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Interest rates are still at record lows, and it looks like they could stay that way for years thanks to Fed Chair Jerome Powell’s recent indication that the central bank won’t increase rates to protect against inflation.
The biggest challenge retirees are now facing is how to turn their nest egg into an income solution — and strategies they have been relying on might not work as well in today's low-rate environment, experts say. New solutions may entail a bit more risk than bonds, which have long been a common income source for retirees. But a little more risk might be necessary.
“If you’re not willing to make some minor adjustments and accept different forms of risk, you’re basically locking yourself into inflation risk and going to lose your buying power,” says Devin Pope, a senior wealth advisor with Albion Financial Group. Inflation risk is the possibility that your money won't have as much purchasing power over time as the cost of goods and services increases.
While there's certainly still room for bonds in portfolios, experts say retirees may not be able to rely on them for income in the way they've become accustomed to. Here are some additional places to look.
Dividend stocks are one way to go. With these stocks, companies pay regular payments back to shareholders in the form of cash or additional stocks.
Of dividend stocks, Pope likes 3M, Cisco and Verizon, all of which he says are strong companies that yield over 3%.
However, many companies have been cutting dividends, leading to a collective plunge of about $108 billion last quarter, according to fund manager Janus Henderson. That's why it’s best to seek out good-quality companies that provide solid income rather than higher income from companies whose finances are not as strong, Pope says. The measures of strength he looks for include a good track record of committing to their dividend payout and increasing their dividends over time, as well as a strong balance sheet and ample cash and liquidity.
“It’s about taking more risk but not going off the deep end and shooting for a really high yield with a potential that maybe the company goes bankrupt or completely cuts its dividend in half," he adds.
For a balanced investment portfolio, Pope recommends around 20-30% in dividend stocks.
Donald Calcagni, chief investment officer at Mercer Advisors, recommends adding high-dividend paying non-U.S. stocks to your mix. One way to do that is via the iShares International Select Dividend ETF.
“With current weakness in the U.S. dollar, non-U.S. stocks dividends could provide some protection against future declines in the value of the greenback,” Calcagni says.
Ryan Giannotto, director of research at GraniteShares, recommends pass-through securities for retirees.
These investments distribute at least 90% of their earnings to investors and are therefore exempt from corporate taxes, eliminating the double taxation dividends usually see and getting profits more directly to the investor. They fall into four categories: master-limited partnerships (MLPs), real estate investment trusts (REITs), closed-end funds (CEFs) and business development companies (BDCs).
When you combine them into a portfolio, you can generate over 10% income, Giannotto says — and he has proof. GraniteShares offers the GraniteShares HIPS U.S. High Income ETF, which invests in a diversified basket of high-yielding pass-through securities and has yielded upward of 10%, reaching 10.93% at the end of July.
But with high yields comes increased risk, says Kelly Graves, a financial advisor with Carroll Financial.
"There are no free lunches in the yield market," Graves says. There could be concern about business failure (that a company will go under and default on their payments). And in turn, if yields go down, the price will likely drop, he adds.
Freddy Garcia, vice president at Left Brain Wealth Management, also recommends REITs. According to his firm’s analysis, of tough economic years, REITs — especially mortgage REITs like AGNC Investment Corporation and Annaly Capital Management — tend to outperform other asset classes in two to three years following market drawdowns.
REITs haven't exhibited this outperformance so far in 2020, but they are undervalued right now and have a lot of room for growth, Garcia says. Investors should hold anywhere between 5 and 20% of their total investment portfolio in REITs, depending on investment objectives, he adds.
Just be mindful of one risk with REITs, says Charles Sachs, director of planning at Kaufman Rossin Wealth: they hold office and retail space, which in the pandemic can mean less money collected in rents, and trimmed dividends in response.
Graves also likes MLPs “for those clients who can take some price volatility in exchange for excellent returns.”
“I like them because they are not interest rate sensitive or credit sensitive like almost all bonds,” he says, and recommends a range of 4% to 8% of a total portfolio, depending on the investor.