The Search for Income

Born between 1946 and 1964, the baby boom generation represents an enormous investor class.

How enormous? According to the Census Bureau, the first of the 78 million boomers in the U.S. will begin turning 65 three years from now. By 2030, 20% of the U.S. population will be 65 and older, up from 12% today. How they (or, I should say, we) live, from working and spending to investing, affects every aspect of all of our lives.

And I believe one effect of the wave of retiring boomers will be an increasing demand for yield-bearing assets. For some, the desire will be to live off their portfolios’ income (see also “Vanguard’s Top Mutual Fund for Retirement“). Others, less willing to accept the volatility of the stock market, will begin searching for investments that lower the risk in their portfolios. Either way, this could result in an inexorable move towards bonds and dividend-paying stocks, driving the prices of those securities up while driving their yields lower.

Boomers Breaking The Bank

As they retire, boomers will begin tapping into their IRAs and 401(k)s to pay their bills. And bear in mind that many are now allowed to make withdrawals from their retirement accounts at age 59-1/2 without any IRS penalties. The income-hungry have already begun to dip into the till.

According to a recent survey by AARP, 25% of Americans age 45 to 64 said they were prematurely taking money out of retirement accounts to make ends meet. Investors desperate for cash are generally unable to stomach much stock market volatility, so these early withdrawers will likely, and I believe mistakenly, move some of their remaining portfolios to “low risk” bonds, if they haven’t already (see also, “Shock-Proof Your Retirement“).

That’s inadvisable but understandable given the circumstances. But the real head-scratcher is… wealthy boomers doing the same now because of the market’s slide. A recent survey by Opinion Research Corp. of 500 sixty-year-olds with portfolios of $1 million or more found that 69% said they were making their investments more conservative, loading up on bonds and money market funds because of the downturn. Only 21% said they were going to increase their stock investments. Not exactly a buy-low, sell-high strategy.

Unfortunately, with interest rates so low, “income” is awfully hard to find. And when you consider that inflation has been on the rise, real returns for many bonds are practically nil. That’s especially true for seniors whose consumption patterns differ from the average American’s. Medical care CPI, for instance, has gone up 4.5% a year since 1999, outpacing inflation by 1.5%. Health insurance premiums are through the roof, rising at more than twice the inflation rate. How’s a Treasury bond yielding 4% going to help pay for that?

The irony is that the stock market could prove to be the best source of income, growth and inflation protection going forward. Now, we need to get our definitions straight here. As I’ve often said, “income” doesn’t necessarily equal interest paid on bonds or dividends paid by stocks. You don’t pay for groceries with income–you pay with cash. That cash could be generated by capital gains. Either way, money coming out of a 401(k) or IRA is all treated the same as far as the IRS is concerned. (Roth versions are treated differently, of course, see also “Are You Making These 401(k) Mistakes?“) And in non-retirement accounts, the tax rates are much lower for stocks–a 15% maximum rate on long-term gains compared to 35% on bond income.

So why not fund your retirement with stocks? It’s true that over the past decade they’ve only delivered a meager 3.9% annualized return, barely outdistancing inflation’s 2.8% rise, while Treasury bonds averaged 7.2%. But the last decade has been an anomaly. Historically, stocks have proven to be the best inflation hedge, edging out the CPI’s 4% annualized rate over the past 30 years by more than eight percentage points.

Not that anyone can guarantee there won’t be any downside in the future. Investors who can most afford to weather the stock market’s gyrations in retirement are typically those least in need of stocks’ outsized returns. People who’ve accumulated large nest eggs can and should wait out the storm for a few years. But those who haven’t saved enough are now in a bit of a pickle.

Luckily, Vanguard investors are in the catbird seat when it comes to income. With management fees less than half those of their peers, Vanguard’s funds all generate more income on a relative basis than competitive funds.

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