David, thank you for being here.
As we know today, though, you can't earn 5% on bonds. And so when you change kind of the model from assuming these long-term averages to where things are today, if they kind of drift back toward their long-term average, you see a very different outcome in terms of what is safe for retirement.
Benz: One thing you talk about in the paper is a problem called sequencing risk, and that's kind of essential to what's confronting retirees right now. Let's talk about what that means and why that is important?
Blanchett: The sequence risk is kind of the implications with bad initial returns. As I mentioned previously, most past research on retirement income assume the same return every year. So, you could assume to earn 5% on bonds on average. Well, having a very low return initially, significantly affects the ability of a portfolio to achieve an income goal.
Right now, for example, if you buy bonds today, you can go out and earn 2% or 3% on bonds. That's well below historical averages, and that significantly affects the ability of the portfolio to kind of take that withdrawal for 20, 30 or 40 years.
Benz: Did your research take into account that as yields might rise over time that the retiree will be able to pick up a higher income stream over time, that we won't be in this 1.5%, 2% yield environment in perpetuity. Did you factor that in?
Blanchett: I actually use what's called an autoregressive model, and I just assume that that bond yields converge back to their long-term averages at their historical rate. So, over the last 90 years, bond yields have been really high and really low, and they tend to revert back to the kind of long-term average at a given rate. So, we assume that as they move through time, the bond does kind of converge toward that average using that long-term rate.
Benz: Let's discuss some of the levers that retirees have. I can see people being very nervous when they hear about this. So, it sounds like you could take your withdrawal rate down if you wanted to increase your probability of success; that's one avenue. It might not be palatable to people, but that's another one.
Another one would be to nudge up the equity position in the portfolio. What do you think about that, and I'm talking to a lot of retirees these days who are saying "Why do I need bonds at all given the prospects, given how low yields are?" What do you say to a higher equity position?
Blanchett: I say that that could work. I think everyone should have some bonds in their portfolio. You just shouldn't go all stocks. But if you want to kind of diversify better, think about things like real estate and commodities. If you want to buy more equities, buy maybe more large-cap [names], more of large-cap value [names]. You can increase the risk of your portfolio by doing so, and there are good and bad things with that. Longer term, equities have outperformed bonds.
So, it should help, on average, you achieve a goal, but if we have another 2008 or early 2000s, it can have a very negative impact on someone's chance of success in retirement.
Benz: Yes, and the volatility profile in the portfolio goes up quite a bit.
Blanchett: There are definitely pros and cons to more equities. But I mean when thinking about someone's plan, the initial withdrawal rate is kind of the starting point. And if you're willing to change in 20 or 30 years, you can still take out 4%. The question then is, how OK are you with a future negative change to your consumption when you're 95 years old?
Benz: What if someone were to maybe use higher-yielding bonds, maybe venture into some lower quality bonds or non-U.S. bonds? What does that do for the probability of the portfolio and the success rate?
Blanchett: It would help. But the return you earn in your portfolio is the number-one driver of the outcome. So, if you move into high yield, non-U.S., or other types of bonds, it could improve the outcome, but there is also more risk.
If you go out and you buy high-yield bonds and high-yield bonds drop significantly, well then all of a sudden you've hurt your chances of success. And so, again if you don't want to buy government bonds, like you said [you can] buy high-yield bonds or buy non-U.S. bonds. Diversify your portfolio into other asset classes that do have higher returns right now.
Benz: Another lever that people might have if they haven't yet retired is staving off that retirement date, and one advantage, it sounds like there are many, but one would be that maybe your starting point for bond yields will be a little more favorable.
Blanchett: Yes. I would say that delaying retirement is like the silver bullet for most retirees because it does a lot of great things. First you have one more year to save and another year for your assets to grow. You have a higher Social Security benefit. You got a shorter distribution period. You got all these things that kind of help someone better achieve a goal. So, I think if you want to make a difference, that's what you should look to do first and say, "Can I delay retirement for maybe two or three years?" And then kind of readdress things then.
Benz: I guess the other risk though is that some people may not be able to delay.
Blanchett: Correct, yes.
Benz: Some of them may have health conditions or spouse's health conditions.
Blanchett: It isn't always an option, but if it is an option, usually you can get a much better job when you're 65 versus when you're 90. So if you're worried about when is a good time [to start] working again, do it when you can versus when you can't when you're older.
Benz: Well, thank you so much for being here to share this research. It's really important stuff. We appreciate you sharing with us.
Blanchett: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
