- Today’s baby boomers retirement will last much longer than their parents retirement
- Most retiring Boomers ask for ‘income’ to replace their employment income
- As Boomers give up on stock gains, they inevitably focus on income investing
Baby boomers will experience a very different retirement environment to their parents, so how can they get what they want?
Question to the Boomers; “How did your parents invest their retirement nest egg?” The common perception is that they only spent the interest and dividends while never touching the principal. Perhaps this explains why so many boomers are trying this strategy. After all, if it worked for the Greatest Generation why can’t it work for you?
Why Boomer’s retirement is different from their parents.
Much Longer Retirement
Many in the Greatest Generation worked as long as they could and very few were fortunate enough to have a retirement that would be considered ‘golden’ by today’s standards. How many spent the last 1/3 of their lives pursuing hobbies and leisure instead of working? Yet boomers retiring in their 60’s can expect to live about 30 years in retirement which is a lot longer than their parents.
Not considering tours of duty in Europe or the Pacific, how many of the greatest generation traveled through Europe or visited the Far East? They were depression era babies who practiced frugality and continued to pinch pennies throughout retirement. In stark contrasts, Boomers want their retirement to include travel, vacation homes, new cars, dining out, etc. This is fine, but it is expensive. Therefore boomers need to plan for a much more expensive retirement than their parents.
Personal Savings instead of Pensions
The greatest generation might have had a lower per capita income but many also had corporate pensions. Boomers wanted higher salaries, freedom to change employers and the ability to save independently. Corporate pensions were largely phased out giving way to the 401(K). However, when given the option, most Boomers didn’t start saving enough or early enough. Today, many boomers haven’t amassed enough in personal savings nor do they have meaningful pensions compared to their parents.
Rising instead of Declining Interest Rates
In the 1980s when the Greatest Generation started to retire, interest rates were about 18%. Today rates are under 1%. This long decline in interest rates provided a great return to bond investors. The boomers are facing the very opposite situation. Instead of an ever declining interest rate, boomers are facing the likelihood of steadily increasing interest rates during their retirement.
Exotic Investment Options
The Greatest Generation had relatively few investment options, mostly ordinary bonds and certificates of deposit. Today’s Boomers are being offered an ever expanding universe of income securities. The investment industry has provided a lot of rope, a lot of new and exciting ways to torpedo your retirement. Investment choices the greatest generation never had.
If they felt like taking risk, they might buy some ‘dividend’ paying stocks. At the time, most of the dividend-paying industries, such as finance and utilities, were highly regulated. Decades of deregulations have caused these industries to become less predictable and more risky; hence, the certainty of previously assumed dividends is now extremely uncertain.
Just about everything the Greatest Generation experienced during retirement is different from the Boomers. Why should we think the investment strategy that worked for them will work for you?
So what are Boomers asking for from the Investment Industry?
I Want Income
Most retiring Boomers ask for ‘income’ to replace their employment income. So what does the investment industry offer? Usually taxable interest and an annuity. But do retirees really want ‘income’ or cash flow? There is a huge difference between income and cash flow. When you ask for ‘income’, you get securities that produce ‘income’. When you ask for cash flow, you are talking about a distribution strategy independent of the securities. Retirees should be asking for a sustainable cash flow from a diversified portfolio producing dividends, interest, capital gains and return of principal.
I Want More Bonds
As the yields on cash, CDs and bonds have plummeted, the amount retirees receive has also declined. This is the realization of reinvestment risk, the risk of having to reinvest at a lower rate. To offset this decline, the common reaction is to increase the percentage allocated to bonds. But in doing so, you increase your risk from inflation, withdrawal rate shocks, and rising interest rates. Essentially, they are trading a higher current income today for more risk to their future. Retirees should set their stock-to-bond mix based on their capacity, their need and their desire for risk, not current cash flow.
I Want Higher Yields
Instead, or in addition to increasing the percentage of bonds, retirees are asking for higher yields. They ask for bonds with yields higher than 5% or 6%. They end up acquiring high coupons that have the same yield-to-maturity as a similar bond with a 2% coupon. The only difference is they are paying a premium. The only real way to increase bond yields is to increase the credit risk or term risk which at some point is just as risky as owning stocks. Frequently, instead of getting bonds, the retiree is sold cherry-picked, income securities such as master limited partnerships or closed-ended funds that did well but won’t necessarily do well. Retirees get securities that have a high historical yield but an unknown future yield. Owning these types of investments can have as much or even more risk than owning stocks. Retirees should ask for a diversified portfolio based on total return per unit of acceptable risk.
I Want More Dividends
For those Boomers still willing to invest in stocks, their interest seems to be concentrated on dividend stocks. Yet empirical evidence shows that a dividend-focused strategy does not have a higher return than a total return strategy. Additionally, the focus on dividend stocks usually increases risk since it decreases diversification. If you feel this risk seems trivial, just ask any retiree counting on BP’s dividend just how real this risk is! Given the countless dividend suspensions and numerous cuts over the last few years, Boomers should have no doubt that the concept of buying a “good” company with a “solid” dividend is a euphemism at best and an oxymoron at worst.
What Boomers really need.
As Boomers give up on stock gains, they inevitably focus on income investing, always on the hunt for higher yields. There is no secret to finding higher yielding securities. In one way or the other, a higher yield just means higher risk– either term risk, credit risk or price risk. Higher yielding securities always have more risk then lower yielding securities. And some high yield securities can even be riskier than a simple basket of stocks yet with a lower expected return. For these reasons, your best opportunity is to ask your advisor to establish a sustainable withdrawal rate and build a diversified portfolio focusing on total return rather than focusing on dividend-producing, interest-paying securities.