What Retirees Can Do About Today’s Low Interest Rate Environment
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If you’ve read my last post, you understand why today’s environment is so difficult for aspiring retirees. Retirees want steady cash flow options, and that often means parking a big chunk of change in bonds. However, bonds are paying a ridiculously tiny 2-3% interest compared to the 7-10%+ interest rates of the last few decades.That barely keeps up with inflation!
What can a retiree do?
Fortunately a lot!
In a nutshell, the situation we’re faced with is the following:
Low interest rates generally make super conservative options relatively less attractive and riskier options relatively more attractive (because many of those risky options can harness the low borrowing rates to work for them).
That means we want to find strategies that harness the low interest rate to work for them rather than just be a lender ourselves by buying bonds.
Higher Stock Allocation
The general approach for a retiree is to try and go for as close to guaranteed returns as possible with little volatility.
If you had a nest egg large enough that you could deploy in government backed notes and have enough to meet your needs, you probably think that’s a great deal, even if dumping 100% of it in the stock market would historically leave you with way more money at the end than buying those treasury notes.
Because of the low interest rate, that may not be possible for retirees without extending their working lives by decades. So maybe you get comfortable with more volatility and chase those higher returns. Instead of 75% bonds/25% stock, maybe you go 25%/75% bonds. This gives you a lot more upside than piling your money into bonds, but it also has more volatility and decreases the chances of your money lasting you through the period you need it to.
The higher risk/higher reward choice to plow more into something like the stock market means when you win, you win big, but that your chances of winning are a lower than the alternative option. Winning here is the defined as having enough to carry you through retirement.
If you backtest against historical bond market and stock market returns, a 75% bond/25% stock allocation would give you a 95% chance of having your money last you through a 30-year retirement but you would only be able to use a 3.14% withdrawal rate. With a 25%bond/75% stock allocation, you would have an 80% chance your money lasts you through a 30-year retirement but you would be able to use a withdrawal rate of 4.12%
Table from RetirementResearcher.
Where is the low interest rate working for you? It’s working for you on the balance sheet of all the companies in the stock market. Because they are able to borrow at low rates, presumably they are able to invest intelligently to generate returns for their investors.
Leveraged Bond Funds
You could also choose to make low interest rates work for you by purchasing leveraged bond funds. The bond fund will use the bonds they purchase as collateral to take out juicy, low-interest rate loans. While the going yield highly-rated bonds is 2-3%, you could juice that with leverage to 4-6% in today’s market.
A particularly interesting section of the leverage bond fund market are municipal funds, which buy notes that are backed by the government. Examples include Pimco’s NY State-focused bond fund PNI which is currently yielding 6% and Blackrock’s national fund MVF which is paying 5.7%. Their dividends also have the benefit of being income tax free at the federal level as well as at the state level if you are buying bonds issued by that state.
There are a few exposures you will want to walk through before deciding on this strategy which include the length of the notes in your bond fund, how many of their notes are callable (can be paid off early), and what would happen to the face value of your share as well as their costs of borrowing if interest rates went up. I will be covering these in detail in a future post.
Given that it’s a bad time to be a lender, it’s a good time to be a borrower. You can use those low interest rates to get a nice juicy mortgage for an investment property, and live off the rent from your tenants.
Local market forces will determine whether this is a viable strategy for you. Some markets like the San Francisco and NYC are priced so high that landlording is a negative cash flow exercise with the goal being to make money on appreciation. In other markets, the rent-to-value ratio is attractive for a retiree’s cash flow strategy. If you can generate 5-6% or more, you’d be well ahead of the game compared to bonds right now.
As a sample, below are the top 10 markets for generating cash flow through investment properties in 2015.
Chart from Bigger Pockets’ 2015 Real Estate Market Index.
Attempt to Wait Out Low Interest Rates
You could find temporary other fixed income opportunities to deploy that portion of your portfolio and wait out the market, hoping that interest rates come back to a more palatable level. Perhaps you dump the money you have ear-marked for bonds into a money-market fund, or purchase bonds with a maturity length of 6-12 months.
Ignore and Pursue a Set It and Forget It Allocation
You could also say to heck with it and pursue a set it and forget it strategy prescribed by ‘experts’ based on historical data. You would just buy the prescribed allocation of 50-90% bonds anyway, hoping that a mix of stocks and bonds will blend to get you an acceptable withdrawal amount each year.
After all, the Trinity Study’s review has showed that a 50-50 bond and stock split while retired, rebalancing every year, could support a withdrawal rate of 4% in almost all 30 year periods studied from 1926-2009, and some of those years also had low interest rate environments.
If you did this, you’d basically be saying that you took comfort that the period they studied (1926 onward) included years in which the interest rates were very low and somehow this allocation carried retirees through with a 4% withdrawal rate anyway, so you’re betting that the same will be true of the environment going forward.
This is not a terrible idea. If after reading the above options you feel none of them suits you or sound too complicated, then indeed, perhaps you will continue with a prescribed allocation anyway.
I personally am not pleased with this approach given the unique data we’re looking at today. Near unprecedentedly low interest means that all those risks we’re taking on of principal erosion, etc. aren’t being rewarded as richly as they were in other years.
A retiree’s greatest vulnerability is in the first five to ten years of his nest egg’s performance. Those first years will matter more than the the next 20-50 years combined in determining whether your nest egg will last you for life.
Buying a bunch of bonds now when the Fed is signalling an increase in interest rate and we’re sitting at some of the lowest rates we’ve seen in decades is like like letting someone take a free hit to your face before a fight. If interest rates increase, your bond funds’ value will decrease. Why? Because they are invested in a bunch of bonds which are paying a lower interest than the market is currently offering on newer bonds.
To compensate for this, the price of your funds drifts toward the face value that will enable a new investor to get an equivalent return from purchasing your shares as they would buying new bonds at the new higher rates. If you have bonds that pay 2% but they can buy bonds that will give them 2.5%, why would they buy your bonds off you? However, if you lowered the face value so that they can get a 2.5% return from your bonds, now you can do business. Of course, you take the hit to your principal by selling below what you paid for it. Do you want to take a hit to your nest egg right off the bat when there’s important information right in front of you that can help you steer clear of it?
Given that interest rates are at near historic lows, you would be compensated much worse than past generations for taking this kind of exposure. Bad news all around in my eyes.
Source: Federal Reserve Board of Governors via FRED
I like for my strategies to be supported by data but also fit with a broad strokes thesis of where market forces seem to be trending and what I can do about it. I’m young and I have a little fat in my budget and padding to my nest egg which allows me to absorb a little more risk. With those factors in mind, I will be using a mix of several strategies covered:
- Higher Stock Allocation – I currently don’t have a ton of exciting fixed income opportunities that aren’t highly dependent on the interest rate. Because of that, I’d like to go heavier in equities. I’m slowly moving money but will be aiming to get to more than 80% stocks by the end of the year.
- Landlording – I am actively seeking real estate investment opportunities that will throw off 6%+ a year in income (on top of potential appreciation). If I can find this, I’d be comfortable moving my allocation to 50% fixed income where the bulk was coming from real estate and the balance being invested in stocks. This will take me at least 3-4 years as I need to see what kind of landlord I make.
- Monitor – I’ll be keeping track of changes in interest rate to see if investing in bonds becomes a more appealing proposition worth deploying more capital in. The Fed has signaled a planned increase in interest rates in December, which may be the first of many that will get bonds back to a reasonable interest rate for retirees. I guess we’ll see.