Let me paint a picture of our current economic situation. Interest rates are at historic lows and will likely be there for a while. The Federal Reserve has indicated the rates are likely to stay low through 2015 or longer. The 10-year treasury is yielding around 1.75 percent. Banks are paying 0.2 percent to 1 percent on savings deposits and charging us fees for anything we do. Bank CDs are not paying much more than that. Social Security benefits are not rising and will need to be lower in the future or the current system will fail. Pensions from companies, municipalities and the federal government have been reduced or eliminated. How does one plan for income in this environment?
When I started in the financial industry twenty years ago, it was not uncommon to use 8 percent as the expected market return for planning purposes. A more conservative person would use 6 percent to 6.5 percent. Ten years later, the expected rates used had dropped to between 5 percent and 6.5 percent and the more conservative went 4 percent to 5 percent. Today, 4 percent to 5 percent is the cap, and I am not sure what the conservative estimates should be.
There are a few things that I am sure you should do. First, avoid longer term high quality fixed-rate debt. Treasurys, state-backed municipals and high grade corporate debt will all suffer once the rates start to climb. If rates go back to five percent, the losses will be substantial. If rates go back the 1970 levels, it will be horrific. And the longer the government keeps printing money to buy treasurys in order to artificially keep down the rates, the more likely it is that the super-high rate scenario will come to fruition. After all, one of the few ways to pay back a national debt as large as ours is to inflate our way out of it through devaluing the currency. This approach could work, but will be very painful if you are not prepared. So how do we prepare? Consider these steps:
Step 1: Pay off all current floating-rate debt and high fixed-rate debt that cannot be refinanced.
Step 2: Keep more cash in reserves than normal. Usually, we suggest six months of reserves but now twice that makes sense. Park that money in a low duration investment to help avoid interest risk and maintain liquidity.
Step 3: Consider investments that used to not make sense as investments that you could now look into. For example, floating rate investments make little sense in a decreasing rate environment. They may when rates reverse.
Step 4: You may want to try stable illiquid long term investments that are similar to many institutional portfolios. For example, senior secured debt portfolios that are heavily collateralized. Many are three-to-one or as much as five-to-one debt to collateral ratios and have floating rate facilities.
Step 5: Buy credit sensitive and floating rate bonds, such as convertible, high yield, emerging market securities, bank loans, treasury inflation-protected securities, etc.
Step 6: Plan. Make sure you get all the free dollars saved by understanding the income, estate and capital gains tax codes.
Step 7: Revisit the plan and always err on the side of the side of conservative.
Step 8: Don’t ever panic. Realize, we are still the envy of the world and the most stable financial system on the planet.
Michael Patrick Jacobs, CFP®, is a Partner at Monument Wealth Management, a Registered Investment Advisor located just outside Washington, DC in Alexandria, Va. Follow Mike and the rest of Monument Wealth Management on their blog which can be found on their website, on Twitter @MonumentWealth, and on the Monument Wealth Management Facebook page.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance referenced is historical and is not guarantee of future results. All indices are unmanaged and may not be invested into directly.