Caution, Retirees: Higher Yields Come With a Price

Higher-yielding investments may come with more risk than retirees realize.

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Adam Bold
Many retirees sock away a portion of their savings in certificates of deposit (CDs), one of the safest investments around. Five years ago, they were paying 4 to 5 percent interest. Now, most pay only 1 or 1.5 percent.

Interest rates have been low for a long time and are expected to remain low for the time being. As a result, retirees who want to roll over money from a matured CD into a new one aren't earning as much income to meet their lifestyle needs. This has driven many people to hunt for higher yields through investments they wouldn't ordinarily consider because they carry much higher risk.

A lot of these higher-yielding investments could be potential time bombs, and retirees may not realize how much danger they're taking on. For example, a recent caller to my weekly radio show said he bought a closed-end municipal bond fund paying 6 percent interest because it seemed like an attractive alternative to low-yielding CDs.

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That's a huge red flag in my mind for several reasons. Here's why:

  • The caller paid a 12 percent premium for the fund. Investors who knowingly pay extra for an investment—even when the value of an investment's underlying assets is less than its market value—may do so if they can recoup the extra cost. In this instance, the higher returns now may help offset that premium, but it's unlikely the underlying assets will increase in value enough to recoup the 12 percent premium.
    • The prospect of rising interest rates. When interest rates go up, the value of existing bonds decreases. If the caller's bond fund falls in value, how likely is it he'll be able to sell shares for the price he paid?
      • How is this fund achieving such a high yield? Turns out it's a leveraged portfolio—managers were using money from investors and borrowing more money to buy more bonds. The caller was looking only at the higher interest rate, and didn't realize that even in a bond fund, the higher rate came with extra risk.
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        Another alternative retirees have is fixed annuities offering high, introductory teaser rates. Fixed annuities pay a fixed monthly payment for a specified period of time on an immediate or deferred basis. The problem is, after a year or some other limited time, the rates paid by these teaser-rate annuities typically fall to market interest rates.

        However, even that rate is not what the bond market is paying; it's a rate set by the insurance company. The company might say the rate will never be less than three percent, but it could end up paying only three percent. Plus, investors typically have to hold an annuity for seven years to avoid paying an early-withdrawal penalty. You may feel trapped in a low-yielding annuity for at least seven years because you won't want to pay the penalty.

        Here are some general guidelines to help you avoid trouble as you seek yield:

        High interest rates usually come with more risk. Take the time to understand the investment, especially why it's able to pay a higher interest rate. The higher rate might look like a reward, but there's a chance the investment could blow up when market conditions change or interest rates rise. Retirees can't afford to take that risk.

        [See the top-rated Vanguard funds from U.S. News.]

        Have a combination of investment types. Even in retirement, investors should have a combination of fixed income (bonds) and stock and growth investments. Bonds will help get you through the bad times in the stock market, while stocks will get you through down times in the bond market. Avoid putting all your money into one or two investments.

        Withdraw wisely. When you withdraw money from your accounts, it doesn't matter if it comes from bonds or stocks. Just as people use dollar-cost averaging—buying a fixed dollar amount of investments every month or quarter—when they add to their accounts, consider doing the same as you take money from your accounts. You want to use both stocks and bonds as a source of income to avoid leaving your account without one or the other.

        One last piece of advice: Now is not the time to lock in the low rates of a long-term CD. If you can, hold off on putting money in a CD until next year when you might be able to get a higher interest rate.

        Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.