By Michael Lynch, CFP
Take a good look at this chapter’s kickoff picture. It represents a childish fantasy, an impossibility that may be conjured in happy minds but is never found in nature. In the financial world, this is a “safe” investment that produces high levels of reliable income. The key here is that safety is defined in the traditional, if antiquated, way: as principal protected. You’ll never lose!
In the last chapter, we explored the paradox that we all live on income, but we constantly fret about the condition of our investment principal. In this chapter, we will add this revelation:
• Investments and assets that keep principal stable and protected allow income to vary widely from day to day, month to month, year to year, and decade to decade. These include CDs, US government bonds, and high-quality corporate bonds.
• Assets that allow principal to fluctuate produce more stable and balanced, increasing income. These assets include dividend-paying stocks and other equities.
UP IS DOWN AND DOWN IS UP
Ponder that. Investments that provide stability of principal result in fluctuating income. Assets that allow principal to fluctuate tend to produce more stable income.
Combine this with the last chapter’s lesson that we live on income, not principal.
Now answer this question: Which is a safer asset for retirement—a well-diversified equity mutual fund or a US government bond fund or CD?
It’s hard to accept and perhaps even harder to say, akin to New York Yankee fans realizing in 2004 that the curse of the Bambino was finally over for the Boston Red Sox. But I do think a redefinition of safety is in order.
Equity-based investments are far safer for retirement than fixed-income investments.
Recall the formula most of us have internalized for financial success—the very formula that destroyed Maria’s retirement:
• Get a good job and keep it.
* Check. Still a good idea.
• Spend less than you earn.
* Check. Nothing is possible if you don’t do this.
• Invest the money in a safe place.
* Trouble ahead. We need an updated definition of safety.
• Live off the interest, and never touch the principal.
* Definitely throw on the scrap heap.
Replacement: live on the returns and grow the principal.
The bottom line is that we need a new definition of safety for retirement income. The money you need in two weeks for the utility bill, in two months for your property taxes, and even in two years to purchase a motor home is only safe if the principal is protected. I agree. I won’t argue with you and will encourage you to give up potential returns to keep your principal from loss when you need to make those payments.
But for your long-term retirement income that may need to last ten, twenty, or even thirty years, safety has nothing to do with principal protection and everything to do with inflation-adjusted income.
YOU CAN HANDLE THE TRUTH
Fasten your seat belt. I’m about to tell you something few others engaged in financial services will.
You don’t need guaranteed principal. That’s what purveyors of low-return banking and insurance products want you to believe. You don’t need guaranteed income. That’s
what purveyors of depreciating products such as fixed-income annuities tout. You need inflation-adjusted income.
That’s right. Safety is contextual and means you need a dollar to be an actual dollar when you need to spend it.
Most people will tell you that you need guaranteed income and principal.
Nonsense. You need inflation-adjusted or “real” income.
FIXED-INCOME DREAM TO NIGHTMARE
Did you ever consider what’s so bad about living on a “fixed income”? That’s never a term used with a smile. It’s more likely used by a person to excuse not being able to do what they want, like go on a big vacation, dine out often, or even assist the next generation.
Flip back to the last chapter and you may be a bit puzzled. If your income were fixed at the level proposed in that chapter—$250,000, inflation-adjusted—there’d be no problem. But here on planet Earth, that’s not the way it goes down—at least not here in America, where the Federal Reserve has a printing press and is committed to at least 2 percent inflation.
If your income is fixed and prices are not really fluctuating so much as increasing, your standard of living is being eroded. I like to fish, and I head out on the Housatonic River to Long Island Sound to get my dinner. The river and sound have currents. If I am not motoring at least at the speed of the current, I’m slowly drifting in the wrong direction.
That’s the trap into which far too many retirees fall. They misunderstand safety and find themselves being carried into poverty by financial currents. Don’t let that happen to you or your family.
What you need is a system that gives you what you need when you need it. That’s the focus of the rest of this book.
The above article originally appeared as a chapter in It's All About the Income and is reprinted with permission from the author Michael Lynch. No parts of this article may be reproduced without correct attribution to the author of this book.