5 ways investors can beat the retirement bandits
Commentary: Demographics, taxes, low yields threaten living standards
03/15 12:01 AM
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PALO ALTO, Calif. (MarketWatch) -- Millions of Americans have worked hard for a lifetime, paid their mortgages, in some cases put their kids through college, donated to charity, and somehow tucked away enough money to take care of their retirement.
Yet because of demography, taxes and debt, their nest egg may not get the job done.
Demographics, the first bandit, is robbing investors of previously anticipated market returns.
The baby boom generation is heading into retirement with the momentum of a massive locomotive. Every day more than 10,000 Americans reach the age of 65. This will continue happening every day through 2030, forming a potent wave of retirees seeking retirement income.
Headwinds of change
While retirees sell stocks in favor of bonds in search of predictable income and greater security, a persistent headwind will hit the stock market. Many doomsday prognosticators believe this downward pressure will result in calamity, but it is more likely that the countervailing force of young, up-and-coming foreign investors will steady the ship. Still, the glory days of 10% annual portfolio returns year after year are likely behind us for the foreseeable future.
If demographic shifts are not intimidating enough, retirees face a second robber -- higher taxes. The Bush era tax cuts are set to expire at the end of 2012, and as a result many Americans will see a 3% to 5% increase in their nominal tax rate along with additional increases to fund Medicare and other special programs.
And just when many retirees are scooping up dividend-producing stocks, the dividend tax rate is set to go from its current, motivating 15% to a taxpayer's ordinary income tax bracket -- for some as high as 39.6%.
Plus, there is the invisible tax of inflation. The Bureau of Labor Statistics shows annual inflation to be around 3%; critics claim it is underreported and is significantly higher when measured by the older, 1980 standard.
Finally, there is the U.S. debt. This bandit comes out of hiding via the Federal Reserve's artificially low interest rate program. In an effort to stimulate the economy back to health and slowly inflate out of our debt debacle, this low interest rate program has left today's retiree with his pockets empty and hands held high. While the traditional government bond portfolio coughs up a meager 2%, inflation and taxes steal back much more.
See risk differently
To confront the bandits and win, you need a new and more creative approach to income generation.
Simply piling into dividend stocks or running to an insurance annuity does not provide the diversification the smart investor requires. Shrewd income portfolios must be highly diversified across asset classes as well as within them.
Additionally, the portfolio must be low-cost and as transparent as possible. There is no reason to cough up a few percentage points in fees when a few percentage points may make the difference between success and failure. This portfolio also needs to be tax-efficient and have an inflation hedge.
Here are a few strategies to consider adding to your allocation as you seek to build a winning income portfolio:
1. Emerging market debt: Emerging nations pay 5% to 7% in bond yields, substantially higher than comparable Treasurys. When some hear emerging economies, they immediately think high risk. Emerging economies are ostensibly going to be the growth engine for the world's economy in the next 10- to 20 years. Additionally, they have far less debt relative to the size of their economies than do developed nations.
Fairly priced, transparent and diversified exchange-traded funds are easy to find. Check Powershares Emerging Markets Sovereign Debt ETF or iShares JP Morgan USD Emerging Markets Bond . Last year, each of these low cost ETFs produced more than 6% in annualized yield, were highly diversified across dozens of emerging market economies, and had excellent volume.
2. High-yield corporate debt: After learning more about today's quality high-yield bond ETFs, you too may decide to add a little "junk" to your portfolio. SPDR Barclays Capital High Yield Bond ETF (JNK:$39.74,00$-0.11,00-0.28%) produced a 7.5% yield last year with massive diversification across a broad swath of industries. Surely, this is no Treasury bond vehicle, so buckle your seat belt and mix this with careful forethought. Adding a little JNK provides some seasoning to your income portfolio and is an additional defense against the bandits.
3. Large-cap dividend ETFs:Dividend stocks are the darlings of the day. With dividends returning more than Treasurys, and the underlying stock ownership providing an inflation hedge, many are getting on the bandwagon. Instead of taking on the unnecessary risk of buying a handful of dividend-producing stocks, some great ETFs help you get diversification and cost structure for a winning portfolio. Check out Vanguard Dividend Appreciation ETF (VIG:$58.51,00$-0.19,00-0.32%) or iShares Dow Jones Select Dividend Index , which each boast more than $10 billion in assets.
4. REITs: By blending SPDR Dow Jones REIT (RWR:$69.91,00$-0.13,00-0.19%) with SPDR Dow Jones International Real Estate ETF , you can top U.S. government bond yields and achieve principal growth. Although you've moved outside the realm of traditional fixed-income investing, REITs provide another good source of diversity and yield.
5. MLPs:Master Limited Partnerships can be powerful portfolio tools. The top MLPs run the nation's oil and gas pipelines and, as limited partnerships, require the distribution of profits. Accordingly, MLP investors historically have received between 6% and 10% in pass-through income with some attractive tax advantages if you don't mind the hassle of having to process K1 tax forms at the end of each year.
Previously only for sophisticated investors, MLPs are now available to the masses through exchange-traded notes such as JP Morgan's Alerian MLP Index ETN . This portfolio combines a diversified blend of high-quality MLPs, but earnings are reported as ordinary income. So you don't deal with a K1, but you also miss the tax benefit.
The problem with AMJ is that you do not own the underlying partnership, but a note or loan to that partnership, so you also assume credit risk. Although clearly not for everyone, this ETN, with a tendency to move independent of market swings, may be worth closer consideration.
