You have to get rich these days just to finance a comfortable retirement.
That’s the conclusion financial advisors are increasingly coming around to, as they gauge the direction of the economy in a strange new world of glacial growth and super-low interest rates. “Twenty years ago, someone with a million bucks would have said, ‘that’s great, I can draw down $100,000 a year, I’ll be just fine,’” Jim McCaughan, CEO of Principal Global Investors, tells me in the video above. “But now, with very low rates, the problem of funding a retirement is much more difficult.”
Retirees don’t need to be told that low rates have cut sharply into the returns on fixed-income investments. But they may need to rethink how to prepare for what might happen in the future. Many investors are waiting for interest rates to go back up, once the Federal Reserve starts hiking short-term rates later this year or early next year. Meanwhile, the Fed is gradually winding down its vast “quantitative easing” program, which deliberately forced down long-term rates. So as that pressure eases, rates ought to go back up. Right?
Maybe not. McCaughan argues that we’ll be in a low-rate environment for much longer than many people expect, for a couple of basic reasons. First, an aging population means the demand for low-risk bonds will rise, pushing up prices but pulling down yields. Second, there’s been a growing gap between global demand and global production capacity, which will keep a lid on prices of most things for the foreseeable future. Low inflation usually coincides with low interest rates.
There's nothing magical (or scientific) about $1 million as a goal for retirement savings. As a round benchmark, however, it's been in the ballpark for a couple hoping to retire comfortably. A $1 million principal will generate $60,000 per year in income if the portfolio's return is 6%, and $40,000 per year at 4%. The amount you need to live on, of course, depends on many factors, including the cost of living where you reside, healthcare expenses, how much you travel and how long you live.
But if rates remain in the low range they’re in now—with 10-year Treasury rates well below 3%, say—it will change the math of retirement planning. During most of the baby boomers' working lives, it was reasonable to expect annual returns of 6% to 10% on a retirement portfolio, without taking much risk. Add Social Security and other pension payments, and a $1 million nest egg was more than adequate for most people.
That same portfolio might now earn just $30,000 to $50,000 in annual income, indefinitely. That leaves retirees with some choices they may not have foreseen. One is to continue working well past retirement age. Another is to get by on less. Neither is especially appealing.
A third strategy would be to take more risk investing your pool of retirement money, which ought to boost returns—while also raising the odds of losing money. And that may require a mental shift. “The period when you could draw down 10% per year, that was an anomalous period,” McCaughan says. “Baby boomers find it hard to escape from the environment in which we built our careers.” One way to do it is through a retirement portfolio that includes more stocks than the Jack Bogle age-bond rule would dictate (the portion of your holdings in safe bonds should more or less equal your age).
Investing more heavily in stocks, later in life, obviously requires more hedging to guard against downturns. McCaughan recommends a mix of annuities, target-date funds and other securities to help offset risks. There may be clever ways to tap the value in a home or other assets, which a financial advisor can help with. You could also save more while you’re working, so instead of the proverbial $1 million, you end up with however much it takes to cull that $100,000 per year in retirement, without running out of money. And if interest rates do actually spike, you’ll finally be able to live richer.
Rick Newman’s latest book is Liberty for All: A Manifesto for Reclaiming Financial and Political Freedom. Follow him on Twitter: @rickjnewman.