Interest Rates and Retirement

Submitted by Lewis J. Walker on Wednesday, July 24, 2013 - 9:00am
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What combination of assets creates the greatest likelihood of providing income you will not outlive? Most likely one with a lot of stocks and an annuity linked to inflation increases.

The question is increasingly important amid current low interest rates, which appear likely to stay low for a while. This environment is spurring re-examination of theories surrounding the sustainability of retirement income. Longevity risk grows (the possibility of outliving your assets) and health-care costs add uncertainty, so academics again are running simulations.

As fewer 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% equities and 50% bonds, 2) 100% equities, 3) a combination of equities and bonds with the equities percentage calculated as 128%, minus your age, 4) a variable annuity with a 5% withdrawal rate and 5) 100% equities with a fixed annuity, where you hand over a lump sum and received a set amount for the rest of your life.

You of course must evaluate a study’s assumptions when determining if its conclusion applies to your situation. The Journal study, by three academics, found that using an equity portfolio and a fixed annuity provide a higher chance of sustaining retirement money than other alternatives.

Focus on the word “fixed.” A fixed-income stream, when rates rise and fall and possible inflation looms, is a challenge. If your fixed annuity pays 4% of the principal yearly and rates rise to 8%, you lose out. 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. Stocks have the potential, shown historically, to outpace inflation.

The trouble with fixed-income instruments is that, as interest rates rise, bond values decline. And higher rates are the norm. Consider the history of the 10-year Treasury note’s yield, 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 were 4% or lower only in seven years, or 14% of the time. Conversely, the rate was above 4% for 86% of the time. In 29 years, 58% of the time, the rate exceeded 6%. Yields exceeded 8% in 12 years, and in six of those years, surpassed 10%.

The point: Today’s fixed annuity income streams of 4% to 5% look great stacked up against a five-year certificate of deposit 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 Sept. 30, 1981. Some may recall 12% mortgages and 13% CDs at the time.

When shopping for an annuity or other retirement vehicles, ask if there is a cost of living (COLA) formula built in. In not, how will you add equities 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 income is delayed for 10 years or more, are popular as a fixed-income surrogate. Contracts are complex and consumers should be wary of aggressive sales pitches. Ask questions about liquidity, penalties for early withdrawal and how the contract fits into your bigger picture.

Some contracts will double the income-generating base in 10 years, regardless of market conditions, so a $100,000 deposit becomes $200,000. For a couple age 65 to 69, income starts at 4%; for a couple 70 to 74, 4.5%. The key question: How do you get a bump up during the deferral phase, the period before the income begins? How do you get an increase in income once you start receiving income? While 4% looks good now, will it in an inflationary future?

Annuities may play a role in providing retirement income stability. However, they should only be a part of a strategy for real income generation – “real” takes into account inflation and taxes. Holistic analysis is called for, answers that are not simplistic answers and full of sales hype.

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Lewis Walker, CFP, is president of Walker Capital Management Corp. and Walker Capital Advisory Services, Inc., a Registered Investment Advisor (RIA) in Norcross, Ga. 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.

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.

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