The Search for Income in Retirement
November 21, 2019
Nick Hughes, CFP®
I regularly hear stories from clients regarding their earlier investing experiences, particularly about the days when rates that were available on CD’s and bonds were much higher. While the U.S. faced two recessions in the early 1980’s, it would seem to be much simpler time to be a saver and investor when you could find Certificates of Deposit at your local bank paying interest rates in the teens. Interest rates on short term CD’s peaked in early May 1981 when you could get paid 18.3% annually on these bank deposits. Imagine being able to generate $50,000 per year in retirement income on a portfolio of just $273,224! With interest rates in the US at close to historical lows and some foreign government bonds yielding negative rates times have definitely changed. This day in time, I believe you have to think outside the box and look at alternative approaches to creating sustainable retirement income.
The Danger in Relying Only on Interest/Dividend Income
Previously when interest rates were much higher, it was popular to invest only in fixed income investments during retirement which could provide a steady paycheck for retirees without the need to invade their principal. One common potential pitfall I see these days which I outlined in a recent blog are investors reaching for yield by investing larger portions of their portfolios in higher yielding instruments like non-investment grade bonds and high dividend stocks. Not only can this result in a lack of diversification, but we know sometimes bonds default, companies reduce or suspend dividends and this can not only disrupt your income stream but also cause the losses to pile up. As illustrated below, companies that go on to cut their dividend may experience a sharp drop before and tend to underperform over the next couple of years. Remember there is no free lunch when it comes to investing and a higher yield is usually a sign of the additional risk inherent.
A more balanced approach that seeks to generate total return (ie. reasonable income with modest growth) may be preferable to today’s retiree. I still believe that keeping a percentage in high quality short, medium term US and non-US bonds along with stock investments in companies that are growing and increasing their dividends makes sense in today’s environment. While the dividend and interest yield may not be enough to meet your current income needs, this could potentially be offset by harvesting some of your appreciated stock holdings, dipping into principal in your bond portfolio or a combination of the two.
Does the 4% Rule Still Apply?
Many Baby Boomers approaching retirement are familiar with the Rule of Thumb in personal finance known of as “The 4% Rule”. The rule was popularized by a 1998 Trinity University study to determine safe withdrawal rates over a successful retirement, according to thebalance.com. The general premise of the 4% rule is that an investor reaching retirement can safely draw 4% of the starting value each year adjusted for inflation. For instance, under the rule an investor retiring with a $500,000 portfolio could draw $20,000/year inflation adjusted over their anticipated retirement period.
A paper by researcher and economist Wade Pfau in 2010, seemed to poke holes in the 4% Rule. The research showed that the 4% rule only seemed to work in 2 of 20 developing countries (the US and Canada) and that it would likely not work for someone retiring into a market downturn or at a time with historically low interest rates (sound familiar?).
While the 4% Rule may provide a simple framework for calculating retirement readiness it is best used as a guideline rather than hard and fast rule. Having helped an increasing number of families retire over the years, it is important to understand that retirement doesn’t occur in a vacuum. A good retirement income plan will account for changing income needs over time. For example, for many retirees it may be desirable to withdraw a higher percentage of their portfolio value in the earlier years of retirement as they anticipate more travel and a more active lifestyle or as a means to delay their Social Security benefits up to age 70. Once Social Security benefits begin or they enter the Slow Go retirement years of less activity retirees will likely want to scale back their portfolio withdrawals.
Should I Buy an Annuity?
Now infamous Forbes columnist and money manager Ken Fisher once wrote “Why I Hate Annuities and You Should Too.” While the quote was harsh and attention grabbing, it is easy to understand why annuities have developed a bad rap due to complex, high fee products and brokers chasing commissions. Just like you should have a variety of tools in your toolbox at home, I believe a sound financial plan may incorporate various products to help achieve specific goals.
In its simplest form, an annuity is a contract between you and an insurance company to provide the investor with a promise of a stream of payments for a certain period of time. It could be your lifetime, yours and your spouse’s lifetime or a guaranteed number of years. These are often used to provide a pension-like income to those in retirement. This can be very attractive for more risk averse retirees and those who anticipate longevity for them or their spouses.
For those seeking to generate the most amount of guaranteed monthly income with the smallest amount of money, a Single Premium Immediate Annuity or SPIA could make sense for a portion of your assets. With a SPIA you exchange a lump sum of money for guaranteed payments under the terms you select. Just like with a pension, there won’t be any money available to your heirs should you die early, which can be a major drawback to this type of annuity. Before purchasing an annuity, I would recommend you first take steps to maximize other forms of guaranteed retirement income (ie. Social Security, pensions) by speaking to a Financial Planner well-versed in Retirement Income Planning. I would also recommend doing your homework on the insurance company providing the benefits as a guarantee is only as good as whatever entity is providing it.
Historically low interest rates, a lack of access to employer pensions, and increased longevity has changed the way Boomers are planning for retirement. Because the stakes are so high, it is important you avoid falling into any of the traps of reaching for yield, utilizing overly simplistic rules of thumb, or misuse of annuities within a retirement plan by making informed decisions. I encourage you to reach out to get a second opinion or to get some outside-the-box thinking on your situation.
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