With all the changes 2020 brought and a new year around the corner, it may be time to revisit traditional approaches to retirement planning. The pandemic and near-zero interest rates dramatically changed the environment, but few advisers have similarly transformed their advice. How should advisers be reworking client retirement plans in 2021?
This year has been a doozy. One item that is likely to significantly impact retirement plans is lower returns. Yields on 10-year Treasurys have dropped about 1% since year-end 2019. While yields have starting creeping back up, I think it’s unlikely we’re going to get back to the long-term average yield of around 5% soon, if ever. That forces retirees to try to do more with less. This new bond yield environment requires advisers to look for new opportunities to generate retirement income since the relative benefit of strategies changes in different market environments. For example:
1. Delaying claiming Social Security benefits. While other forms of guaranteed income have payouts that tend to move with interest rates, the more interest rates change the more Social Security retirement benefits stay the same. This means Social Security is a great “deal” today.
2. Improving portfolio returns. I’m leery of the idea of increasing returns through taking on more risk (e.g., a higher equity allocation) so it’s important to be strategic about where to seek additional return. One type of asset that has become relatively more attractive over the past few years is fixed rate annuities, also called multiyear guaranteed annuities. These products are guaranteed and are offering yields well above bond indexes with similar credit ratings that aren’t guaranteed.
3. Improving portfolio longevity. Assuming delaying Social Security isn’t an option, other approaches to improve longevity are worth considering. One example would be an annuity that offers some form of guaranteed lifetime income stream — a more traditional product like an immediate annuity, or something more modern, like a product with a Guaranteed Lifetime Withdrawal Benefit (GLWB). Annuity payout rates decline as interest rates decline, but actually become more attractive to fixed income, relatively speaking, in a low rate environment. Therefore, retirees looking to invest in something safe are going to be better off today considering annuities than investing in other safe assets, like government bonds.
Low returns can lead retirees to make two very different types of mistakes.
Those uncomfortable spending down their savings will naturally spend less because they refuse to see their nest egg get smaller. It is more expensive to create income from a balanced portfolio of stocks and bonds than it has ever been in U.S. history. It costs over $100,000 to receive $1,000 in yields from 10-year Treasury bonds and $1,000 in dividends from the S&P 500
Conservative investors hoping to skim income from their savings will spend less than they could safely spend, especially if they got rid of the risk of running out of money by setting aside a portfolio of their portfolio to buy an income annuity.
The other mistake is to plug historical numbers into a Monte Carlo safe retirement withdrawal rate simulator. This will result in recommended spending amounts that may have been safe when interest rates were 4% or 5%, but aren’t safe when interest rates are 1% or 2% and stock prices are twice their historical average.
Advisers especially need to consider how much income they can buy with the 50% or 60% of a retirement portfolio that’s invested in bonds. At today’s negative after-inflation rates, a retiree will run out of safe assets after about 21 years by following the 4% rule. And nearly two-thirds of healthy retirees will still be alive at that age. In a low interest rate environment, an adviser needs to look for any way to create more income from safe savings. Annuitization can provide as much as 40% more income compared with spending down bonds to the age at which a retiree has a 10% chance of outliving their savings. In fact, annuitization becomes even more valuable when interest rates on other safe investments fall.
With interest rates declining for the past decade, retirement duration expanding, and most Americans required to self-fund the majority of their spending, funding a secure retirement — the primary financial goal of most Americans — has never been more challenging and 2020 added an exclamation point.
The traditional investment approach to retirement has been to migrate from equities to fixed income when nearing retirement to safeguard assets and provide income. In the historically low interest rate environment we are in, that simply doesn’t work any longer without adding meaningful risk to the portfolio.
So when the risk-mitigating, income-generating portion of the portfolio can’t even keep up with inflation any longer, you need to look to other instruments to fill that requirement. Some people look to dividend stocks and other alternative investments that provide income, but these add risk for the retiree. A safe alternative to these investment approaches is to add insurance in the form of a low-cost annuity that can provide an income stream for life and take pressure off investments to generate income.
The fact is today, with interest where they are, to safely fund a 30+ year retirement requires a combination of investments and insurance.
We can think about funding retirement in three basic ways. The baseline is using bonds — build out a bond ladder for the entirety of the potential retirement horizon. Because it is important to use a planning age that extends well beyond life expectancy to guard against outliving your assets, a bond ladder will not support much spending.
There are two ways to potentially spend more than bonds alone. In the investments world, build a diversified portfolio with the expectation of earning capital gains on riskier assets to support a higher spending rate. In the annuity world, provide lifetime income protections through risk pooling and mortality credits.
An annuity can pay out more than a bond ladder because the insurance company can pool longevity risk. This risk pooling can be competitive with the stock market. And deferred annuities with living benefits provide the potential to invest for upside while also holding downside protection through a lifetime income benefit that can outlive the contract value in the annuity. People often think lower interest rates reduce the case for using an annuity, here’s why that’s not the case: Lower interest rates will lower the spending rate on any retirement income strategy, but because the mortality credit component of annuities is not connected with interest rates, the benefits of risk pooling become relatively stronger. In other words, the cost of funding retirement with bonds will grow faster than the cost of funding retirement with annuities.
In the same manner, capital gains become relatively more important as a spending source with diversified investments, but this acts to increase the sequence of returns risk because with low rates, investors are more vulnerable to having to sell principal at a loss to fund their expenses. In this context, one should not overlook the potential role for an annuity to help fund retirement expenses.
David Lau is founder and chief executive of DPL Financial Partners; David Blanchett, Ph.D., is head of retirement research at Morningstar Investment Management, and Michael Finke, Ph.D., and Wade Pfau, Ph.D., are both professors of retirement income at American College of Financial Services.