When I think back to my grandparent’s retirement years, I remember them talking about how they generated income from their investments. While they received a Social Security check each month in the mail, a good portion of their income actually came from their investments. Most of their investments were in what are considered safe investments, (bank certificates of deposit and bonds) to help lower the risk of them losing principal. The rest was invested in high quality, dividend paying stocks. Unfortunately today, many retirees cannot take the same approach with their retirement income. The primary reason is because of low interest rates.
If you are looking at brick-and-mortar banks, you will be hard pressed to find an account paying anything more than 0.25% interest. In some cases, this might even be high! Granted, there are some smaller, local credit unions that pay a higher interest rate, but for the most part, it is still not ideal.
You can turn to internet banks, but they too offer interest rates too low for most. In these cases, you’ll be lucky to find interest rates around 1%. With inflation currently hovering around 2%, keeping your money in a savings account is a losing battle.
Certificates of Deposit
Historically, bank certificates of deposit have paid higher interest rates than bank accounts. This is because the bank will pay you a premium to “lockup” your money for a set period of time. While the interest rate offered on bank CD’s today are still higher than a standard bank account, the interest rate is still paltry. Various five-year certificates of deposit are paying around 1.8% as of this writing. For shorter term CD’s, the story is even worse.
Looking back to the mid-2000’s a $100,000 investment in a six-month certificate of deposit will churn out over $5,000 of income annually. Fast forward to today and that same $100,000 will earn you about $450-$750 annually depending on the bank.
Where to Look for Alternatives to Low Interest Rates
With rates being so low, what is a retiree to do? There are a few options. First, you can look towards high quality dividend paying stocks. These companies tend to be less volatile than smaller company stocks and many have been increasing their dividends. (Note that many slashed their dividends during the recession of 2007-2009 but have been increasing payouts since and many have reached their previous payout levels.) Of course, investing in stocks carries the risk of lost principal and many retirees cannot afford to lose much of their nest egg. For this reason, it is wise to invest only a portion of your portfolio in stocks.
Another option is with short-term bonds. While short-term bonds will carry a lower interest rate when compared to longer term bonds, there is good reason for this. The same risk-return principal that applies to stocks also applies to the maturity of bonds. The longer the term of the bond, the higher the risk of interest rate fluctuation, among other risks. This means that since the price of bonds move in the opposite direction of interest rates, when interest rates rise, the price of the bonds will decrease, meaning lost principal. (The reason for this is because investors will sell the lower yielding bonds for higher yielding ones. As a result, the demand for the lower yielding bonds will decrease, forcing prices lower.) With short-term bonds, this risk is greatly reduced since the bonds mature in such a short period of time.
The best way to invest in short-term bonds is through a low cost ETF fund. Doing so provides instant diversification among many short-term bonds for much less money than investing in individual bonds directly.
With the Federal Reserve Bank promising to keep interest rates low through at least 2014, retirees are stuck when it comes to finding higher interest rate investments. Your best bet is to have a portfolio of many different investments (short-term bonds, longer term bonds, high quality dividend paying stocks and some cash) to allow yourself to get the most income while also not placing all of your eggs in one basket and feeling the repercussions should something happen.
Unfortunately, there is no low risk, high yielding investment out there. If anyone approaches you claiming otherwise, your best bet is to turn and walk the other way. It can be tempting to buy into their story, but know that all investments are tied to risk and return. To offer a high return, you are going to have to take a good amount of risk.
More on Bonds
- What Are Treasury Inflation Protected Securities?
- Comparing Different Types of Treasury Securities
- Everything You Need to Know About Buying I Bonds