Why Bond Portfolios are a Flawed Retirement Strategy

This post is a summary of a session from the FRA’s 8th Annual Managed Accounts Summit.

There are three phases of life and three phases of investing based on a client’s income needs: Growth Only, Growth and Income and Income Only, according to Michael Jones, Founding Partner, Riverfront Investment Group. For retirees in the Income Only phase, what they really need is a cash flow that grows.

Instead, what the industry has done is use systematic withdrawals and build a growth portfolio with a little lower volatility and then hope that everything will work out, according to Michael. The financial crisis showed a major flaw in this strategy. Suddenly a 6% annual withdrawal became a 9% annual withdrawal due to the drop in valuation. If you’re blowing a hole in your portfolio on year one, it’s really hard to bounce back, he observed.

“What do retirees want?”, Michael asked.  They want a quarterly statement from their asset manager that has the same number on it as it did last quarter.  That’s how they define safety.  What do they need?  Income.

Because of this, Michael pointed out that retirees are scared and they’re running to bonds.  They didn’t want bonds back in 1990 when interest rates were at 9% or in 2000 when they were 7% or in 1984 when they were 14%.   Now we have 2 ½% treasuries and they can’t get enough of them!

According to an article Michael recently published (“The Bond Bubble: Are Your Portfolio’s “Safe” Assets Safe?”), he expects deflation will be avoided and “history suggests that bonds currently offer extremely low potential returns in exchange for a substantial risk of loss. For example, if 10-year Treasury yields rise to 4%, a level seen as recently as April 2010, bond investors are likely to incur a principal loss of approximately 10%.”

In this environment, if we don’t get inflation, bond investors will be hit hard. As Michael explained, while treasuries were overvalued, corporates, mortgages and high yield were so cheap you could get away with buying bonds and make out reasonably well because spreads were so wide. But now, spreads have collapsed and yields on all those asset classes are at all-time lows.

Compared to the returns on a one- year treasury rolled over annually, the dividend yield on the S&P 500 beats it handily over the past 40+ years. In the past 10 years, there’s been a 40% increase in dividend income from the S&P500, even with the financial crisis, Michael reported.

You can potentially get a higher yield from the dividends paid by the stocks in the S&P 500 than from their 10- year bonds. All the growth potential and net dividends you can get for free. More current income, more future income higher short-term volatility, but lower in the long-term.