“What would YOU do in my place?” asked Alan a couple of weeks ago. “How would YOU stretch a $750,000 nest egg to live on for the rest of your life, if you were ‘only’ 43 and could live on $30,000 a year comfortably by buying smart, etc. as your book taught me to do?”
Now writes Barry Basden:
“You advised splitting Alan’s stash 1/3 Vanguard Intl Index, 1/3 Vanguard Total Stk Mkt Index, and 1/3 Vanguard Prime Mmkt. [I also advised him to consider going back to work for a while at something he enjoys, which he’s apparently thinking of doing — but that’s another story.] What do you think of substituting a variety of investment-rated (at least BBB) preferred stocks for all or part of the Vanguard Prime Money Market? This portion of the pie would then generate about 8 percent income annually instead of about 5+ percent for VG Prime. My situation is similar to Alan’s, but I’d like a little more income. Is there some gigantic downside risk I’m missing by buying a basket of preferreds?”
Good question. “Gigantic” is putting it a little strongly. You could certainly do this, but buying preferred stock is gambling on interest rates and the safety of the issuers. You get a bit more yield, for sure, but take both interest rate and credit risk. They are like perpetual bonds in disguise, with one big advantage for corporations that buy them — which becomes a disadvantage for you. To a corporate investor, much of the dividend is tax-free. Not so to you or me. Why pay for a tax benefit you don’t get?
Chances are, your basket would work out fine and give you more current income. But if we ever entered a period where interest rates gradually rose and rose, as they once did (remember?), the value of your preferreds would fall and fall. You’d still get the income, but it would buy you less because of inflation.
Keeping that money in a money-market fund instead lets you “rebalance.” If interest rates rise and stocks tumble, you could buy more shares at lower prices so that your ratio remains 2/3 stocks, 1/3 money market.
A better compromise might be 5-year Treasuries, which would yield something between the money-market fund and the preferred shares with none of the credit risk and less of the interest rate risk. (The shorter a security’s maturity, the less its price swings up and down with interest rates. Think how much more wildly a kite goes up and down than the string just a few feet away from your hand.) Treasuries have the added plus of being free of state and local income tax and being easily purchased and sold with little or no transaction cost.
But as I said in my answer to Alan, there’s no one “right answer.”