IB#9-17

Introduction

For households seeking retirement income security, short-term deposits (such as money market accounts, certificates of deposit, and Treasury bills) seem an ideal and appropriate investment choice – particularly given the recent extraordinary turbulence in the financial markets.  Over the past year, an investment in short-term deposits would have actually outperformed investments in corporate bonds and far outperformed corporate stocks.

Retired households exhibit a strong preference for holding such apparently safe investments.  One study found that 86 percent of households nearing retirement (ages 60-64) had bank accounts, while only 33 percent owned stocks directly and only 7 percent owned bonds directly.  And the desire for short-term investments increased with age.  But short-term investments, while safe, produce uncertain returns.

This Issue in Brief highlights the trade-off that households must make between a guaranteed return of capital and a guaranteed return on capital – they cannot have both at the same time.  Short-term deposits provide a guaranteed return of capital, but offer no guarantees as to the return the household will receive on its capital.  In contrast, a portfolio of Treasury bonds of appropriate maturities provides a guaranteed return on capital, but with the return of capital guaranteed only at maturity.  This brief argues that retired households seeking a secure and dependable income should prioritize return on capital over return of capital.  For such households, the true risk-free asset is a portfolio of bonds and, in particular, inflation-protected bonds of appropriate maturities. 

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