Retirees are always flummoxed by the question of how to generate income from their assets. But in this recent article, my former Morningstar colleague, John Rekenthaler, lays out the basic options for income in retirement — bonds, inflation-protected bonds, and immediate annuities. In doing this, he provides a useful service for investors in organizing the landscape beyond Social Security.
These are different instruments, and hard to compare directly. But it’s worth going through all their features.
For plain bonds Rekenthaler sticks to Treasuries, but they could be corporates, mortgage- and other asset-backed securities. (You’d want a fund to own those things, but they could qualify as a bond source of income in retirement.)
Assuming a woman has retired recently at 65 and statistically has 20 more years to live, a plain 20-year US Treasury was yielding 4.05% as Rekenthaler went to press.
That is a “nominal” yield, meaning it’s not adjusted for inflation. So, for every $100,000 the woman invests, she’ll receive $4,050 in annual interest payments and then the $100,000 at maturity.
According to Rekenthaler, the distribution on a 20-year TIPS ladder (bonds of different maturities arranged in a portfolio) was 5.89%.
However, those payments will be adjusted for inflation as measured by the consumer price index (CPI).
Finally, an annuity is paying 7.13%, according to Rekenthaler. The drawback there is that the investor’s principal is gone. She has given it to the insurance company permanently in exchange for payments for the duration of her life. If she doesn’t live that long, the insurance company gets the better of the deal.
Two important considerations in trying to choose among these three instruments are inflation and longevity.
High inflation will erode the purchasing power of the payments from the nominal Treasury. It will not for its TIPS cousin.
High inflation will also erode the purchasing power of the payments from the annuity, since we are talking about a fixed annuity here, where the payment doesn’t change.
Low inflation, by contrast, will favor the nominal Treasury and the annuity.
Longevity (those who are postponing their “meetings with the Grim Reaper, as Rekenthaler puts it) will be best served by annuities — assuming low inflation.
Since nobody knows what inflation will be or how long they will live (though some people have a more accurate assessment of their health than others), some mixture of these three types of investments if often reasonable.
By the way, I find it useful to repeat this for many investors — a bond, whether a plain nominal Treasury or a TIPS version with inflation protection (or a corporate bond, for that matter) — is a loan. As the lender or purchaser of the bond, you get an interest payment and principal back at maturity.
