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Where to Invest When Yields Are Low

How does an investor extract a livable income stream from a retirement portfolio in such a low-yield environment?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Although bond yields have ticked up a bit in recent months, they're still quite low by historical norms. Joining me to discuss how to wring a livable income stream from a retirement portfolio is David Blanchett. He is head of retirement research for Morningstar Investment Management.

David, thank you so much for being here.

David Blanchett: Thanks for having me.

Benz: David, let's talk about something that you have researched extensively, the interplay between yields and safe withdrawal rates. Can you talk a little bit about that and what the research suggests that retirees should do in terms of their withdrawal rates when yields are as low as they are today?

Blanchett: There's been a lot of research going back over two decades now on how much you have to have saved when you first retire. And not surprisingly, the assumed rate of return on a portfolio really determines what that number is going to be. If we had 30-year bonds right now yielding 8%, you could have a pretty nice safe withdrawal rate. But today, to your earlier point, bond yields are relatively low. And so, I think that retirees need to kind of take a step back and say, what is a safe withdrawal rate today given lower possible returns in the future.

Benz: Looking at the standard, sort of 4% guideline, would you suggest that retirees who are just starting retirement think about maybe taking a lower amount because of those lower yields?

Blanchett: I actually really like 4%. I've done a lot of research. Here's the thing. So, 4%, the rule itself, it's been redone lots of ways. But it's largely based on historical U.S. returns. If you rerun the analysis and you better calibrate the return assumptions to today, the results that led to 4% lead to 3% or less, OK? But here's the thing. There's a lot of incredibly restrictive assumptions in that analysis. You have to have a certain amount of income every year for 30 years, increased by inflation. It deems failure as you're falling $1 short in the 30th year of retirement. I still think that 4% is a relatively good starting place for a lot of retirees. Not everyone is a healthy married couple at age 65. Now, that being said, there's other important questions, too, like how much guaranteed income do you have, how willing are you to kind of cut back if you have to. But high level, yes, things are more difficult today than they've been historically on average, but 4% I think still is an OK place to start.

Benz: Let's talk about the portfolio itself and how retirees should think about constructing their portfolios in this very low-yield environment. I talk to a lot of retirees who are kind of inclined to throw bonds and cash overboard because of their very low yields. They are investing exclusively in dividend-paying stocks. What do you think about such a strategy that emphasizes stocks perhaps to the exclusion of safer assets?

Blanchett: Retirees are an odd bunch to some extent. When I do research on retirement, I assume that people are going to spend down their nest eggs--you save to spend it. But that's actually not what happens, right? People in retirement really like the idea of living off of income. They want to leave the principle alone to kind of hedge against an uncertain life span; you've got healthcare costs, you've got bequest goals, all these things. The goal is often, "I'm going to live off of the income." Well, that is I think doable if you've got bonds that yield 5% a year. We're not there right now. And so, I think a lot of retirees are saying, "Well, how can I generate income from a portfolio?" And one way to do that is by owning dividend-paying stocks. It's not actually a rational approach, but it's an approach that aligns with the goals of retirees.

And I've been looking at that topic using historical data. So, you can look at data going back from like 1870 to 2019 for 16 different countries. And you can say, "Hey, how does the optimal strategy change for someone who wants income in different yield environments?" And long story short, in an environment like today where you've got dividend yields that are roughly equivalent to the yield on Treasury bonds, it can make a lot more sense. Or at least, it has made a lot more sense historically to allocate more to equities that pay dividends versus just owning bonds, because you can get just as much yield or higher from those stocks and possible capital appreciation. Now, I do worry about retirees going a bit overboard and just saying, "I'm not going to own any bonds when I own a lot of equities," and then the markets collapse. But, at least historically speaking, that's been a pretty viable strategy.

Benz: If a retiree wants to emphasize dividend payers as part of their portfolio, what's a reasonable allocation? Can you give us sort of a ballpark estimate? Or how should retirees approach the percentage allocation to stocks relative to perhaps safer assets like fixed income and cash?

Blanchett: It's hard to generalize one number. If I had to pick a number off the top of my head, I would say maybe 50%. I mean, one benefit about owning dividend-paying stocks is that they're typically relatively mature companies in mature industries that should do relatively well if the markets go down. These aren't tech stocks that are going to go up 100%, and they're relatively safer. Now, to the extent that you as a retiree are not going to sell your portfolio no matter what, if you're comfortable holding on for the long term, maybe you can have all of your portfolio in dividend-paying stocks. You have to understand the risk. Because I just did some research back looking at participants trading in 2020 and the folks that made the biggest mistakes were those that were older and invested aggressively, and older being defined as someone who is near retirement and invested in mostly equities. And so, my one concern about this recommendation is it's kind of against what you see retirees actually do, which is they tend to freak out a little bit when equity markets fall if they've invested aggressively. So, the extent that you cannot react to a market downturn, then I think you can allocate potentially pretty heavily to dividend-paying stocks, but just be aware that there's also a lot of risks there. 

Benz: I want to talk about other higher-yielding security types, maybe bank-loan investments or junk bonds, emerging-markets bonds. How do higher-yielding, higher-risk fixed-income investments fit into the picture, if at all?

Blanchett: So, they can. I think the one thing that people need to really realize is that the realized return on high-yield/junk bonds is not the yield when you buy it, right? Defaults are a really big deal. And the actual spread in the realized return of higher-yielding bonds is actually quite similar to those with better credit quality due to the impact of defaults. The problem with defaults is just that when they happen, it's somewhat catastrophic. But it doesn't usually happen all that often. You can think about doing things to increase the income of your portfolio, but I would just say that you're also increasing the risk. I think that we often define the risk of a portfolio as equities or fixed income. In some sense, high-yield bonds can be riskier than equities, right? So, don't kid yourself thinking I'm going to buy some high-yield bonds and it's still not making my portfolio very aggressive. It can have just as much an effect or more as buying mega-cap high-quality stocks.

Benz: Is it a way to think about it perhaps that I use such investments to be sort of equity substitutes as opposed to supplant fixed-income allocations?

Blanchett: Yes. I mean, a lot of the things that you mentioned, people might call them fixed income, but they're very risky fixed income. I define equity as higher volatility, higher chance for a loss. A lot of the investments that you mentioned, especially high-yield bonds, have that potential. So, just view them according to your portfolio. Like a safe portfolio is not a 50% allocation to high-yield bonds and 50% allocation to large-cap stocks. You've got a very risky portfolio there. Understand the risk of the investments that you're using.

Benz: David, such a helpful overview. Thanks so much for being here.

Blanchett: Sure thing.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.