If you incorporate these rules when selecting retirement income investments, you will avoid the most common errors and enjoy a more consistent income with fewer surprises.
1. Long term investments will pay more than short term investments
Most of the time (unless the Federal Reserve is attempting to slow inflation), long term interest rates will be higher than short term rates. That means you will earn more from a 5-year treasury note or 5-years CD than you will from a 6-month treasury note or 6-month CD. Fight the urge to invest short term which becomes the emotion preference as you get older. Your retirement income investments should be consistent with your life expectancy. So at age 70, you should seek investments with 16-year horizon (the average life span of a person who has reached age 70). You will earn more income from longer term investments and thereby reduce the risk that you run out of principal. In order to locate and identify suitable retirement income investments, visit your financial advisor or retirement planning center (e.g. local office of Fidelity or Schwab).
2. The higher the reward, the more the risk.
The point of retirement income investing is not to retire rich, but rather, to have a comfortable and sustainable retirement income after you have ceased working. Generally (not always), the higher the interest rate, the higher the risk. If the bonds from IBM pay 6% and the bonds from ATT pay 7%, the bonds from ATT will usually have a lower rating because the rating industry views the ATT bonds as more risky. Are the ratings always accurate? No. But unless you have sufficient knowledge to do your own research and make sophisticated judgments, you need to rely on the ratings.
3. A high current yield usually means something is amiss or that your principal is being used to generate income
A woman told me she purchased some preferred shares that were high quality and paid 8%. Within a few months, the preferred shares were "called" and she got $25 per share paid to her for her $27 investment. What she did not understand at the time of purchase was that the preferred shares were selling at a premium, were likely to be called and the risk of losing principal was high. The market understood this and thus paid investors well because of the risk. The focus of retirement income investing is not to maximize the current yield, but to maximize total risk adjusted return.
Many years ago, Putnam funds sold mutual funds with very high yields printed on the brochure in big type, '14.02%' The high current yield was accomplished by buying stocks and writing call options for income. That means that any appreciation on the stocks would be little or non- existent yet the full stock price declines would be shouldered by the fund investors. So the fund was converting potential appreciation into current income yet leaving investors with a higher risk portfolio. Most conservative retirees would agree that this is not a great strategy for their retirement income investing.
4. Focus on total return, not just current yield
Because potential appreciation can be converted into current income using options or other hedging strategies (making the current income illusive), its best to invest for total return. Would you rather own an investment that pays 6% annually but does not grow or and retirement income investment that pays 4% annually and then grows 4% annually, for a total return of 8%. In the long run, you do better by focusing on total return rather than current yield.