Simply Saving vs. Informed Investing
Fearing they will run out of money, many investors become so risk-averse that they err on the side of caution, but there’s also a risk to playing it too safe.
Let’s consider two hypothetical couples, each of whom had a $200,000 nest egg when they retired 20 years ago. One couple (the “Savers”) decided to put their money in a 20-year U.S. Treasury bond, confident in the fact that they wouldn’t lose any money. The other couple (the “Investors”) were willing to take a bit of risk in order to increase the value of their account in the decades to come. Treasuries are guaranteed by the U.S. government; fund shares are not.
When the Savers retired in 1996, a 20-year Treasury bond paid a guaranteed 6.73% a year. Withdrawing just the interest on that bond, the Savers took an income of $13,460 each year — leaving their original investment of $200,000 intact.
Meanwhile, the Investors purchased shares of The Investment Company of America (ICA), a mutual fund from American Funds. They decided to take monthly withdrawals at an annual rate of 5% of the account value at the end of each previous year. Willing to brave the ups and downs of the market, they came out ahead. Not only did they withdraw more money, but the value of their investment nearly doubled. (See charts below.)
The Investors’ annual income varied, but they withdrew more than the Savers did over 20 years. The Savers lived on the annual interest of their original investment, while the Investors withdrew 5% of their account each year
The Investors’ account value fluctuated with the market, but ended considerably higher than the Savers’ account.
Making It Last
Unfortunately for the Savers, when their bond matured at the end of 2016, they decided to buy another one — only to find that the rate on 20-year Treasuries had dropped to 2.79%, which would provide them with less than half their previous income — even as they were faced with the rising cost of living. True, they still had their $200,000, but it wouldn’t buy as much as it used to. The Investors, on the other hand, had an account value of $357,317, and continued to withdraw 5% each year.
While it’s important to protect your nest egg, it’s equally important to protect against the rising cost of living. Those concerned with market volatility who try to “save” their way through retirement likely will come up short.
Living in retirement requires more than just putting money aside — you need it to grow. A mutual fund, such as ICA, is invested in companies that can potentially add value. “Even in a very low interest rate environment, we are able to find companies that can offer significant dividend yields and have some potential for capital appreciation,” says American Funds portfolio manager Joyce Gordon. “Sectors such as utilities, telecommunications and consumer staples have provided above-average and — in many cases — growing dividends. There are many companies in other industries that should do well in a rising rate environment.”
Retirement should not be the end of the story, but rather a transition to the next chapter. So you’ll need to make your money last. “A diversified investment portfolio can help produce income without taking too much risk,” adds Gordon.