Reducing Risk While Beating Inflation
By: Stacey Nickens
Some investors get nauseous riding the roller coaster that is the stock market. Especially as individuals near retirement, risking loss of principal can feel less and less appetizing. These investors may flock to “safer” investments that experience less volatility but also offer lower returns. However, these lower returns also expose investors to the risk of running out of money in retirement.
With that in mind, more risk-averse investors may want to consider an inflation-protected U.S. savings bond (I bond). I bonds could appeal to investors who currently have significant chunks of money in bank accounts or money-market funds. Those with their savings in baking accounts may see their funds grow about 0.02% each year. Comparatively, an I bond currently offers an annualized yield of 3.54% and will offer this yield through November 1, 2021. Moving your savings from a bank account to an I bond could accordingly increase your rate of return 177-fold.
Why might this higher rate of return be beneficial in retirement? Suppose you’ve saved $500,000 in a bank savings account. When you retire, you estimate that $500,000 will be enough money to last you through retirement. However, inflation rates rise, as does the cost of healthcare, nursing homes, and other goods and services. You end up spending more money to maintain your lifestyle than expected. Your withdrawals from your savings accounts accordingly increase, but your retirement assets aren’t growing enough each year to offset your withdrawal rates. Such a scenario could mean you end up having to go back to work in retirement.
You accordingly want your retirement investments to earn a high enough rate of return to compensate for inflation and withdrawal rates. For example, if inflation is at 2% and you’re withdrawing 4% of your assets per year, you need to earn at least a 6% annual return to break even, and that calculation doesn’t even account for taxation.
I bonds could help your accounts achieve stronger growth because they offer higher return rates than money-market funds, savings accounts, three-month Treasury bills, and even 30-year Treasury bonds. You should keep in mind that the rate of return on I bonds does reset every six months to account for changing inflation rates. I bond yields could accordingly decline during deflationary periods, but unlike Treasury inflation-protected securities (TIPS), the I bond yield never drops below zero.
I bonds also offer favorable tax status. Their interest is exempt from state and local taxation, and you can choose to defer federal taxation on I bond interest until they mature or you redeem them, whichever comes first.
A downside to I bonds is their lower liquidity compared to money-market funds or bank accounts. You must hold the bonds for at least 12 months before cashing them out, and if you redeem within five years of purchase, you lose the last three months of interest. However, after five years, you can sell your I bonds and recover the entirety of your principal.
Risk-averse investors could thus consider I bonds for slightly higher returns than other “safe bet” investments. As long as you remain invested long enough, I bonds offer the full backing of the federal government as well as a guarantee that you will recover your principal and match or outpace inflation.
I bonds can also be a strong diversification tool for investors prone to taking on significant risk. Having some of your funds in an I bond could help you hedge against losses in the rest of your investment portfolio.
Those interested in investing an I bond need only to visit the TreasuryDirect website. Doing so will allow you to create an account and invest anywhere from $25 to $10,000 in I bonds.