How ‘Safe’ Investments Can Destroy Client Portfolios

(Bloomberg) — If your client wants a consistent stream of income when they retire, they’ve probably heard about a few familiar investment strategies. A dividend-paying stock gets investors a regular cash payout from a company while letting them participate in the stock market’s upside. Municipal bonds are safely backed by governments, and their income usually isn’t taxable.

But after years of low interest rates and rising stock markets, these once-conservative strategies might actually be putting investors in risky situations. Here’s where these income investors are going wrong:

1. They invest too narrowly.

When online investment firm SigFig analyzed 300,000 investors’ portfolios, it found that people who are focused on income — rather than growth — are getting most of that income from just a few sources. Of income investors over the age of 40, 52% are getting their income entirely from three or fewer dividend-paying stocks. Thirty-one percent are relying on only one dividend-paying stock.

“Being so concentrated in a few income-generating stocks is dangerous,” says Jason Hsu, co-founder and vice chairman of Research Affiliates. With only a few stocks, investors are violating an important rule of investing: Spread money around to lower the risk of big losses and make one’s portfolio less volatile. Advisors typically put clients in funds owning hundreds of stocks and bonds in a variety of categories. SigFig in October created a “diversified income” portfolio that produces income from eight different exchange-traded funds, or ETFs, with exposure to U.S. and international stocks, U.S. preferred stocks, and five types of bonds.

2. They’re falling for sales pitches.

With interest rates so low, many older investors are desperate for income. Some brokers are taking advantage of that desperation to sell investors products that are expensive, overly complicated, and wrong for their particular situations. That’s the conclusion of a new report from the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority. Regulators found that “broker-dealers may be recommending unsuitable transactions” that seniors don’t understand. The most worrisome investments were in structured products, nontraded real estate investment trusts, variable annuities, and alternative investments including leverage- inverse ETFs. Investors, some over age 90, found their money locked up in these highly risky investments. They also ended up paying big fees, which ate up any income the products might have yielded.

3. They’re betting on overvalued investments.

Pinning your client's retirement on just a few companies is risky enough. But the current state of the stock market adds to the risks: By historical valuation standards, U.S. stocks that pay a dividend are looking expensive, Hsu says. The Dow Jones U.S. Dividend 100 Index is up 181% over the past six years. Those prices reflect high expectations that could be dashed if profits or the economy stumble. If people are willing to invest in companies based outside the U.S., Hsu says, they can find companies paying healthy dividends at more reasonable valuations.

Municipal bonds — debt backed by cities, states, and other local governments — have also had a great run lately, with the S&P Municipal Bond Index returning 5.8% in the past year. Muni bonds can be tax-free, and that’s made them popular after recent tax increases on wealthy Americans, says Marilyn Cohen, president and chief executive officer of Envision Capital Management. While Cohen thinks munis will keep doing well, she says investors need to diversify, spreading their exposure over bonds with shorter durations.

4. They’re taking risks.

Unfortunately, investors are drawn to the riskiest bonds because they also offer the biggest payouts. The riskiest muni bonds, for example, are issued by governments with fiscal trouble, including Chicago, Puerto Rico, and New Jersey, Cohen says. “You can tiptoe around those land mines.”

High-yielding stocks, which Hsu calls “junk stocks,” have the same risks. Dividend payouts at troubled companies may look generous, but there’s a good chance those companies won’t be able to keep paying them. “You’re picking up a lot of risk,” Hsu says.

Income investors may not be able to avoid risk entirely. With stocks at record highs and interest rates at record lows, it’s harder and harder to find an income that’s perfectly safe. To get the income they need, clients need to protect themselves by spreading their assets among as many income- producing investments as possible. And they should beware of any investment that promises a big payout — it’s almost certainly too good to be true.

Read more:

• Kitces: Bond Ladder vs. Immediate Annuity
• Tougher Rules But Flexible Comp Under New Fiduciary Proposal
• Earning Income With Dividend Funds