If you’re living on your income, falling rates have squeezed your standard of living. If you’re saving for the future, you aren’t building capital for the long term. An 8 percent yield, minus one third for taxes and adjusted for 4 percent inflation, leaves you a real investment return of just over 1 percent. So your purchasing power stays pretty flat. In a 5 percent money-market mutual fund, your savings lose value every day.
Caught in this bind, the typical investor performs the celebrated interest-rate shuffle-switching to investments that offer ever-higher yields. But some of the hottest high-interest-rate products are probably going to disappoint you. You need a better theory of income investing, and it all boils down to this: Interest-rate investments don’t cut it. To increase your income over time, you also have to be buying stocks.
To many conservative income investors, stocks are the fear that goes bump in the night. They’d rather gamble on complicated high-interest products that brokers evasively peddle as “safe.” The following three, all popular now, may leave you dissatisfied down the line.
Collateralized mortgage obligations (CMOs). Individual investors have thrown more than $40 billion into CMOs on a stock-broker’s word that they’ll earn 9 percent “government guaranteed.” Many buyers seem to think they’ve got something like a high-rate certificate of deposit. But on CMOs, your yield may change. And potentially, you run more risk to your principal than the broker is likely to disclose.
CMOs are backed by mortgages that are usually triple-A or government guaranteed. As the mortgage holders repay their loans, you get your money back plus interest. But you may not receive your money on time. If you have to sell early, you’ll probably get a lower yield than expected.
Say, for example, that you buy a five-year retail CMO. The broker is assuming that that security will mature in about five ever, mortgage holders won’t prepay their loans as fast. Your five-year CMO might turn into a 10- or 20-year investment. If you need your money earlier, and try to sell the CMO, you’ll be offered less than you invested. Individuals with a few CMOs–say, under $100,000-often can’t get a decent price.
Conversely, if interest rates fall, you may get your money back sooner than planned and will have to reinvest at a lower rate.
A type of CMO known as a PAC (for “planned amortization class”) will pay off pretty much as promised. But it costs a minimum of $25,000 and isn’t what brokers usually offer. The typical retail CMO may do you wrong unless interest rates stay stable for years.
No fixed-income investment is more complicated than a CMO, says Robert P. Andres of the money-management firm Martindale Andres & Godshalk in West Conshohocken, Pa. Yet none of the risks is clearly explained in the sales brochures. Even worse, retail buyers often pay an inflated price. The average investor shouldn’t touch CMOs with a 10-foot pole. Prime-plus mutual funds. These funds go after money-fund investors, promising them yields that match the 8.5 percent prime interest rate. But the funds don’t usually reach that goal-due in part to high fees and expenses.
And as it turns out, that’s the least of your worries. Prime-plus funds invest in “junk” bank loans that are both speculative and illiquid. You could lose money if a loan defaults or if your fund has to sell assets fast. Furthermore, questions are being raised as to whether these funds have fairly disclosed the potential losses in their portfolios. Some $6 billion has been poured into prime-plus investments. But you’re not getting worthwhile returns for the risk.
Adjustable-rate mortgage (ARM) funds. These funds invest your money in mortgages. They’re far safer than the prime-plus funds and yield around 1.5 to 2 percentage points more than money-market funds. Share values haven’t fluctuated much; still, your principal isn’t 100 percent safe. What’s more, ARM funds have upfront or back-end sales charges in the 3 to 4 percent range. So they’re no place to park money for short periods of time. You might want them for money kept permanently in cash, but they don’t help your capital grow.
Once you swear off the interest-rate shuffle, the only sensible company to keep is (1) well-established investments for your ready cash, like money-market mutual funds and short-term bond funds; (2) some medium-term bonds for balance, and (3) no-sales-charge stock-owning mutual funds. To buy stocks, however, means redefining what you mean by “income.”
To most investors, income means only interest and dividends. But you also earn income from the profits you make on stocks. Not one of the planners consulted for this story put their income-oriented clients–including retirees–entirely into-fixed-interest investments. They picked stocks for 30 to 60 percent of the assets.
You may think that stock mutual funds are too risky for your safe money. “But a bigger risk,” says Robert Preston, a retirement consultant and actuary in Danbury, Conn., “is having too much in fixed-income investments because of inflation and the way that interest rates fly around.”
According to Ibbotson Associates in Chicago, stocks have yielded an average annual return of 6.7 percent over the inflation rate since 1926, compared with 1.4 percent for long-term U.S. bonds and only 0.5 percent for Treasury bills. After taxes, the bonds and the bills have fallen way behind.
Stock-owning mutual funds make it easy to get income from your investments. You reinvest all the earnings and use the fund’s systematic withdrawal plan. The fund will send checks on a regular schedule (usually once a month) of whatever size you need. Your remaining money stays invested for growth. Even if the market drops, your capital should-over time-increase by more than you withdraw. This is especially important for young retirees. If your money doesn’t grow in your early retirement years, you’ll be eaten by inflation later.
The table on the previous page shows how withdrawal plans can work. After 10 or 15 years of withdrawing money, investors in these funds would still have had more than they started with. In the single instance where their remaining capital shrank-Selected Sectors, 10 years out–the fund invested only in a single industry (energy). Withdrawal plans work best when funds buy a wide selection of stocks.
If you’re building capital rather than living on it, stock funds become even more important-especially in tax-deferred retirement plans. One dollar invested in 1926 grew to $517 by the end of 1990, tax-deferred, Ibbotson says. If taxed annually, however, that same investment would have grown only to $117. One dollar put into long-term U.S. bonds would have grown to $18 tax-deferred, only $8 if taxed.
For both stocks and bonds, consider “balanced funds” that invest in both. Since the late 1970s, this group has had only one losing year, says John Rekenthaler of Morningstar in Chicago, which rates mutual funds. Rekenthaler’s picks: the balanced funds from Dodge & Cox (415-981-1710), Fidelity (800-544-8888), Vanguard’s Wellington (800-662-7447) and Pax World (for socially responsible investments, 603-431-8022).
Planner John Sestina of Columbus, Ohio, prefers to create his own balanced portfolios. Part of his clients’ money goes into money-market funds, short-term bond funds and Treasuries or tax-exempt municipals (maturities up to six or 10 years). The rest goes into equity-income funds, which lean toward high-dividend stocks. They carry slightly more risk than balanced funds and should yield higher average returns over time. Among equity-income funds, Rekenthaler picks Founders Equity-Income (800-525-2440), Lindner Dividend (314-727-5305), SAFECO Income (800-426-6730) and USAA Mutual Income Stock (800-531-8181).
One warning about stocks, from Burton Malkiel, professor of economics at Princeton University. After the dizzying ’80s market, it’s reasonable to expect the 1990s to simmer down. “I think you’ll be lucky to average 9 or 10 percent a year,” he says. Quality 10-year corporate bonds also yield 9 percent-so today bonds are looking pretty good. But Malkiel buys stock funds, too. For income investors, the lesson from history is this: the greater your participation in stock funds, along with your bonds, the higher your income is likely to be.
A good stock-owning mutual fund adds more money to your nest egg than you take out. This example assumes an original investment of $100,000. If you withdraw $10,000 every year, you should still wind up with more capital than you started with.
TAKING $10,000 AMOUNT LEFT IN YOUR FUND AFTER:’ A YEAR FROM: 10 YEARS 15 YEARS Guardian Fund $189,178 $292,980 Partners Fund 195,938 428,692 Selected Sectors 85,452 186,329 Plus Energy*
*ALL DATES ENDING 6/30/91, *AN ENERGY FUND UNTIL 1989. SOURCE: NEUBERGER & BERMAN
