It’s common in financial markets to see investors seeking certainty, even if it means sacrificing potential returns or dealing with additional financial complexities. An example of this is equity-indexed annuities, which promise market-like returns with no downside risk. However, these investments often only capture a portion of market gains and come with high back-end sales commissions for early withdrawals.
Even seemingly solid investment options that offer some level of certainty may not always be the best choice. Series I savings bonds, certificates of deposit (CDs), and holding individual bonds to maturity are examples of such options. While they can provide a sense of security amidst market volatility, they also have their downsides:
Series I savings bonds have restrictions on early redemption and may incur penalties if sold within the first few years. Additionally, while they typically guarantee returns at least equal to inflation, taxes can erode their after-tax returns, especially in times of high inflation. For instance, if inflation matches your yield and your tax bracket is 22%, you could fall behind inflation by 1.1 percentage points after taxes. In contrast, if inflation and yield are both 1%, the after-tax loss would be much lower at just 0.22 percentage points.
Investors who opt for certificates of deposit (CDs) also face penalties for early withdrawal, and while CDs offer a guaranteed nominal return, their real return after inflation and taxes can be uncertain.
Individual bonds present their own challenges, such as difficulty in selling before maturity and lack of diversification. Additionally, reinvesting interest payments from individual bonds is not as simple as with mutual funds. Even if the issuer doesn’t default and the bond is held to maturity, the after-inflation, after-tax return remains uncertain, similar to CDs.
Given these drawbacks, it’s puzzling that some investors prefer the perceived safety of individual bonds held to maturity over the greater safety offered by bond mutual funds.
Another retirement-income strategy gaining attention is the construction of a ladder portfolio of Treasury inflation-protected securities (TIPS), with bonds maturing gradually over the next 30 years to provide a guaranteed, inflation-protected income stream. While this strategy has received endorsements from respected individuals, it’s important to carefully evaluate its suitability for individual financial goals and circumstances.
While building a ladder of Treasury inflation-protected securities (TIPS) may seem appealing due to its mathematical elegance and performance certainty, there are several reasons why some investors may not be fully enthusiastic about it.
Firstly, a TIPS ladder may not provide longevity insurance, unlike Social Security or lifetime annuities. If an investor outlives the 30-year maturity period of the ladder, they may face financial uncertainty in their later years.
Secondly, constructing a TIPS ladder can be complex and time-consuming, as it requires purchasing bonds with varying maturities. The process may involve consulting with financial advisors or spending significant time researching and selecting appropriate bonds.
Thirdly, while TIPS aim to keep pace with inflation, they may not fully capture improvements in living standards, which tend to outpace inflation. As a result, investors relying solely on TIPS for income may find themselves falling behind in terms of purchasing power over time.
Lastly, for investors with longer time horizons, investing in stocks may offer better growth potential and the opportunity to maintain or even increase their standard of living over time. While there are risks associated with stock investing, it may provide higher returns and the ability to leave a larger legacy to heirs or charitable causes.