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Posts Tagged ‘TIPS’

Whatever your retirement dreams, they can still be made a reality.  It just depends on how you plan and manage your resources. On any journey it helps to have an idea where you’re going, how you plan to travel and what you want to do when you get there.

If this sounds like a vacation, well, it should. Most people invest more time planning a vacation than something like retirement.  And if you think of retirement as the Next Act in your life and approach it properly, you won’t be so easily bored or run out of money to continue the journey or get lost and make poor money decisions along the way.

It’s How You Manage It That Counts

How much you need really depends on the lifestyle you expect to have.  And it’s not necessarily true that your expenses drop in retirement. Assuming you have an idea of what your annual expenses might be in today’s dollars, you now have a target to shoot for in your planning and investing.

Add up the income from the sources you expect in retirement.  This can include Social Security benefits (the system is solvent for at least 25 years), any pensions (if you’re lucky to have such an employer-sponsored plan) and any income from jobs or that new career.

Endowment Spending: Pretend You’re Like Harvard or Yale

Consider adopting the same approach that keeps large organizations and endowments running.  They plan on being around a long time so they target a spending rate that allows the organization to sustain itself.

1. Figure Out Your Gap:  Take your budget, subtract the expected income sources and use the result as your target for your withdrawals. Keep this number at no more than 4%-5% of your total investment portfolio.

2. Use a Blended Approach: Each year look at increasing or decreasing your withdrawals based on 90% of the prior year rate and 10% on the investment portfolio’s performance.  If it goes up, you get a raise.  If investment values go down, you have to tighten your belt.  This works well in times of inflation to help you maintain your lifestyle.

3. Stay Invested:  You may feel tempted to bail from the stock market.  But despite the roller coaster we’ve had, it is still prudent to have a portion allocated to equities.  Considering that people are living longer, you may want to use this rule of thumb for your allocation to stocks: 128 minus your age.

If you think that the stock market is scary because it is prone to periods of wild swings, consider the risk that inflation will have on your buying power.  Bonds and CDs alone historically do not keep pace with inflation and only investments in equities have demonstrated this capability.

But invest smart. While asset allocation makes sense, you don’t have to be wedded to “buy-and-hold” and accept being bounced around like a yo-yo.  Your core allocation can be supplemented with more tactical or defensive investments.  And you can change up the mix of equities to dampen the roller coaster effects.  Consider including equities from large companies that pay dividends.  And add asset classes that are not tied to the ups and downs of the major market indexes.  These alternatives will change over time but the defensive ring around your core should be reevaluated from time to time to add things like commodities (oil, agriculture products), commodity producers (mining companies), distribution companies (pipelines), convertible bonds and managed futures.

4. Invest for Income: Don’t rely simply on bonds which have their own set of risks compared to stocks. (Think credit default risk or the impact of higher interest rates on your bond’s fixed income coupon).

Mix up your bond holdings to take advantage of the different characteristics that different types of bonds have. To protect against the negative impact of higher interest rates, consider corporate floating rate notes or a mutual fund that includes them.  By adding Hi-Yield bonds to the mix you’ll also provide some protection against eventual higher interest rates. While called junk bonds for a reason, they may not be as risky as one might think at first glance. Add Treasury Inflation Protected Securities (TIPS) that are backed by the full faith and credit of the US government.  Add in the bonds from emerging countries.  While there is currency risk, many of these countries do not have the same structural deficit or economic issues that the US and developed countries have.  Many learned their lessons from the debt crises of the late 1990s and did not invest in the exotic bonds created by financial engineers on Wall Street.

Include dividend-paying stocks or stock mutual funds in your mix.  Large foreign firms are great sources of dividends. Unlike the US, there are more companies in Europe that tend to pay out dividends. And they pay out monthly instead of quarterly like here in the US.  Balance this out with hybrid investments like convertible bonds that pay interest and offer upside appreciation.

5. Build a Safety Net: To sleep well at night use a bucket approach dipping into the investment bucket to refill the reserve that should have 2 years of expenses in near cash investments: savings, laddered CDs and fixed annuities.

Yes, I did say annuities.  This safety net is supported by three legs so you’re not putting all your eggs into annuities much less all into an annuity of a certain term. For many this may be a dirty word.  But the best way to sleep well at night is to know that your “must have” expenses are covered.  You can get relatively low cost fixed annuities without all the bells, whistles and complexity of other types of annuities.  (While tempting, I would tend to pass on “bonus” annuities because of the long schedule of surrender charges). You can stagger their terms (1-year, 2-year, 3-year and 5-year) just like CDs.  To minimize exposure to any one insurer, you should also consider spreading them around to more than one well-rated insurance carrier.

