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AARP Article

Investing If You’re Nervous

What to buy when the payoff you need is peace of mind

What should you do with your money if you’re deathly afraid of stocks and want to keep your capital safe? That’s a tough one. No-risk investing comes at a cost. You’re giving up the opportunity to make your retirement savings grow. Low-cost, broad-market index funds from companies such as Vanguard, Fidelity or Schwab will grow nicely over time if you leave them alone.

But your personal anxiety takes precedence over third-party financial advice. So, as a secondary goal, try to grow your savings at something close to the inflation rate. At this writing, both the principal consumer price index and the special index reflecting older Americans’ expenditures are rising at the rate of 2.9 percent. That’s the investment return you would need to preserve your purchasing power.

First choice, for people seeking safety first, is often a high-rate, federally insured bank certificate of deposit. One-year CDs with low minimum deposits are paying roughly 2.5 percent, according to Bankrate.com. For 3 percent, you have to deposit your money for five years. These rates are generally available only at online banks, such as Barclays and Capital One 360. Local banks might pay closer to the national average of 0.72 percent for one year and 1.29 percent for five years.

Even though these insured CDs may slowly lose purchasing power, they preserve the face value of savings, so you’re never alarmed when the financial world contracts. They’re also a good choice for people with smaller nest eggs—say, $50,000 or less—who can’t afford to take risks.

An option that pays a bit more than these CDs is what’s known as a multiyear guaranteed annuity. It’s a simple product with no links to stock-market indexes. You invest your money with an insurance company (minimums typically range from $2,500 to $100,000). In return, you get a fixed rate of interest for a specified number of years—usually at least three. You pay taxes on earnings only when you withdraw them. You can usually take out a certain amount of money each year, penalty free, although insurers will charge you penalties for quitting annuities early. Currently, five-year investments pay from 3 percent to 4 percent, and three-year investments from 2.5 to 3 percent. (For a list of multiyear guaranteed annuities, go to ImmediateAnnuities.com.)

You might get even more money over the long term from mutual funds invested in bonds. Their return isn’t fixed. As interest rates rise, the market value of these funds declines. But there’s a silver lining: As rates rise, the funds’ managers will buy new bonds that pay higher rates. So the income produced by a bond fund will rise too. Assuming that you leave that income in the fund, you’ll be buying new shares at higher yields, and all your shares will rise in value the next time interest rates decline. Current yields on general intermediate-term bond funds are running in the neighborhood of 3.4 percent, and blue-chip corporate bonds at 4 percent.

Warning: Don’t fall for fancy investments promising above-market rates. That always means risk. 

(Originally published in The AARP Monthly Bulletin.)

AARP Article

Steer Clear of Risky Bond Funds

You can get burned by reaching too high for more yield on investments

Today’s super-low interest rates present enormous temptations to people who invest for income. To raise your game, you’re likely to fall, hard, for high-yield “junk” bond mutual funds. These funds look pretty sexy today, with current yields as high as 7-plus percent, when the average intermediate-term government bond fund is yielding 1.9 percent. But they’re also naughty and not worth the risk.

When business goes bad, some of the bonds held by high-yield funds will default or have their credit ratings slashed, causing their prices to fall. That has been happening recently to bonds issued by energy and mining companies. The money you lose from downgrades and defaults could easily cost you more than you’re earning from the fund’s higher interest rates. In fact, a 2012 study by the Vanguard mutual fund company found that investors in these funds, on average, do not—I repeat, do not—collect the high yields that they expect.

The bonds in high-yield funds are called “junk” for a reason. They’re issued by companies with poor ratings for credit quality, BB or below—often way below. That fact will be clearly spelled out in a fund’s prospectus under the heading “principal investment strategies.” Also, most of the funds have the words “high yield” in their name.

Double losses are possible. When times are good, junk bond funds “lull you into a sense of security,” says Larry Swedroe, director of research for the BAM Alliance of financial advisers and author of The Only Guide to a Winning Bond Strategy You’ll Ever Need. When times turn bad, junk funds add to your loss.

