NEW YORK (CNN/Money) -
When my husband and I retire, we'll need to supplement our Social Security with an income-producing investment and maybe continue to work some. Would investing in a corporate bond mutual fund be the best source of income?
-- Janet Smith, Cook Station, Missouri
Like many retirees and near-retirees, you seem to think that investing for income is synonymous with investing in bonds and bond funds. In fact, that notion is not only erroneous -- it can be downright dangerous to your financial health.
Let's assume, for example, that you put all or nearly all your retirement portfolio in a corporate bond fund. And let's further assume that the fund invests in a diversified portfolio of highly rated corporate bonds, so that defaults by individual issuers aren't really a factor.
You might be satisfied at the moment with the interest payments of 5 percent or so a year that you would receive, but consider how you might be vulnerable.
Bonds are riskier than they seem
For one thing, even though the high quality of the bonds and the diversification of the portfolio should protect you from credit or default risk, it does nothing to protect you from interest-rate risk.
If interest rates rise from their present low levels -- which is likely once the economic recovery eventually begins to take traction -- the principal value of the bonds in your portfolio would drop. That's because interest rates and bond prices have this seesaw relationship. When rates rise, bond prices go down.
So if you had the bulk of your portfolio in this bond fund, your entire retirement account would drop in value. I don't think it's a good idea to have all your money vulnerable to rising rates.
But let's assume that rates don't rise, or at least don't rise enough to cause a problem for you. You would still have to contend with the fact that the income you receive from your fund would be vulnerable to inflation over the long term.
Let's say that you invest $100,000 in a corporate bond fund that yields 5 percent and thus provides you with $5,000 a year in income. Over time, inflation would chip away at the buying power of that five grand.
Even if inflation were to amble along at a modest annual rate of, say, 2 percent per year, your five thou would lose about a third of its purchasing power within 20 years. Meanwhile, the value of your $100,000 principal would also be declining relative to inflation.
Think diversity, not just bonds
So what's the solution? I recommend that retirees stop thinking in terms of just bond funds or "income" investments and instead think of building a diversified portfolio of stocks and bonds that can grow over time.
Yes, I know that the idea of putting money into stock funds might seem scary right now. But if you think you're going to still be around 10 or more years from now, the fact is you probably need some capital growth in your portfolio -- which means you need some stocks in there.
I can't tell you exactly how much to put in stocks -- the amount will depend on your age and your tolerance for risk -- but I can tell you that putting all your money in bonds, corporate or otherwise, could put you in a position late in life where you find yourself having to make do with an income that's shriveled in relation to the cost of goods and services.
I suggest you do two things: first, go to our Asset Allocator tool for help in creating a diversified portfolio of both stock and bond funds. You'll also find some suggestions for both stock and bond funds you might consider investing in.
Second, check out the Retirement Income Calculator at the T. Rowe Price site. You plug in your age, the value of your portfolio, the amount you plan to withdraw each month and then select from the menu of investment portfolios one that most closely resembles yours. And the calculator then shows you the percentage chance that your portfolio will be able to sustain your planned withdrawals over the rest of your life.
After performing this exercise, I think you'll see that a diversified portfolio of both stock and bond funds is a far better solution for retirement income than relying on a corporate bond fund alone.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday mornings at 7:40 am on CNNfn.