Bad news: you’re going to have to save a lot more for retirement
BY TERRY SAVAGE February 10, 2013 6:02PM
The Federal Reserve has kept interest rates near zero. | Karen Bleier~AFP/Getty Images
Updated: May 3, 2013 12:15PM
The Federal Reserve is trying to save the economy — but it is killing retirees’ financial plans. This prolonged period of low interest rates has been devastating to those who planned to live on their interest income. And for those approaching retirement, it means you may need much more money to afford retirement.
Chicago-based Morningstar Inc., the largest provider of 401(k) managed accounts with more than 800,000 participants, has just announced it is changing its retirement modeling program because of the Fed’s actions. And whether you’re just in the “saving for retirement” stage or the “withdrawal planning” stage — or in the midst of actually trying to live on your savings — you might want to reconsider your plans, too.
Taking money out
How much can you withdraw from your retirement accounts every year and not run out of money before you run out of time? That’s the overwhelming question facing every retiree — and those planning to retire.
The whole question is made far more difficult by the low interest rate environment of the past few years. While the Fed pushes rates down to try to get the economy going, those who planned to live on their interest earnings are devastated.
Real interest rates are actually negative when you take into account the impact of inflation. And inflation for seniors — which is heavily weighted toward medical care, and property taxes, and food and energy bills — is even greater than the inflation numbers measured by the traditional Consumer Price Index (CPI). It’s fair to say that for seniors, savings invested conservatively in 10-year Treasuries is producing a real loss of buying power each year.
And that is the real issue here: How much can you withdraw every month, or year, to keep your standard of living? And if low rates force you to withdraw more, how much sooner will you run out of money?
The traditional rule
Financial planners have sophisticated computer models to tell you how to diversify your investments — and how much you can withdraw on a regular basis. The process is called Monte Carlo modeling. It takes into account historical returns of investments, such as stocks and bonds.
Monte Carlo goes beyond using an average return for investments. That would be dangerous, because averages mask great extremes. Instead this computerized modeling takes into account the small but existing possibility of extreme movements in markets. That’s the kind of action we’ve seen in the past decade in the stock market.
The simple rule derived from this kind of modeling has always said that with a well-balanced investment portfolio that contains both stocks and bonds: You can withdraw 4 percent a year from your principal and have a 90 percent probability that you won’t outlive your money.
Since Monte Carlo modeling takes into account the potential of wide swings in the stock market, retirees and their planners have felt confident in using this rule to plan their retirement investments and withdrawals — even during recent wild swings in the stock market. Those kinds of stock movements have happened before. And as we’ve seen, the market ultimately returns to its norms.
You could live with volatility in stocks as part of your portfolio — because you were getting a steady return from your conservative bonds. But what happens when bond yields go to extremes — as they have today — extreme lows? What happens when bonds are not yielding anywhere near their historic models, and the low yields persist over a period of years?
The impact could be devastating on a retiree’s withdrawal strategy, causing him or her to run out of money far more quickly than expected.
That’s the scientific explanation of the anxiety that seniors are facing today.
Changing the model
Now the experts are considering changing their models to adjust for this unprecedented and prolonged Fed intervention in the bond market. Morningstar says that a 4 percent withdrawal rate from a balanced portfolio, once considered a secure way to plan, could now lead to a 50/50 possibility of running out of money too soon.
Instead David Blanchett, head of retirement research for Morningstar’s Investment Management division, suggests that a retiree who wants a high degree of certainty over not outlasting his or her money should reduce the withdrawal rate from 4 percent a year to only 2.8 percent annually. And to get the same amount of money to withdraw each year, that means you would need 43 percent more savings before retirement!
Blanchett is not alone in his findings. Well known financial planner Joe Tomlinson has just published a sophisticated research paper in Advisor Perspectives Inc., suggesting that the immediate impact of current low bond yields will crush most retirement withdrawal plans. He notes that most planning software includes an average historical real (after-inflation) return of 2.4 percent for intermediate term government bonds. But the current real return, as measured by yields on Treasury Inflation Protected Securities (TIPS) is a negative 0.73 percent. The impact of wrong assumptions exponentially impacts the likelihood of the plan’s success. The report can be viewed at http://suntm.es/XzUmBS
What to do now
No matter what your stage of retirement planning — or retirement living, this is the time to re-think your numbers. If the Fed keeps rates low even for another few years, you have to think about working longer, saving more, earning some extra money in retirement, or living on less.
What you should NOT do is take on more risk! Trying to get higher yields on the bond portion of your investments by purchasing riskier bonds, or locking your money up for longer time periods, could be even more devastating when the Fed loses control — and all the money the Fed has already created produces inflation, which will bring higher rates.
Yes, these are tough times. And according to the financial models, times will get even tougher for retirees living on fixed incomes. It’s time for AARP to take the Fed to task for its low-rate policies. And that’s The Savage Truth.
Terry Savage is a registered investment adviser. Post a question on her Sun-Times blog at www.TerrySavage.com. Copyright Terry Savage Productions, Ltd. Distributed by Creators Syndicate.