Ian McGugan
Plunging bond yields are putting your retirement at risk.
Over the past few years, the fading payouts from fixed-income investments have boosted the cost of a secure old age by roughly a third.
The big increase in the price of retirement is one of the most insidious ways in which the great slump in interest rates is hurting average Canadians.
But don't lose hope. There are strategies that can help counteract the drag imposed by today's miserly yields.
"You have more options than you may think," says Wade Pfau, a professor of retirement income at American College of Financial Services in Philadelphia and a prominent researcher in the field of retirement planning.
Four types of strategies can help you deal with the financial uncertainties of retirement planning, Prof. Pfau says.
The first – although probably the least appealing alternative – is to put a tight lid on your retirement spending by using a fixed withdrawal rate to tap your portfolio.
How conservative should you get? Many people rely on the 4 per cent rule, which says a retiree can safely withdraw an annual amount equal to 4 per cent of his or her initial portfolio, adjusted for inflation.
The guideline is rooted in a landmark 1994 article by William Bengen, an American financial planner. Rather than relying on theory, Mr. Bengen crunched the actual historical numbers to determine the highest fixed withdrawal rate that would have allowed a retiree's portfolio to weather any downturn in the previous decades. He settled on 4 per cent as a good guideline for anybody contemplating a 30-year retirement.
But here's the problem with the 4 per cent rule: Bond yields in the period surveyed by Mr. Bengen were typically much higher than they are now. The decline of interest rates to record-low levels since the time of his original paper means it's now time to redo his retirement math.
"You would probably have to cut your withdrawal rate to 3 per cent today to create the same level of safety that Bengen achieved with 4 per cent in his original study," Prof. Pfau says.
Unfortunately, ratcheting down from a safe withdrawal rate of 4 per cent to a rate of 3 per cent is a bigger deal than it may appear at first glance.
With the 4 per cent rule, a retiree would need $1-million of savings to produce a steady, inflation-protected income of $40,000 a year. But at 3 per cent, the same retiree would require a third more money – in excess of $1.3-million – to generate the same income.
Such savings are simply impossible for most people to achieve. For that reason, many planners now recommend more nuanced approaches that adjust your retirement spending to reflect the actual performance of your portfolio. If your portfolio happens to thrive during your retirement, these flexible approaches let you spend considerably more than the 4 per cent – or 3 per cent – rule would allow.
Prof. Pfau says a good example of this second approach to managing retirement risk is a rule-based system developed by U.S. financial planner Jonathan Guyton. It can allow initial withdrawal rates of 6 per cent or so – but with the proviso that you must be prepared to slash your spending, in line with preset guidelines, if markets move against you.
Yet another approach to managing retirement risk is even more cutting edge. It involves looking for smart ways to reduce portfolio volatility.
For instance, a retiree could maintain a healthy exposure to stocks but replace bonds with income annuities that guarantee to pay her a fixed monthly amount until she dies.
This unconventional mix of risky stocks and safe annuities provides an attractive combination of profit potential along with longevity insurance, Prof. Pfau says. The annuities ensure retirees cannot outlive their savings, while the stocks provide potential for growth.
By removing bonds from the picture, this strategy also removes the danger of being blindsided by an unexpected rise in interest rates. Bond prices move in the opposite direction to interest rates so "you have to be concerned that if rates ever do start going up, retirees with large bond holdings will suffer severe capital losses," Prof. Pfau warns.
A final approach to managing retirement risk is to build up buffers outside your investment portfolio. If the stock market tumbles, you can tap these buffers for funds until your stocks bounce back. As a result, your portfolio can include more stocks and feature a higher withdrawal rate.
Potential buffers include cash savings accounts and reverse mortgages. "Instead of being forced to sell assets at a loss if the market goes down, you can use these buffers as part of a co-ordinated strategy to give your portfolio time to recover," Prof. Pfau says.
He believes this approach and its counterparts all deserve a closer look as people wrestle with how to manage retirement risk in an era of remarkably low interest rates.
"A lot of financial planning software simply plugs in historical averages and assume bonds will provide 5 per cent or so annual returns," he says. "But that's not mathematically possible – not with yields where they are today."