That’s because in bad times, these funds tend to behave like stocks. When the broad market plunges, the prices of high-yield funds capsize, too. If you own both stock funds and junk bond funds in your retirement account, you’ll take a double loss.

As an example, look at what happened over the 12 months ending early in March of this year. The Standard & Poor’s index of 500 leading stocks fell 6.18 percent. Morningstar’s index of high-yield bond funds followed stocks down, losing an average of 6.73 percent. Some funds are down 12 percent or more.

Junk bond funds don’t even help with diversification. Vanguard’s study concluded that “high-yield bonds on average would not have improved the risk and return characteristics of a traditional balanced portfolio.” In short, you don’t need them.

Go for un-sexy As investments. The role of bonds is chiefly to reduce your risk. That’s best done by owning the mousy, un-sexy funds you may have overlooked: those that invest in Treasuries and other U.S. government securities. They’re yielding nearly zilch. But when stock prices take a tumble, they generally rise in price. Over the 12 months ending in early March, after general alarm spread through the markets, Morningstar’s intermediate-term government bond fund average rose 1.54 percent. If you owned both government funds and stocks, the government funds would have reduced your loss. If you want to hold Treasuries to maturity, skip the funds and buy them, free, through TreasuryDirect.gov. If you like the convenience of easy withdrawals, buy the funds.

One other option, for safety first, is FDIC-insured certificates of deposit. You might find a five-year bank CD at around 2 percent, which is more than Treasuries pay. (Look for high-rate CDs at Bankrate.com.)

Just don’t kid yourself about bonds that apparently beat the market. There is no free lunch. 

(Originally published in The AARP Monthly Bulletin.)

AARP Article

Get More Out of Your Savings Bonds

Avoid these four mistakes that can cost you money

Are you sitting on a pile of U.S. savings bonds? If not, should you be? For safety-first investors, savings bonds still hold an edge over bank certificates of deposit. Savers put more than $631 million into these bonds last year. Those of you sitting on a pile might find, to your surprise, that some of them currently yield 4 or 5 percent.

Savings bonds come in two flavors — EE bonds, at fixed interest rates, and I bonds, at floating rates that change with inflation every six months. You have to hold them for at least one year. If you sell before five years are up, you pay a penalty equal to three months’ interest. Bonds generally stop paying interest after 30 years.

Almost all savings bonds today are sold electronically, through treasurydirect.gov. You can invest up to $10,000 a year for each type of bond (double that if your spouse buys, too). An additional $5,000 is available in the form of old-fashioned paper I bonds, if you ask that your tax refund be paid that way.

I bonds are the most popular. At this writing, a new bond yields 1.48 percent — and before you turn up your nose, consider the competition. A five-year CD might pay 2 percent, but it offers no inflation protection. You’re taxed on the interest every year unless you buy through a tax-deferred individual retirement account. You also pay taxes at all levels — federal, state and local. The income from savings bonds is tax deferred and then taxed only by the feds.

A quick word about EE Bonds. New bonds are paying (if you can call it “paying”) just 0.1 percent. If you hold them for 20 years, you’ll earn at least 3.5 percent, thanks to a guaranteed catch-up payment. Still, not appealing.

If you’ve owned savings bonds for years and are ready to cash them in, be sure to find out exactly what each bond is worth. Without that information, you might make one of four big mistakes, says Jackie Brahney, marketing director of savingsbonds.com, a service that helps you manage your bond portfolio.

Mistake 1: You cash in the oldest bonds first. They might be your highest earners.

Mistake 2: You look only at the bonds’ face amount when deciding how many to redeem. That might bring you more taxable income than you want. Bonds that add up to $3,000 on their face might be worth $6,000 or more, once the interest is counted.

Mistake 3: You cash in so many bonds at once that the cumulative, taxable interest puts you into a higher bracket.

Mistake 4: You redeem a bond in the day or week before a six-month interest payment is due to be paid.

