THE closer you get to retirement, the more questions you ask about the adequacy of your retirement portfolio. What if you live longer than your investments? How do you maximise your retirement income? Can you survive without a regular pay cheque? While there is no one-size-fits-all strategy in moving from saving for retirement to living off your retirement portfolio, there are strategies that can help you plan effectively.
Investing in bonds is one such strategy and should be considered the foundation of any retirement portfolio. Bonds are medium to long-term debt instruments where a corporate or governmental entity or country borrows money from an investor. This is usually for a defined period of time and at a predetermined rate of interest. Some common features in almost all issued bonds are a maturity date and an interest payment frequency, which is usually twice per year. These two features make this asset class an important source of retirement income.
Bonds can be purchased at a discount, or at a price that is less than its face or par value, which is usually US$100. They can also be purchased at a premium, in which case the investor pays more than par value for the bond. The interest rate offered on the bond is influenced by, among other things, the rating assigned to the bonds. The US rating agencies, Moodys, Standard & Poor's and Fitch, have prescribed ratings for bonds ranging from investment-grade to junk. Bonds with high investment-grade ratings have the lowest interest rates, since these are issued by entities with good fundamentals. On the other hand, entities with ratings less than investment-grade tend to pay a higher interest rate on their bonds to compensate investors for taking a higher risk.
On approaching retirement, expenses and cash needs must be reviewed. These can then be separated into discretionary spending and necessities, such as healthcare, housing, food, and utilities. This allows the potential retiree to create an annual budget for expenses that will then be matched with income from annuities and pension plans from past employment. Any shortfall in income will have to be picked up by a retirement portfolio.
By using a technique called laddering, the maturity and interest payment dates for different bonds can be staggered and spread out over time to coincide with any projected need for cash or income. Since most bonds pay interest every six months, an ideal plan would be to invest in bonds that mature one year apart.
A bond ladder allows an investor to take advantage of longer-term bonds that usually have higher yields, while getting the benefits of shorter maturities. In addition to providing regular income, bonds become due regularly and any principal amount that is not used becomes available for reinvesting.
Since laddering allows for the purchase of bonds with varying maturities it automatically allows an investor the ability to diversify a retirement portfolio with bonds across different industries and with different credit ratings. This minimises the risk on the portfolio, since a default by any one issuer or entity would have a minimal impact on the overall portfolio. This, however, is dependent on the level of diversification within the portfolio.
Using bond ladders to plan for retirement can help with some portfolio issues, such as market timing. It also allows an investor to enjoy the benefits of a stable income during the ups and downs of the interest rate cycle. There is no one investment strategy that fits all, and retirement portfolios must be tailored to fit individual needs. Laddering, however, can reasonably manage the fixed income portion of your retirement portfolio by managing the interest rate and default risks associated with bond investments.
Noel Harty is the branch manager for Stocks & Securities Ltd Montego Bay Division and may be contacted at email@example.com.