By John Spence
Generating sufficient income is one of the biggest challenges for investors nearing or in retirement. Low interest rates and the fact that individuals are living longer make this goal even more important.
Although it's difficult to determine exactly how much investors will need during retirement, a rule of thumb is 80% of pre-retirement income. Of course, how early investors plan to retire and future inflation are among the wild cards when estimating income needs.
Annuities are one popular retirement option for income, but individuals looking for yield can also consider certain asset classes in their investment portfolios.
"Finding income near retirement is a problem," says Matthew Pierce, president and founder of Island Light Capital, a Massachusetts-based registered investment adviser. Island Light Capital manages several portfolios on Covestor, including the Income Portfolio.
With 10-year Treasury note yields still stuck below 3%, a traditional bond portfolio may not generate enough income for investors in retirement. What's more, low inflation and weak employment data suggest the Federal Reserve probably isn't in a hurry to scale back its bond purchases or raise interest rates.
"Rates in fixed-income markets are quite low, and it's a lot harder to generate a 5% income stream now than it was just 10 years ago when rates were much higher," Pierce said.
The catch is that older investors and those in retirement are naturally more risk-averse because they don't have as much time to recover from losses, relative to younger investors early in their careers. This means investors close to or in retirement need to be very careful about adding riskier asset classes such as dividend-paying stocks in search of yield. Other income-producing sectors such as Master Limited Partnerships (MLPs) and preferred shares can also be volatile in the short term.
One relatively conservative option for income is investment-grade international bonds that are paying higher yields than U.S. Treasuries. Vanguard Total International Bond ETF (BNDX) invests in this asset class but minimizes currency risks by hedging its exposure to foreign currencies.
Adding corporate bonds is another way to boost income. However, Pierce favors investment-grade corporate debt with shorter durations to limit risk.
"We're trying to avoid duration risk rather than credit risk. Longer maturities mean a bigger hit if interest rates rise," he said, adding that the risk of loss is greater than the opportunity of owning long-term bonds. Bond prices and yields move in opposite directions.
ETFs that invest in short-term corporate bonds include iShares 1-3 Year Credit Bond ETF (CSJ) and Vanguard Short-Term Corporate Bond ETF (VCSH).
These funds for investment-grade international bonds and short-term corporate debt aren't paying huge yields. But at least they can beef up the choices for low-risk investors approaching retirement who want some yield.
For those who are willing to take on a little more risk, mortgage-backed securities could be one fixed-income sector to consider. The iShares MBS ETF (MBB) tracks mortgage-backed bonds issued by Freddie Mac, Fannie Mae and Ginnie Mae.
"The credit risk is as good as the U.S. government," Pierce said. These agencies were bailed out during the financial crisis, so the bonds are backed by the government.
"Mortgage-backed bonds are a large portion of the U.S. bond market, so they have a place in fixed-income portfolios. They're not as volatile as many investors think they are," Pierce noted.
Other ETFs for the asset class include SPDR Barclays Capital Mortgage Backed Bond ETF (MBG) and Vanguard Mortgage-Backed Securities Index ETF (VMBS).
The investments discussed are held in client accounts as of September 30, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.
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