If you pick up a book about retirement from the ’80s, you’ll probably see a recommendation to park all your funds in government bonds and get yourself to the beach for a relaxing few decades of mai tais and warm sand. That’s because, until recently, the interest rate in the U.S. has been a healthy 8%–10% or more.
Today it’s a different story.
This graph above shows the 10-year Treasury yield. The previous generation — you know, the “experienced” retirees from whom we’re taking retirement advice — retired in a golden age of high interest rates.
Such a strategy of parking your money in safe government bonds would throw off more than 8%–14% a year. That’s plenty to meet one’s annual needs. At today’s approximately 2% yield, your money would barely keep up with inflation, much less throw off enough to support your expenses.
So what can a retiree do in a period of low interest rates?
If cutting expenses is not an option, there are three approaches you can take.
1. Seek More Aggressive Options
If the yield of the safest bonds won’t cut it for your retirement needs, you may need to evaluate high-risk, high-reward options. That doesn’t mean you have to dump your money into risky stocks. There is a wide variety of options along the risk-reward spectrum.
Dividend-Producing Preferred Stocks
Preferred stocks are equity instruments that have special rights attached to them that distinguish them from common stock. Often they will have a liquidation preference. This means if the company were ever liquidated, the preferred shareholders would get their money back before common shareholders saw a dime.
They generally also have a conversion option. This is where the holder can exchange his preferred shares for a certain number of common shares. If the company does well, the holder can then participate in the upside. And best of all, you can search for preferred stocks that have a high dividend attached to them.
Big bank stocks and utility stocks generally have the highest dividends. You can often see dividends of 6%–10%. Some offer treatment under the advantageous qualified dividends tax rate. This keeps more dollars in your pocket.
With preferred stocks, you will want to pay attention to whether the stock is redeemable or callable by the company. This refers to the company being able to choose to buy you out of your holding.
Your biggest potential downside when purchasing dividend-producing preferred stocks is the risk that the company suspends dividend payments due to financial hardship. You will want to examine their history of dividend payments as well as evaluate the strength of their financial statements and growth prospects carefully.
Two banks stocks that offer a 6% dividend yield are Bank of America’s Series L Preferred and Wells Fargo’s Series L Preferred. Both of these options are not redeemable by the company and command the advantageous qualified dividends tax rate.
Low-Cost Index Funds
Rather than picking risky individual stocks, you can diversify and invest in a low-cost index fund that tracks the market. Historically these funds have yielded 8%–10% returns when measured over the last 50+ years.
You will also collect the dividends of the underlying companies held by the fund. These typically amount to about 2% a year. Examples of strong index funds include Vanguard’s Total Stock Market Fund (VTSAX) and Fidelity’s Total Market Index Fund (FSTMX).
2. Become a Borrower
When interest rates are low, you can actually make money by being a strategic borrower. Center your strategy on an approach that employs cheap leverage to increase your returns.
Leveraged Bond Funds
In a low interest rate environment, consider buying leveraged bond funds. A leveraged bond fund is a fund that buys a basket of bonds and then uses those same bonds as collateral. It borrows additional dollars at low interest rates to go out and purchase even more bonds.
The municipal sector is generally considered one of the safer classes of bonds. You might see 3% returns in unlevered funds. This contrasts with the 5%–6% in leveraged bond funds holding the same underlying instruments.
Leveraged municipal bond funds are especially attractive. This is partly because they are lending to lower-risk government entities. But they also are tax exempt at the federal and sometimes state levels. That means a higher net return to you.
The biggest downside when investing in leveraged bond funds is the sensitivity it will have to changes in the interest rate.
Bond prices move in the opposite direction of interest rates. As with all bond funds, you will run the risk of an increase in the interest rate. That would lead to a decline in the price of your bond fund shares. This is because in order to get someone to purchase your basket of bonds issued at the lower rates, you need to lower the price. That way, the new buyer sees a return equal to what they would get if they bought newly issued bonds that offer the higher rate.
In addition if the interest rates rise, their borrowing costs will also rise. This squeezes the fund in a negative way that will impact the dividend it can pay out.
Of course if the interest rates decrease, you will see significant upside. Leveraged bond funds are a bet that will be enticing or unappealing based on your view on which direction interest rates will move.
Invest in Rental Properties
Another way to become a borrower is to take out a mortgage on a rental property. You can use that cheap leverage to increase your returns. Depending on your local market, you may be able to generate 8%–10% annual returns on investment real estate.
When you sell your property, you can use a 1031 exchange to delay the payment of any taxes. Alternatively, you could move into the property for two years before you sell, in which case the first $250,000 of gains per individual, or $500,000 per couple, will be exempt from tax.
3. Wait It Out
If you strongly believe that the period of low interest rates we are experiencing is temporary, your best option may be to wait it out. You will not want to invest in any instrument that is highly sensitive to the interest rate. The price of these instruments moves in the opposite direction of the interest rate itself.
That may mean purchasing short-term CDs that pay only 1%–1.5%. You will then be in prime position to take advantage of the juicy higher-yielding opportunities when the market does move to your expected target.
Timing the market can be high risk. I would not recommend it unless you have strong conviction and strong data to support your position.
Additionally, a wait-it-out strategy will generally not work out well if the expected timeline exceeds 12–18 months. This is because the missed potential dividends begin to weigh heavily on the scale against potential price erosion due to increases in the interest rate.
There remain plenty of options that will meet the needs of retirees, even in a low interest rate environment. With low interest rates, finding ways to harness attractively priced leverage and moving toward higher-risk, higher-reward options can continue to satisfy one’s retirement needs.