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Retirement Income Planning in a Low Interest Rate Environment

Retirement Income Planning in a Low Interest Rate Environment

One effect of the COVID-19 crisis and impact on the financial sector has been a decrease in interest rates. This is on top of the already historically low rates since the 2008 financial crisis.[1]

Although there are several methods of generating retirement income, I’ll focus on two common choices of financial professionals and consumers. A retiree has the option to convert a portion of their assets into a steady stream of income by purchasing an income annuity. Or they can systematically withdraw assets from their investment portfolio.

In the situation where a consumer converts a portion of their assets into an income annuity, low rates have downward pressure. Annuity payouts are made up of principal, interest, and mortality credits gained through risk-pooling.

One portion of this payment is sensitive to interest rate movements. A downward move in rates, especially when projected to be sustained for long periods of time, results in the reduction of payout rates on new annuities available for purchase.

A period of sustain low interest rates will also put downward pressure on the safety of a withdrawal rate.[2] In this case, the investor builds a portfolio of stocks and bonds that is appropriate to his financial objectives, time horizon, and risk profile. Then the investor determines an appropriate amount to withdrawal to manage a bad market return sequence (think of someone retiring in 2007) and longevity risk (the greater the number of years of income needed, the lower the rate of withdrawal).

A portion of the underlying portfolio could be invested in bonds. As interest rates decrease, so do bond yields. Therefore, the amount of income they could count on from this portion of their portfolio may decrease.

Another portion of the underlying portfolio could be in stocks. Investors might consider trying to make up for the loss in bond yields by using a higher stock allocation. However, stocks returns are correlated with returns of risk-free assets (ex: US Treasuries, that have almost no default risk). [3] Investors have historically been rewarded, over time, for taking risk. But only to a certain level above the risk-free asset. This concept is often referred to as the risk premium.[4] As the risk-free rate goes down with interest rates, so does the expected return on stocks. For example, if fixed assets are earning 3%, stock returns might average 9.2%. But if fixed assets are earning 1%, stocks might average 7.2%.[5]

The safe withdrawal rate varies based on asset mix, life expectancy, inflation adjustments to income, and flexibility of spending. As a hypothetical, we’ll use 4% as a benchmark safe withdrawal rate and 3% after rates decrease.[6]

If a retiree had $1,000,000, a 4% withdrawal rate would generate an income of $40,000 per year. However, a 3% withdrawal rate would mean an income of $30,000 per year. Put another way, he would need $1,333,333 to generate the same $40,000 per year.

The decrease in withdrawal rates and annuity payout rates could affect both near retirees and new retirees the most, but pre-retirees should also be aware. The amount a pre-retiree needs to save to achieve their desired lifestyle in retirement should reflect the possibility of reduced income potential and lower equity returns. Being aware of this allows pre-retirees and retirees to adapt their own strategies and properly manage their expectations.

The views and opinions expressed are those of Andrew Eppes. Andrew Eppes’s views are not necessarily those of Massachusetts Mutual Life Insurance Company, MMLIS or its subsidiaries.

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