Free calculators at treasurydirect.gov and savingsbonds.com will tell you what each of your bonds is worth. For as little at $5.95 a year, Brahney’s service will value the bonds and brief you, monthly, on what they currently earn and how much interest they’ve accumulated. Knowing your bonds can save on taxes and raise your earnings, too.

(Originally published in The AARP Monthly Bulletin.)

AARP Article

Make Your Money Last

How much can you safely withdraw from your nest egg each year?

How long can your savings last? That’s a critical question if you’re planning to retire or have already left the full-time workforce. You have Social Security income and perhaps a pension. Maybe you have a part-time job or are collecting rents from a property you own. But sooner or later, you may have to rely on whatever financial nest egg you have accumulated — mutual funds, bank CDs, stocks, bonds and so on. How much can you withdraw each year and still expect your money to last for life?

For financial planners, the gold standard is 4 percent. You can afford to spend 4 percent of your savings in the first year you retire. In each subsequent year, you’d withdraw the same amount that you took in the previous year, plus an increase for inflation. If you stick to that rule and are properly invested, your money should last for at least 30 years and, in most cases, much longer. You should be financially safe.

Why 4 percent?

The 4 percent rule was developed by financial planner Bill Bengen of La Quinta, Calif., more than two decades ago. Looking back, it would have carried retirees successfully through the worst 30-year periods of the 20th century, including those starting in 1929 and 1973 (the year stagflation began). It’s too early to know the 30-year outcome for people who retired in 2000, but Bengen says that the rule is working so far.

The hitch, for many retirees, is in the words “properly invested.” Most withdrawal-rate research is based on the longtime performance of leading U.S. stocks, represented by Standard & Poor’s 500-stock average, and intermediate-term Treasury bonds. It assumes that you keep half your money in each (or in low-cost mutual funds that track those market indexes). If you diversify — 42.5 percent of your money in large stocks, 17.5 percent in small stocks and the rest in bonds — the initial “safe” withdrawal rate rises to 4.5 percent, Bengen says.

Many retirees wouldn’t dream of being that heavily invested in stocks. Some don’t trust stocks at all. You’re limiting your future, however, if you don’t invest at least some of your long-term money for growth. Those who rely entirely on fixed-income investments can safely withdraw no more than 2.5 percent of their savings in the first year plus annual inflation increases, says Wade Pfau, a professor of retirement income at the American College in Bryn Mawr, Pa.

Josh Cohen, head of the institutional defined contribution business at Russell Investments in Seattle, has a different approach. He says you can use the 4 percent withdrawal rate while keeping just 32 percent of your money in stocks with the rest in bonds. After 20 years, you should still have a large enough nest egg to buy an inflation-adjusted annuity that supports you for life.

Prepare to be nimble

But what if a 4 percent withdrawal rate isn’t high enough to pay your bills? If you’re 65 percent invested in stocks, says financial planner Jonathan Guyton of Cornerstone Wealth Advisors in Edina, Minn., you could safely start your withdrawals at 5.5 percent. The key is flexibility. You have to be prepared to cut back if the markets turn bad for several years — say, by refraining from taking inflation increases for a while.

Pfau, by contrast, thinks we might be entering a long period of poor performance for long-term investors, with stocks currently overvalued and interest rates too low. He advises retirees to start withdrawals at 3 percent and raise them only if the markets perform well.

All these calculations, by the way, are pretax. Whatever taxes you owe would be paid out of the withdrawals.

To make these spending rules work, stay the course. That means following the withdrawal plan and taking extra money only if markets go up for several years. If you overspend when you first retire, you should be prepared to cut spending later.

Conversely, if you sell when the market falls and miss the upturn, you’re way behind. You’ll have to begin again with the money you have left. You’re also off the charts if you own individual stocks or funds that don’t keep up with the market average. The simpler your investments, the more reliable your spending plan will be.

(Originally published in The AARP Monthly Bulletin.)