This week, Gail discusses the importance of setting realistic investment goals. No single investment solution can protect your principal and generate significant income, but if you keep an open mind you can find a reasonable compromise.

Hi Gail,

I would like to address something that I find has eluded me (and probably untold others) from the day I started investing: What do I do now that I have retired and wish to draw enough dollars annually (with low to no risk) and still protect my principal?

I’ve seen a number of those beautiful investment charts illustrating how your money can grow over time. But they’re based on not touching the money, i.e. reinvesting all capital gains and dividends. That’s all well and good when you’re accumulating assets, but where are those charts after a person needs to start drawing the money to live on?

I am fully aware that the most prevalent answer is "invest in 20 year (or longer) treasury bonds". The problem is the interest rate is so low these won’t provide the income we need — about $3,000/month.

My wife and I have attended numerous of dinners/meetings sponsored by investment firms, but all they talk about is "how to invest for the future." But for me and my wife, the future is now.

Several investment advisors have recommended an annuity, but this is not an option I will consider.

My wife and I have a total of $550,000in 401(k). All we are asking is to draw a lousy $3,000 a month (to start) and then index it for inflation and protect the principal.

Carl

Dear Carl —

You are searching for the Holy Grail of investing: a vehicle that will guarantee your principal and generate significant income that grows each year so that you can keep up with inflation!

Unfortunately, as financial advisor Gary Lux points out, these two goals are “mutually exclusive.” Investments that meet your first criteria, don’t have to provide as high a return as others that involve some risk. People who are only concerned about not having the value of their account fluctuate will accept the puny returns on such things as CDs, savings accounts, and money market funds. According to bankrate.com, these are currently paying around 3.4 percent (one-year CDs), 3.1 percent, and 2.2 percent, respectively.

The Bureau of Labor Statistics reports that through the first four months of this year, inflation is running at an annual rate of just under 4.8 percent, much higher than the 3.3 percent rate we saw last year, thanks to rising prices at the gas pump.

But you and I know that many retirees find their expenses increasing faster than the national average. That’s because a large component of a retiree’s budget is health care, which has been rising at a faster pace than inflation for years. This trend isn’t expected to change: the Centers for Medicare and Medicaid Services projects that health-related spending will increase 7.3 percent per year from now until 2013!

Even if you invested your entire 401(k) in a CD, at an annual rate of 3 percent, this would only generate half the annual income you say you need ($550,000 x 3 percent = $16,500).

The gold standard for investors seeking to have their principal guaranteed is the U.S. Treasury. In the fall of 2001 the government announced it would stop issuing 30-year bonds. The longest term for new treasuries is 10 years, although you can find bonds with longer maturities trading in the secondary market. And, of course, you are only guaranteed to get your principal back if you hold the bond to maturity. In the interim the value of your bond fluctuates, moving in the opposite direction of interest rates. (If rates go up, the value of your bond declines and vice versa.)

Trouble is, as you’re aware, the new 10-year treasury notes auctioned off last month only carried a rate of 4.1 percent. Rates have inched up a bit since then, but not enough to solve your problem. Investing all of your 401(k) assets in these bonds would not generate the $36,000/year ($3,000/month) you say you need. And the income they produce certainly will not increase each year to compensate for inflation.

Treasury Inflation Protected Securities (“TIPS”) are a type of government-issued security that, as the name implies, compensates you for changes in inflation. While the interest rate is fixed, twice a year your principal is increased based on the 6-month change in the Consumer Price Index. As a result, your semi-annual interest payments increase.

But this is hardly the answer to your prayers. The fact that they are backed by the U.S. government and offer inflation protection reduces the risks associated with all fixed income securities (default risk and purchasing power risk) and makes TIPS very attractive investments. As a result, the government doesn’t have to pay as high an interest rate as it does on other bonds. The 5-year TIPS issued last month which matures in 2010 carried an interest rate of less than 1 percent (0.875 percent). The 20-year TIPS that came out in January of this year sports a fixed interest rate of 2.37 percent.

