Tapping Consistent Income Streams in Retirement

1. With interests rates as low as they are, how might retirees think about generating income without taking on excessive credit risk?
Retirees might want to consider looking at a short-term, investment-grade bond fund. While taking a modest amount of interest rate risk compared to money market funds, the yield pickup is substantial ( Baird Short Term Bond Fund is yielding over 3% while most money market funds are yielding 0.5% or below). Credit risk is limited in investment-grade bonds, and investing in a fund vs. buying individual issues also significantly increases diversification, which further limits credit risk. A mutual fund also offers significant advantages in terms of liquidity. One can contribute or withdraw funds at the NAV, avoiding the often large bid/ask spreads on individual issues. Furthermore, these contributions and withdrawals can be accommodated without changing or upsetting the overall portfolio structure.

2. Is the notion of "consistent income" an elusive/unrealistic goal for investors, particularly retirees?
We do not believe that the notion of consistent income is an elusive or unrealistic goal for investors. Clearly, as interest rates change, principal values of bonds (and bond funds) will fluctuate, and income levels will change over longer periods of time, but these two variables tend to offset one another over time. So far this year, yields on investment-grade corporate bonds have declined significantly and yields on investment-grade bond funds have fallen in step. However, the net asset values (NAV) of these funds have also risen, so an investor's investment in a fund has appreciated. Therefore, although investors are earning lower yields, they are earning them on a larger principal base, which minimizes the effect on their overall income level.

The key is for investors to select a bond fund that appropriately matches their risk tolerance and investment objectives and then stick with it over time. Too often investors invest with their stomachs (emotions) and change funds in anticipation of market changes (e.g., move from a short fund to a long fund) even though their income requirements have not changed. In doing so, they often move at the wrong time and experience a drop in income without receiving the benefit of an increase in principal. Staying the course can help smooth income.

3. You recently told Morningstar that there is time before inflation hits. That said, how might an investor concerned about the long-term impacts of inflation think about protecting his or her portfolio for this potential long-term occurrence?
Investors who are concerned about the long-term effects of rising inflation can protect the fixed-income portion of their portfolios from significant erosion of value simply by minimizing exposure to the longer end of the yield curve. We believe that intermediate funds offer investors the bulk of the value in the bond market yet significantly limit exposure to the impact of rising interest rates that accompany higher inflation. This is particularly true in the municipal market where the long end of the curve flattens out and investors continue to pick up incremental risk without picking up much incremental yield. One other way for investors to protect their portfolio from the long-term impact of higher inflation is to allocate a portion of their portfolio to inflation protected securities (TIPS). We caution that while TIPS do offer good long-term protection against the impact of inflation (viz. an increase in CPI), they do not necessarily offer good protection from rising interest rates in the short run. The bid/ask spread on TIPS is also much wider than that of regular Treasury issues, so investors are well-advised to take a long-term, buy-and-hold strategy with TIPS and/or consider investing in a TIPS fund.

4. Many have criticized officials at the Fed and Treasury for getting us into our current predicament (through actions such as leaving rates too low for too long, allowing financial institutions to get too big, etc.) Do you have the confidence that when the time comes to start pulling back on all the stimulus supporting the markets, they'll time it well and avoid such occurrences as rising inflation, or is that an impossible task?
We believe there is plenty of blame to go around on all fronts for the current state of affairs and do not hold the Fed and Treasury solely responsible. We also believe the Fed's (and Treasury's) main concern for the time being is still the risk of deflation. With the Fed funds rate at zero, the Fed is already "all in" and cannot lower rates further. Hence, they will probably error on the side of accommodation to avoid "snuffing out" the recovery prematurely and may be a little late in their subsequent fight against inflation. However, they have plenty of room to raise rates when they need to, and we believe they have the tools to effectively fight inflation.

5. What signs are you looking to as leading indicators of a stabilizing economy and how far away are we from reaching them?
Housing led the economy into this decline, and we believe stabilization in homes prices will be a necessary foundation for a sustainable recovery. We are seeing encouraging signs that home prices are approaching a bottom and believe a bottom could be reached by early or mid-2010. Employment is another sign post and while job growth is typically a lagging economic indicator, we believe the economy needs to stop losing jobs before it can post sustainable growth. Unemployment is expected to peak above 10%, and we believe that peak will be reached next year as well.

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