Interest Rate Realities and Retirement Income

The low interest rate environment is spurring re-examination of theories surrounding the sustainability of retirement income. As longevity risk grows (the possibility of outliving one’s asset base), and health care costs add uncertainty, academics again are running simulations. What combination of assets create the greatest likelihood of providing income one will not outlive?

As less workers retire with old-fashioned pension income streams, planning and saving risks increase. Witness the explosion in seminars pushing retirement security. If you like “free” meals, you could partake weekly by attending a seminar rooted in an annuity sales pitch. All of this is driven by Federal Reserve policy that is holding interest rates at extreme lows. What is the downside and upside for those planning for or entering retirement?

 A January 2010 study in the Journal of Financial Planning evaluated five retirement portfolio strategies: (1) 50 percent equities and 50 percent bonds, (2) 100 percent equities, (3) a combination of equities and bonds with the equities percentage calculated as 128-minus-attained-age, (4) a variable annuity with a 5 percent withdrawal rate, and (5) 100 percent equities with a fixed annuity lock. One must evaluate the assumptions used in any study when determining the applicability of a conclusion to their situation. The study by three academics in the Journal concluded that using an equity portfolio with a fixed annuity component provides a higher chance of maintaining retirement distributions than other alternatives.

 Focus on the word “fixed.” A fixed income stream in a variable rate and inflationary world is a challenge. The authors stress equities in the mix as an inflation hedge, with good reason. Inflation, interest rates and bond values moving up or down tend to correlate over time. The 10-year Treasury note yield is the benchmark for U.S. interest rates. In 2012, the 10-year rate averaged 1.81%. In the last 50 years (1962-2012), 10-year rates have been at 4% or lower only 7 years out of 50, or 12% of the time. Conversely, the rate has been above 4 percent 88% of the time. In 29 years, 58% of the time, the rate exceeded 6%. As interest rates rise, bond values decline.

 Yields exceeded 8% in 12 years, and in 6 of those years, surpassed 10%. The point: today’s fixed annuity income streams of 4% to 5% look great stacked up against a 5-year CD at 1.15%. They would not have looked so hot in the inflationary 1970s and early 1980s when 10-year Treasury yields generally exceeded 7%, reaching an all-time high of 15.84% on September 30, 1981. Some may recall 12% mortgages and 13% CDs at the time.

 If a retirement annuity or pension option is being considered, ask if there is a cost of living (COLA) formula built in? In not, how will you add equities and/or alternative investments to create an inflation hedge? How will you handle the potential volatility of asset classes such as equities?

 Deferred annuities in which the generation of income is delayed for 10 years or more are popular as a fixed income surrogate. Contracts are complex and consumers are urged to be wary of aggressive sales pitches. Ask questions about liquidity, penalties for early withdrawal, and how the contract fits into your bigger picture.

There are contracts that will double the income-generating base in 10 years regardless of market conditions, e.g., a $100,000 deposit becomes $200,000. For a couple age 65-69, income starts at 4%; for a couple 70-74, 4.5%. The key question: how do you get a “bump up” during the deferral phase? How do you get an increase in income once you start receiving income? Four percent looks good now. Will it in an inflationary future?

Annuities may play a role in providing stability to base income. However, they should only be a part of a strategy for real income generation, “real” taking into account inflation and taxes. Holistic analysis is called for, not simplistic answers and sales hype!

 Investing involves risk including the potential loss of principal.  No investment strategy can guarantee a profit or protect against loss in periods of declining values.

 Lewis Walker is President of Walker Capital Management LLC. and Walker Capital Advisory Services, Inc., a Registered Investment Advisor (R.I.A.) Securities and certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA).  Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with the Walker Capital Companies. ▪ 3930 East Jones Bridge Road ▪ Suite 150 ▪ Peachtree Corners, GA 30092  ▪ 770-441-2603 ▪ lewisw@theinvestmentcoach.com