None of these “guaranteed” investments comes close to the return you need to produce the income you’re looking for. Even if you were to invest your entire 401(k) value ($550,000), you would need approximately a 7 percent return to generate the $36,000/year you’re looking for. And, except for TIPS, fixed income investments are exactly that: the income they pay is fixed, meaning it doesn’t increase to compensate for the higher cost of living. Lux, who heads his own firm in Churchville, Pa., points out, “You can’t get 7 percent in a guaranteed investment today. If you could, everyone would be doing it.”

I don’t know why you’re dead-set against an annuity. While I don’t think it’s the answer for everyone, frankly, yours is a textbook case of when an annuity is appropriate. A combination of a “fixed” annuity — which pays an income stream that never changes — and a “variable” annuity — which has the potential for increasing income based on stock investments — could be the ideal solution for you.

Equity investing clearly does not come with “guarantees” – of either principal or income. But take a look at this chart provided by Ibbotson Associates. Compare what a $1,000 investment in the stock market (as represented by the S&P 500 Index) at the start of 1984 would be worth by the end of last year to what the same amount would be worth if it had been invested in long-term government bonds.

Click here to see the Ibbotson chart (pdf).

Clearly, this graph illustrates the significance of reinvesting the earnings (dividends or interest) your investments produce. However, notice that even if you had kept/spent all of the dividends your stocks generated, your principal still grew to $7,249, leaving you far better off (even after the recent 3-year bear market) than someone who spent all of the interest on his/her bonds.

I am not suggesting this time frame is representative of the entire history of the market or that we’re likely to see a repeat performance over the next twenty years. In fact, as I wrote recently, a number of experts believe stock returns will be slightly lower. All I know is that going back to 1926 (when regular data collection began), whether you took your dividends or reinvested them, stocks have tended to out-perform bonds over the long term. This is especially true if you adjust your returns for inflation.

What’s “long term?” Twenty years. If you’ve recently retired, Carl, you can expect to have at least that number of years ahead of you. Your wife should live even longer. An annuity is simply a way to guarantee your money doesn’t run out before the two of you do!

In my opinion, annuities get a bad rap because critics focus on the costs involved. Sure, annuities are slightly more expensive than mutual funds, but that’s because they give you more — for instance, a death benefit and guaranteed income for either a specific number of years or for life. Most annuities that offer a lot of special features (such as the ability to withdraw principal) allow you to opt out if you don’t want or need the benefit. Or you can simply look for one of the bare-bones annuity products on the market today.

There are also “no-load” annuities, which means you don’t pay a commission. This is fine if you don’t need advice. But, frankly, in your case you would probably find it helpful. You can request the names of Certified Financial Planning professionals in your area by visiting the Financial Planning Association’s Web site: http://www.fpanet.org/PlannerSearch/PlannerSearch.cfm

My concern is that you are not truly open to advice. The fact that you and your wife are frequent attendees of investment dinners makes me wonder if you are more interested in a free meal than in solving your income need. You reject every advisor you’ve encountered at these dinners because he/she can’t provide the magic investment you want — an investment that doesn’t exist!

As I’ve said before, investing is all about risk and return. If you insist upon zero risk, you will get very little return and vice versa. There are strategies — annuities, “put” options, and others — that can help you manage the risk.

Here’s my suggestion: Ask your relatives and friends the name of their financial advisors. Meet with a few to see if you’re comfortable with their approach. Choose one to work with. Don’t expect the impossible. Understand that no one can predict the future. Do expect at least an annual review and the income you need. Give your investments and your advisor the courtesy of at least a few years before you make judgments.

Take your wife on the vacation you’ve always dreamed of. Visit the grandkids. Twenty years may seem like a long time, but it can zip by. It’s too precious to waste eating an endless stream of free chicken dinners.

Keep the faith.

Gail

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