The financial press regularly reports that investors can increase income by investing in longer-term securities or by taking on more risk.
This advice usually appeals to retirees who, particularly in this low-income environment, are always looking for ways to generate more cash.
Markets are generally efficient and there are few, if any, ways to get that income without taking more risk. To quote a familiar trope, there is no free lunch. But such articles do help consumers if they are prompted to understand the nature of risks.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
A risk primer
Here are the ways I think about risk when it comes to generating income:
Duration risk
Interest on bonds is generally higher for longer-term bonds, so you can increase income by investing in bonds that mature later. However, you increase your risk if interest rates go up and the value of the security falls.
Market risk
Securities go in and out of favor — remember junk bonds? And, of course, individual securities may fall in value because of problems with the issuer. The market may respond before you are able to.
Reinvestment risk
Eventually you will have to reinvest when a security matures. Hopefully, you will be able to put the money that is maturing in a new security at a reasonable interest rate. But that doesn’t always happen.
Timing risk
This is buying high and selling low. It happens to the best of us.
Assuming a New Risk for More Income
In fact, you may take on several risks in your search for an increase in income. But what if you were able to eliminate all other risks by assuming one new risk?
Your income would not be subject to duration, market, reinvestment or timing risks.
And this financial vehicle would pay up to 3% or more income.
What is the vehicle, and what is the remaining risk?
The vehicle is an income annuity — build up higher amounts of income for later in life.
An Example of How It Might Work
How could such an annuity raise the bar for someone looking for security? Take a 70-year-old woman who has a portfolio that includes $250,000 in fixed-income securities, e.g., bonds and CDs, that is currently paying her $10,000 per year. She could take that amount and purchase an income annuity that would pay her $17,500 per year. In her case, the additional $7,500 is like getting 3% more income from her original $250,000 portfolio.
Income annuities do come with their own risk — survival risk — and that is what generates the extra income. The extra 3% or more above what you could earn in comparably rated bonds is very competitive in your favor … if you live beyond your life expectancy. If you die young, and you don’t elect beneficiary protection (an option that comes at an added cost), you could even have a negative return, because your payments would end before you got out as much as you put in.
That’s why you ought to cap your allocations to income annuities at 30% or 35% of your retirement savings, and elect beneficiary protection if you’re concerned.
Additional benefits
When you know you are earning a certain cash flow from income annuities, it frees you up to take more of other risks in other parts of your retirement portfolio and hopefully get better returns. Ideally, you will live a long time — and stick out any downturns in the market — to make the historical long-term returns.
Income annuities make sense when considering all the various risk scenarios the market poses. Balancing those risks with income annuities improves your chances for financial success in retirement.