When I first started in this business in 1991, I remember one-year CD rates were 6%, ten-year government bonds paid 7.5%, stocks offered a yield of 3% (S&P 500 average dividend yield) and retirement planning was fairly simple. We just allocated money to stocks, bonds and cash (or cash equivalents like CD’s) and rebalanced the portfolio annually.
Today interest rates are 1% for one-year CD’s, 1.5% ten-year treasury bonds, and 2% for the S&P 500. This begs the question; how do you earn a reasonable rate of return in retirement without taking substantial risk? CD’s by definition will never get you a better return than the current interest rate. Although the return on government bonds has been exceptional over the past 30 years (as rates have come down on these bonds, prices have gone up), it is unlikely that rates will decline substantially from here. That leaves us with stocks.
According to Dr. Jeremy Siegel, the long term (he’s looked at over 200 years of historical data so I mean really long term) the return on stocks is roughly 8% compounded. “That’ll do,” you say. Well, unfortunately that return is not consistent. There have been periods (even periods as long as ten years or more) where stocks have substantially underperformed cash and bonds. Additionally, if you need income in retirement and you have to sell some of your stocks to get it, it doesn’t matter that the stock market ultimately recovers. You had to sell your shares to live. Bummer. Additionally, retirees are living longer today than they have in the past. So not only do you have uncertain investment returns to contend with, you also have a longer lifetime to fund. We are dealing with this new normal a few different ways...
Declining Expenses: We have found that most people reduce their spending habits later in life. The Employee Benefit Research Institute found that household spending is 19% less for 75 year-olds than it is for 65 year olds, and 34% less than 85 year olds. Additionally, according to David Blanchett with Morningstar’s retirement research “higher income retirees saw a more notable decline than others because so much of their spending is discretionary.” So you may be able to take more income now, because you won’t need as much in the future.
Lifetime Income planning: This is a fancy term for your heirs don’t get as much. Trading market and mortality risk for guaranteed lifetime income options makes more sense when rates are low. Using this tool may allow the remaining portfolio to grow with less income stress than it otherwise would have.
Managing volatility: Re-balancing the portfolio when there is a substantial difference in the performance of assets that are not positively correlated can add some return while reducing your overall risk. Managing retirement income in a 0% interest rate environment is tough.
Let’s just hope for your sake and mine, we don’t have to figure out how to do it in a negative interest environment like they have in parts of Europe and Japan. Now that’s a depressing thought.