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For individuals in retirement living on a fixed income, it can devastate one’s savings and lifestyle.

As a bond or CD-holder, the purchasing power of regular interest income gets hit.  As a stock investor, stock prices can suffer as profit margins and earnings of your equity holdings are hurt by the higher costs for inputs like energy, precious metals and labor.

Right now, Wall Street is in a good mood.  For the quarter just ended, the Dow has gained about 14%, the S&P increased 14.5% and the NASDAQ was up 15%.  In fact the last time the Dow saw such a large quarterly surge was back in the fourth quarter of 1998 when it rose more than 17% as the dot-com bubble was forming.

This quarter’s rally continued a trajectory that began in mid-March 2009.  It has been primarily propelled by glimmers of light at the end of the tunnel.  A variety of positive statements from Federal Reserve Chairman Ben Bernanke contributed to a more optimistic view.  Residential real estate sales continued to come back mostly prompted by a first-time homebuyer tax credit.  Corporate earnings have been up.  The popular “cash for clunkers” program spurred auto sales and by some measures consumer spending increased marginally even without the impact from auto sales.

Despite the Wall Street rally, Main Street is still hurting: unemployment continues to rise, business and personal bankruptcies have increased, bank failures are at their highest level and the dollar continues to weaken fueling fears of inflation down the road.

Signs of future higher inflation are on the radar screen:  All the government economic stimulus here and abroad coupled with mounting public debt; the Fed’s projected end of a program in March 2010 that will likely lead to higher mortgage rates; a Fed interest rate policy which has no place to go but up and rumblings that foreign governments and investors may not want to continue at their current pace of supporting our debt habit. 

So how do you position yourself to profit whichever way the tide turns?

Now, more than ever, it is important to have a risk-controlled approach to investing.  This is centered on an age-based allocation that includes exposure to multiple assets.

This is why we will continue to manage portfolios with an allocation to bonds and fixed income but there are ways to protect from the impact of inflation and still allow for growth.

1.)    Include dividend-paying equities:  Using either mutual funds or ETFs that have a focus on dividend-paying stocks will help boost income as well as return.   Stocks that pay dividends have averaged near a 10% annual return compared to a total return less than half of that for stocks that rely solely on capital appreciation.  Better yet, consider stock mutual funds or ETFs that focus on stocks that have a record of rising dividends.

2.)    Stay short:  By owning bonds, ETFs or bond mutual funds that have a shorter average maturity, you reduce the risk of being locked into less valuable bonds when higher inflation pushes future interest rates up.

3.)    Hedge your bets with inflation-linked bonds: Fixed-rate bonds offer no protection against inflation. A bond that has changes linked to an inflation index (like the Consumer Price Index) like TIPS issued by the US-government or ETFs that own TIPS (like iShares TIPS Bond ETF – symbol TIP) offer an opportunity for a bond investor to get periodically compensated for higher inflation.

4.)    Float your boat with Floating-Rate Notes: These medium-term notes are issued by corporations and reset their interest rates every three or six months.  So if inflation heats up, the interest rate offered will likely increase.  Yields in general are higher than those offered by government bonds typically because of the higher credit risk of the issuer.

5.)    Add Junk to the Trunk: Hi-yield bonds are issued by companies that have suffered down-grades – sort of like homeowners with dinged credit getting a mortgage.  Yields are set higher than most other bonds because of the higher risk.  Yet, as inflation heats up with a growing economy, the prospects of firms that issue junk improve and the perceived risk of default may drop. So as the yield difference narrows between these “junk” bonds and Treasuries, these bonds offer a “pop” to investors.

6.)    Own Gold and Other Commodities:  Whether as a store of value or hedge against inflation, precious metals have a long history with investors seeking protection from inflation.  It’s usually best to focus on owning the physical gold or an ETF that is tied directly to the physical gold. Tax treatment of precious metals is higher because of its status as a “collectible” but this is a minor price to pay for some inflation protection.  And because the demand for commodities in general increases with an expanding economy or a weakening dollar (in the specific case with oil), owning funds which hold these commodities will help hedge against the inflationary impact of an expanding economy.

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