By David Blanchett, Michael Finke, David Lau and Wade Pfau
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?
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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 /zigman2/quotes/210599714/realtime SPX +0.36% . 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.