NEW YORK (Money Magazine) -
It takes a lot to rattle my Aunt Betty, who grew up during the Depression on a frosty farm in upstate New York with no electricity, running water or central heating.
But when she called me a few weeks ago, she was uncharacteristically unsettled. The problem: a sudden, severe case of yield deprivation.
Aunt Betty's one-year certificate of deposit, yielding 3.2 percent, was about to mature -- and her bank offered to renew it at 1.06 percent.
"That's not enough," she said angrily. "I need to supplement my Social Security, and that yield is just not enough for me to live on."
When she asked whether she could do any better, Aunt Betty was referred to the bank's securities representative, who suggested a bond fund with a yield of less than 6 percent -- and a sales charge of 4.5 percent.
Albert Einstein himself couldn't have slipped that kind of math past my Aunt Betty, who promptly headed over to a competing bank.
A broker there recommended a variable annuity. "Well," my aunt told me, "that didn't sound right either." That's for sure. While a variable annuity can be appropriate for a small percentage of younger investors, it is wildly unsuitable for any 86-year-old.
In her anxiety over falling rates and what to do about them, my aunt is far from alone.
With the Federal Reserve pile-driving rates downward, fixed-income yields are near their lowest since 1958, when Elvis Presley was recording "A Big Hunk of Love."
The rise in yields that began in July is not nearly enough to ease the pain for the millions of Americans who live off their investment income or are planning to retire soon.
Today investing for income seems to yield a big hunk of nothing.
To Boston University finance professor Zvi Bodie, co-author of "Worry-Free Investing," it's a familiar story.
"What your aunt is experiencing," he told me, "is a perfect example that the level of a person's wealth is no guarantee of consumption or standard of living if interest rates fluctuate."
Putting feelings first
So what can you do to survive this yield drought? Start by recognizing that much of the traditional wisdom about investing for retirement income may no longer make much sense.
Researchers led by Laura Carstensen, a psychologist at Stanford University, have shown that as people age, their perception of time shortens and they focus more on fulfilling "emotional needs" than on "gaining knowledge or preparing for the future."
Carstensen's research also shows that as we age, we are more likely to recall the emotional aspects of past experiences -- and to try to control our exposure to negative emotions in the present.
As I see it, then, it's no surprise that many older people are so concerned about making sure that the principal value of their investments will stay intact no matter what.
This research makes something else clear: How we perceive retirement is one thing, but how we experience it is a whole other thing entirely.
As growing older makes us feel that time is running short, we intuitively focus more on the emotional aspects of investing (like avoiding the frightful chance of losing any money). My aunt believed that the income from her CDs was the only thing keeping her above life at a subsistence level.
But the interest on CDs is deferred; they pay no current cash income at all. Thus the emotional comfort my aunt got from that steady yield was so powerful that it led her to overlook the fact that her CDs weren't adding anything to her monthly spending money.
Similarly, many bond fund investors reinvest their monthly interest rather than using it for living expenses; at Vanguard, for example, more than 80 percent of bond fund investors reinvest their payouts. If you don't actually need the income to live on, why get so upset about falling interest rates?
Besides, for most people, time isn't really running short. Today the average 65-year-old can expect to live another 18 years. Carstensen's research shows that as we age it will seem to us as if the sand is running low in the hourglass of life, compelling many investors toward extreme caution.
But most of us will end up living -- and investing -- far longer than we expect. That, in turn, suggests to me that many older investors are more conservative with their money than they should be.
Your other bond portfolio
John Bogle, founder of the Vanguard funds -- who is 74 years old himself -- agrees that rising life expectancies have changed the rules of the game.
If you're going to be retired for decades instead of just a few years, then it's neither practical nor desirable to make the absolute protection of principal your prime directive.
Of course, that doesn't mean you should put your money into something risky just to get a little more income. It does mean recognizing that it's acceptable to have some minor fluctuations in principal value over, say, a 10-to 20-year investing horizon.
It also means realizing that as you approach retirement, you are about to acquire an intangible but very real allocation to bonds; it's called Social Security.
Let's say your projected Social Security benefit (which you can view at ssa.gov/mystatement) is $1,000 a month. That $12,000 in annual income is the equivalent of owning $273,000 in Treasury bonds at their recent yield of 4.4 percent.
So if you're 55 and thinking of buying more bonds to bolster your income in retirement, remember that Social Security will soon be adding a huge slug of bonds to your portfolio.
That's yet another reason that income-paying stocks are what many retirees need (see more on that argument here).
Be an inchworm
Whatever you do, don't be rash. Junk bond funds look very attractive right now, with their fat yields of 7 percent and up. But in most cases, these funds' bonds are overpriced, yields are doomed to fall, and net asset value is sure to wither over time.
Instead, be an income inchworm. If you're in CDs, consider stretching into a short-term bond fund -- but only, and I mean only, from very large and reputable firms like Vanguard, Fidelity and T. Rowe Price -- which should raise your yield to between 2.5 and 3 percent.
A second small stretch would put you in a medium-term fund like Vanguard Intermediate-Term Bond Market Index, with roughly a 4 percent yield.
If you don't need the income to live on, consider the U.S. Treasury's inflation-protected I Bonds (publicdebt.treas.gov), which pay deferred interest, lately at 4.66 percent; that's what I recommended to my aunt.
Finally, a low-cost fixed -- not variable -- annuity from outfits like Vanguard, GE or Warren Buffett's Berkshire Hathaway (brkdirect.com) may make sense.
Just be sure to read all the fine print; fixed annuities have some quirky tax and estate-planning wrinkles. At brkdirect.com, for example, if you're 60 years old, roughly $165,000 will buy you a single-premium immediate annuity guaranteeing $1,000 in monthly pretax income for the rest of your life.
Not a bad deal -- and, with Buffett behind it, you don't have to worry that the insurer will go under before you do.
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