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How to Avoid Outliving Your Money in Retirement – Part 2

Yesterday, I discussed the income dilemma that many retirees are facing in this low interest rate environment. Do they put their money into low-yielding government bonds knowing that they may outlive their money, or put it into higher-yielding investments with an unknown future value?

As obvious as it sounds, one of the keys to not outliving your money in retirement is by not losing a lot of it in overly risky investments.

Today, I am going to show you some of the investments being pushed on baby boomers by Wall Street that create the appearance of steady income but carry more risk than you may realize. That does not necessarily mean that they are bad investments, only that they may not be as safe as they first appear to be.

Enhancing Income with Derivatives

As its name suggests, an EIF (enhanced income fund) uses some form of financial engineering to increase its dividend yield. In some cases that is fine, such as selling covered call options against a portfolio of stocks. However, in other cases that can be a problem, especially if the fund manager does not fully grasp the potential risk involved.

Case in point: Twelve years ago, a well-known fund company converted its high-yield bond fund into an enhanced income fund, using a wide variety of financial instruments, including credit default swaps, to generate yield. Over the next year, the fund sold off most of its corporate bonds and replaced them with swap contracts from financial institutions used as collateral for real estate mortgages.

If you read the book or saw the movie “The Big Short”, you know what happened next. The real estate market crashed the following year, making most of those swap contracts worthless. In less than six months, this fund lost 90% of its value! Imagine being a retiree and having something like that happen to you. If you own a fund with the word ‘Enhanced’ in its name, make sure you read the Prospectus to understand exactly how they are using it so you can determine if that strategy is appropriate for you!

Treating Capital Gains as Income

Since 2008, we have gone ten straight years without a negative return in the S&P 500 Index. That historically unlikely sequence of events has goaded some funds into distributing some of their capital gains as income, similar to stock dividends and bond interest.

The reason why is simple; many stock funds, especially those that invest in growth stocks, would otherwise show a very small dividend yield if they only passed through actual income. But by taking some of the capital appreciation and distributing as income, their yield magically become much more attractive.

That strategy works so long as the stock market keeps going up. However, it’s only a matter of time until the market will go through a major correction or crash, wiping out some or all of the appreciation used to enhance the dividend payments. When that happens, that fund you thought had a 4% yield may suddenly turn into a paltry 1% (or less). If you aren’t sure exactly how your fund generates its dividend income, a quick look at its most recent Annual Report will tell you exactly how much of it is true income and how much is from capital appreciation.

Unconstrained Income, and Risk

I don’t know about you, but I am instinctively wary of any investment with the word ‘unconstrained’ in its title. Call me old-fashioned, but when it comes to managing risk in a bond portfolio I think a constrained approach is advisable. Regardless, the product peddlers on Wall Street believe an unconstrained approach to generating income is what investors want these days so that is what they are giving them.

What unconstrained really means in this instance is that the fund managers can do pretty much whatever they want in pursuit of higher yields. According to FINRA, the regulatory agency that monitors these types of funds, “unconstrained bond funds often invest in a variety of debt instruments, including loans, foreign securities, mortgage-backed securities and credit derivatives such as credit default swaps.”

In essence, they operate more like hedge funds and are designed to generate big fees to their managers when the outsized risks they are taking pay off. But when those risks blow up, it is the shareholders that are left holding the bag. As FINRA advises, “investors should do their homework before deciding to invest in an unconstrained bond fund.”

The Bottom Line: You don’t need to subject yourself to unnecessary risks! There are perfectly legitimate ways to generate high income in today’s market such as this one that my colleague Ari Charney manages for Investing Daily.

What To Read Next?

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