How to Keep Low Rates From Souring Retirement
3 ways to manage your money in a world of chintzier bond and CD returns
(This article previously appeared on RealDealRetirement.com.)
The biggest challenge facing investors today are low yields and the prospect of anemic investment gains in the years ahead. Here’s how to prevent subpar long-term returns from derailing your retirement and other financial goals.
People can and do argue about why interest rates are so low and what that means for economic growth and investment returns. If you’re interested in following, or even joining, that debate, I suggest you check out former Federal Reserve chairman Ben Bernanke’s new blog, which has already generated an animated discussion among a number of high-profile savants, including former Treasury Secretary Larry “Mr. Charm” Summers and economist-turned-columnist Paul “Those *#@!! Republicans” Krugman.
But wherever you come down on how and why rates are so low — and for the record, Bernanke pointedly denies “throwing seniors under the bus” by artificially depressing yields while he ran the Fed — this much seems clear: Most investment experts believe the long-term annualized returns of 10 percent for stocks and 5 percent or so for bonds that prevailed over many decades are a thing of the past.
One example: Well-known investment adviser and ETF (exchange-traded funds) guru Rick Ferri recently released a long-term forecast that, assuming 2 percent annual inflation, projects annualized gains of about 7 percent for stocks and 4 percent for bonds over the next 30 years. Some market watchers consider even that generous.
This sort of sobering outlook requires a radical re-thinking of how you plan for retirement and other financial goals. Here’s a rundown of three things you must do to succeed in an era of undersized returns:
1. You’ve got to save more (and probably work longer): The prospect of lower investment returns means most people will have to boost their savings rate to have any kind of shot at a secure retirement. That’s hardly a revelation. Since the money you stash away won’t grow as much as it would have at a higher rate of return — $100,000 grows to about $466,000 after 20 years at an 8 percent annual return vs just under $321,000 at 6 percent — you’ve got to contribute more dollars of savings to build an adequate nest egg.
But many older workers who’ve been saving diligently may find coming up with sufficient extra savings a challenge, as they may not have enough time left in their careers to stash away enough new money to make up for the slower growth on their existing savings due to lower returns.
Here’s an example. Let’s say you’re 50, earn $80,000 a year, receive 2 percent annual raises, have $300,000 invested in a mix of 60 percent stocks and 40 percent bonds and you contribute 10 percent of pay to that retirement kitty each year. Back in the heyday of robust returns, a 60-40 portfolio might have gained 8 percent a year. With that return on existing and new savings, you might have ended up with a nest egg of roughly $1.2 million at 65.
Given current forecasts, however, a 60-40 mix might deliver annual returns closer to 6 percent, which would leave you with an age-65 retirement balance of about $935,000, some $265,000 short of the $1.2 million you might have had with the higher rate of return
Most of that difference is because the existing $300,000 in savings grew to only $719,000 with a 6 percent annual return vs. $935,000 with an 8 percent annual gain. Saving more from age 50 to 65 can only do so much to recoup that shortfall. For example, even if you’re able to double your savings rate from 10 to 20 percent a year, you’ll still end up a bit shy of $1.2 million.
Which is why the answer for most people will be a combination of socking more away and putting in a few extra years on the job. For example, if the 50-year-old above saves 15 percent and retires at 67 instead of 65, the combination of extra savings and more time for those savings to grow generates a nest egg of $1.2 million, although that balance does require two extra years of working and saving.
2. You’ve got to spend more carefully in retirement. Lower returns also demand a shift in strategy once you’re living off your nest egg in retirement, except spending becomes the focus of your efforts rather than saving. The basic idea: if you’re earning lower returns on your savings, you’re going to have to be more diligent about how much you draw from savings if you don't want to outlive your dough.
Consider: In the era when stocks gained an annualized 10 percent or so long-term and bonds returned about 5 percent annually, you had roughly a 90 percent chance that your savings would last at least 30 years if you invested in a 50-50 mix of stocks and bonds and you followed the 4 percent rule — that is, you drew 4 percent, or $48,000, initially from a $1.2 million nest egg and increased that amount each year for inflation. But if you stick to the same scenario as above but assume that stocks and bonds are projected to gain just 7 percent and 4 percent annually, you have an 80 percent-or-so chance that your savings will last 30 years or more.
In short, you either have to accept a higher probability of exhausting your savings sooner or you have to cut back the amount you withdraw. You always have the option of investing more aggressively and shooting for higher returns. But if you do that you also run the risk of being hit with a bigger loss during market downturns, which could deplete your savings even sooner.
The better strategy: Go with a retirement portfolio that jibes with your risk tolerance and that won’t get decimated by market setbacks — for most people, anywhere from 40 to 60 percent in stocks is decent guideline — and limit withdrawals so you have at least an 80 percent or so chance of your money lasting through retirement.
You can see how the probability of your money running out changes with different stocks-bonds mixes and withdrawal by going to a retirement income calculator like the one in the RealDealRetirement Toolbox.
3. You’ve got to invest smarter. You can’t control the returns the market delivers. But you do have some sway over how much of that return you keep after investment expenses. How? By investing your savings as much as possible in low-cost index funds and ETFs. The savings can be considerable.
In a recent report, Morningstar estimated that the average mutual fund charges 1.25 percent annually in expenses. You can easily find index funds and ETFs that charge 0.20 percent a year or less at such major firms as Vanguard, Schwab and Fidelity. In short, without much effort you can pare annual expenses by a full percentage point or more each year compared with the average fund.
Can I guarantee that lowering expenses by a percentage point will boost your return by exactly that amount? No. But the same Morningstar report also shows that lower-cost funds tend to outperform their higher-cost counterparts. Which means one way of counteracting the effect of lower returns in the future without taking on more risk is to get as much of that return as you possibly can by sticking to low-cost investments that give up as little of their gains as possible to fees and expenses.
It’s possible, of course, that all the experts predicting anemic returns in the years ahead might be mistaken. It wouldn’t be the first time that investment analysts’ projections were off. But it’s better at this point at least to prepare as if the consensus for lower returns is correct.
Otherwise, you could end up not just with diminished returns, but a diminished retirement as well.