for yields to increase is for bond prices to drop.

Another interpretation of U.S. Treasury yields is that these bonds are increasingly being treated as a form of money, rather than as an investment.  In other words, buyers of Treasury bonds value them primarily as a liquid default-free vehicle to store savings.  If U.S. government bonds have taken on the role of a store of value (like money) rather than an investment that generates positive real returns, income-seeking investors will need to look elsewhere.  The real return of short and intermediate Treasury bonds makes these bonds resemble money quite closely.

The current estimated rate of inflation in the U.S., as measured by the Consumer Price Index (CPI) is 1.4% for people living in urban areas (this is the CPI-U, the standard reference for inflation).  Investors receiving 1.65% yield on 10-year Treasuries are basically break-even with inflation at the current time, but current inflation is far below the historical average for the U.S. (around 3%).

There is another potentially expensive impact of current rates on retirees.  Imagine that you retire with a portfolio of Treasury bonds and spend only the yield of the portfolio.  Your principle is perfectly safe.  As the bonds in your portfolio mature, you will need to buy more bonds to provide future income.  The problem is that you have less to invest in real terms because your portfolio has not kept pace with inflation, even assuming that the current very-low inflation environment persists.

What Can Conservative Income-Seekers Do?

The reality for income investors is that even conservative investors need to take a broader view of how they generate income and cannot simply look at government bonds.  It would be great if there were a simple risk-free asset that would provide substantial income but that asset class does not currently exist.

The fundamental reality of investing is that if you want a return higher than a risk-free investment, you must bear some risk.  U.S. government bonds have very low default risk but a fairly significant risk of ownership should interest rates raise.  Assuming that your goal is to provide for long-term income and not to take a bet on interest rates, you have to diversify beyond government bonds.

 In the second part of this article, I will explore specific alternatives for investors seeking low-risk income-oriented portfolio solutions.

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9 thoughts on “The Challenge of Long-Term Income: Part 1

  1. mlonier

    If following Bernstein’s advice, someone has saved 20-25x their annual retirement expenses net of social capital (SS + pension), then they do not need to put their savings at risk seeking higher yield– they need safety and an inflation hedge. Bode’s suggestion to invest in TIPs is exactly that. Once someone has secured their essential income requirements in such a risk-free inflation-hedged manner, then any additional savings can be sensibly invested in risky assets for growth. Most will be hard pressed to save the required 20-25x, and so have every reason not to risk their inadequate savings in the market–they can’t afford the risk. Anyone who has saved more than enough, maybe 50x or 100x their essential annual expenses, may be fortunate enough to live off the interest their principal yields. Those are the fortunate few–who are also likely to have a solid, hedged, risk-free floor, and an upside portfolio of risky assets for growth above the floor. Upside growth (or high ‘yield’) investment in retirement is not for those who cannot afford the risk. Sequence of return risk can decimate such an inadequate porrfolio, and the retiree will run out of money while still alive. That and not low yields or less-than-market returns is the definition of retirement plan failure.

  2. Geoff Considine Post author

    Hi Mlonier:

    Thanks for the note. You have nicely articulated the problem. The basic case for ultra-low risk investments is that people cannot afford the risk of a run of poor returns. The problem is that most people also cannot afford to live on the principal that they have accumulated when the low-risk investments deliver such low yields. People must choose a compromise solution between these two constraints. Obviously retiring later and saving more are good solutions in theory, but some of these discussions about saving 25X income requirements (beyond SS and any pension) seem to ignore the fact that the vast majority of retirees have assets nowhere close to that amount and probably never will. This is a complex problem without a single answer. I admire Bodie very much for spending so much effort to get people to understand the risk proposition here.

  3. mlonier

    Indeed! Someone who is under-funded for retirement has limited choices–working longer, cutting expenses, saving more, the charity of family and friends, and taking market risk. Market risk is arguably the least efficacious– since they are underfunded, they do not have large sums to leverage, so the small gain they might receive is at the expense of outsized risk. If they’ve only saved enough to cover ten years of expenses (10x), what will they gain by adding a small increment of ‘yield’ while putting their savings at significantly higher risk? 6 months? A year? What happens if there is a 30% drawdown and they lose 3 years of expenses? The best council we can give someone in this situation is to become realistic about their situation, make significant adjustments, perhaps annuitize some or all of their funds to maximize guaranteed income from savings, and don’t think of the capital markets as a lottery where if they just follow a few simple ideas, they’ll hit a home run.

  4. Geoff Considine Post author


    Thanks for the further thoughts. Please understand that I am not trying to convince you or anyone else of the single ‘right’ solution. I explore the tradeoffs more in Part II. Ultimately, my concern with the argument that a ‘risk free’ solution is always the right choice is that I then have to ask how low yields can go before you change your allocation? If real TIPS yield is negative, are you willing to put all of your money into them? How low can yields go before you start to change your view? I have batted this issue around with Wade Pfau. For some people, the argument may be that there is no price too high for getting inflation protection and guaranteed repayment (e.g. they will always accept the prevailing TIPS rate). That is one choice and I am not trying to talk you out of it.

    There is no doubt that market risk can reduce your quality of life and your ability to support yourself–but so could negative real yields. I sometimes think about this in terms of other risks. If I got in a bad ski accident, it could cripple me or kill me (e.g. market risk). On the other hand, the long-term personal reduction in quality of life that I would get from not skiing is too high for me to choose not to ski. We all face these tradeoffs in life.

    The annuity piece is really interesting and is too complicated to go into here, but I have written an article on that elsewhere.



  5. mlonier

    Traditionally in an accumulation portfolio, bonds either offset equity risk or provide current income (or both). In a retirement income plan, a third approach is to buy a ladder of (inflation-hedged) future income, held to maturity and discounted at the prevailing interest rate. Each year you get a planned amount for expenses, which is the sum of your principal contribution, plus interest (if STRIPs), plus inflation (if TIPs). Yield only enters into it as it effects the cost, the rate, to buy that future income.

    Which approach to use depends on where someone is in the planning lifecycle, their earnings, savings, and expenses. If essential retirement income is secured by a ladder of risk-free Treasuries, then the individual could take even more than ‘traditional’ risk with the balance of their investments, perhaps not holding other bonds at all, and be focused on growth or at least total return.

    Yes, today TIPs are expensive and at some point even with the CPI adjustment, a price that starts with a negative yield may not be worth the inflation adjustment held to maturity, compared to the cash alternative with no inflation adjustment. Which argues to keep average maturity of a retirement income ladder short. In using TIPs for guaranteed retirement income, it’s not so much yield as it is the comparable cost to provide the same level of future income via other risk-free methods–cash, annuities, STRIPs, etc.

    I always enjoy your posts, and look forward to part II!

  6. Pingback: The Golden Rule of Investing « Portfolio Investing Blog: Portfolioist

  7. Pingback: The Challenge of Long-Term Income: Part II « Portfolio Investing Blog: Portfolioist

  8. Pingback: Saving and Investing for Retirement: Part One « Portfolio Investing Blog: Portfolioist

  9. Pingback: Managing Your Portfolio’s Exposure to Interest Rates « Portfolio Investing Blog: Portfolioist

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