Getting low-risk yield has been one of the toughest challenges for retirees ever since the financial meltdown of 2008-2009. Interest rates are near zero, and many retirees are nervous about bonds out of fear that rates might jump.
All of which leaves a simple question: How about a good old-fashioned certificate of deposit?
Retirees desperate for yield can find some respectable deals on CDs. The yields may not sound sexy, but there's no risk to principal and the Federal Deposit Insurance Corporation protects accounts up to $250,000.
There's nothing new about the higher rates on CDs compared with bonds. Banks, especially those without extensive retail branch networks, have long offered generous rates on CDs, mostly online, as an inexpensive way to attract deposits. It's also a way for banks to bring in retail clients who can be cross-sold other higher-margin products.
But there's an especially compelling case to be made for CDs in the current rate environment.
"For retirees, it's the one corner of the investment world where you can get additional return without additional risk," says Greg McBride, chief financial analyst for Bankrate.com.
The most aggressive banks will sell you a two-year CD with an annual percentage yield (APY) of 1.25%; compare that with current two-year Treasury rates, now at about 0.48%. Three-year CDs top out at 1.45%, compared with 0.92% on a Treasury of the same duration. If you want to go longer, five-year CDs top out over 2%.
Five or 10 years ago, the high rates came mainly from smaller no-name banks, but that's not the case now. Some of the more aggressive offers currently come from big names like Synchrony Bank (formerly GE Capital Retail Bank), Barclays and CIT Bank. Bankrate.com lets you search and compare offers.
You could get higher yields on corporate or junk bonds. But they're risky because the available yield isn't adequate for the credit risk you need to take, argues Sam Lee, editor of Morningstar's ETFInvestor newsletter.
"I'd rather be in a five-year CD than a bond fund taking on more duration or credit risk," Lee says. "If rates do rise, you can lose a whole bunch of money on long-duration bonds — maybe 10 or 20% of your principal."
The only risk you face locking in a longer CD — five years, for example — is the lost opportunity cost of obtaining a higher rate should rates jump. Lee likes that strategy.
"The interest rate sensitivity is very low, because you can always just get out and reinvest at a higher rate," he says. "You'll pay a bit of a penalty, but that is more than offset by the higher rate and value of the FDIC guarantee."
McBride isn't convinced rates will jump substantially anytime soon. "The long-awaited rising rate environment has yet to show itself — it might happen next year, or maybe not."
Still, you should understand CD penalties in case you do need to make a move, because the terms can vary. The most common penalties for early withdrawal on a five-year CD are 6 or 12 months' worth of interest, says McBride. "The terms can vary widely — some are assessed just on the amount you withdraw, others on the entire investment."
If you're worried about opportunity cost, some of the banks offering aggressive CD rates also have attractive savings accounts that let you make a move at any time - although some require a minimum level of deposit to qualify for the best rates. For example, Synchrony will pay you 0.95%. That's not much less than the 1.1% it pays on a one-year CD - or the 1.2% for a two-year CD, for that matter.
The other option is a step-up CD that boosts your rate if interest rates rise in return for a lower initial rate. But those aren't easy to find right now, McBride says. "We'll see those become more prevalent if we get into a rising rate environment."
No matter how long you go, Lee says, the implication for retirees is clear: Use CDs for the risk-free part of your portfolio and equities for whatever portion where some risk is acceptable.
Equities should help keep your overall portfolio returns substantially above the rate of inflation. The Consumer Price Index is up 2.1% for the 12 months ended in May.
"The U.S. stock market's expected real [after-inflation] return right now is about 4%," he says. "The expected inflation-adjusted yield on bonds right now is close to zero."