Jan 27 2015
Article does not represent an endorsement by MOAA.
By Hildy Richelson and Stan Richelson
Author Bio: Hildy Richelson and Stan Richelson specialize in fixed-income investing through Scarsdale Investment Group Ltd., a registered investment advisor. Hildy and Stan authored the award winning and best-selling book BONDS: The Unbeaten Path to Secure Investment Growth, Bloomberg Press, 2nd edition, 2011.
The goal of retirement planning is to replace your earned income with a reliable and consistent stream of predictable income, (i.e., cash flow). This is called the paycheck system of investing, and its goal is to provide you with financial independence. You can rely on a paycheck from bonds to provide you with a secure form of income. High-quality bonds have low risk and low fees and are tax efficient.
The major sources of cash flow to replace or supplement your earned income include:
- Rental income: requires managing one or more properties;
- Dividend income: requires predicting the direction of stock values and may result in significant losses;
- Annuity income: you make the insurance company your heir, and you give up control of your investment; and
- Bond income: you receive semiannual interest payments and a return of your investment on a specified date.
High-quality bonds can be a good source of cash flow in retirement because, by investing in bonds, you can predict your monthly and annual income, plus bonds require no maintenance. Though the value of bonds will fluctuate just like any other investment, only bonds will return their face value on a specified date. (Face value describes the amount of money or principal you will receive when the bonds come due.)
What is a bond?
Bonds are debt securities. For example, the U.S. government raises cash by issuing Treasury bonds, Treasury Inflation Protected Securities (TIPS), and EE and I- Savings Bonds. Municipalities, federal agencies, and corporations also issue bonds. These bonds are purchased by individuals, U.S. and foreign institutions, and corporations. Tax-exempt municipal bonds are favored by individuals because they might not be subject to federal, state, and local taxes. However, you can purchase all of the other kinds of bonds in your retirement accounts.
Why not purchase a bond fund?
All bonds are not created equal. It’s recommended you buy high-quality bonds to avoid a potential loss. Why not just buy a bond fund? The bond fund may hold low-quality bonds, foreign securities, and derivatives that might result in large losses. Most bond fund or ETF buyers do not look under the hood. In addition, bond funds actually are quasi-equities and, unlike individual bonds, the funds never come due. The funds might also charge high annual fees, as well as burden you with the costs of trading. If interest rates rise, the value of a bond or a bond fund will decline. However, though the value of individual bonds will fluctuate, they will pay their face value when they come due. Read more about this in “Buy Bonds and Not Bond Funds.”
The bond ladder.
A powerful strategy for using bonds in retirement planning involves the creation of a custom bond ladder. Investing in a bond ladder means buying individual bonds that have different maturity dates. For example, you might have bonds coming due each year starting in year five and then coming due in each subsequent year through year 15. In addition, if you need a bigger paycheck for a specific purpose, such as your child’s college education in 10 to 14 years, you can purchase an unequal amount of bonds coming due in those years. The issuer is required to redeem the bonds in the maturity year, thus facilitating your planning.
If you plan on retiring in 15 years, you can establish a bond ladder that integrates your personal account and your IRA and Roth accounts that will mature starting in year 15. You can choose to reinvest the proceeds of your bonds as they come due to create more income or start living off the principal. Reinvested interest payments give you investment growth through the compounding of interest. Knowing you have cash flow from your bond ladder to supplement other sources of income, as well as the predictability of lump-sum payments, can relieve a lot of stress.
Tax benefits of municipal bonds.
The interest income paid by many municipal bonds is not subject to federal income tax. In addition, if you have made you legal residence (or domicile) in a state that has no personal income tax, such Texas, Florida, or the District of Columbia, you would not pay any state or local income tax on your tax-exempt municipal bond income, even if you find yourself stationed in a high tax state.
Benefits of bonds.
An investment in high-quality bonds will help you sleep at night. You can predict when the principal will be returned to you. You will get interest payments every six months for the life of your investment. You can plan for your future concretely instead of hoping that your investments will have risen in value just at the moment you need to withdraw funds. You can create a tax-free diversified bond portfolio no matter where you are deployed. You will be able to count on a paycheck that you have created.