Rethinking Retirement Strategies in the Low-Yield World

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. What does the current low-yield environment mean for retirement planning?

Joining me to discuss that topic is Christine Fahlund. She is a senior financial planner and vice president with T. Rowe Price.

Chris, so good to be here with you.

Christine Fahlund: It's terrific.  Thank you, Christine.

Benz: Let's talk about the challenging environment that retirees are facing, and specifically the conundrums, the multiple issues created by very low yields currently.

I'd like to look at annuities, start there, because historically they have been sort of standard planning advice for people getting ready to retire. The single premium immediate annuities that I know a lot of planners like you recommend have relatively low payouts at this point. So, does that mean that they shouldn't be part of retirees' toolkits?

Fahlund: No, I don't think so. Maybe not the single premium annuity right now, because of the very low rate. But certainly tax-deferred annuities, variable annuities, you'd have the option to go with equities, heavily into equities in those.

It's important to have that guaranteed income in your portfolio. So, I think too often we overreact to what's happening today. We all want higher yields and growth, but it can make sense to have the annuities anyway.

Benz: Let's just discuss some of the key benefits that one gains by having an annuity. I think people hear the word "annuity" and their hackles go up. They think very high costs.

Fahlund:That's right.

Benz: Let's talk about what you see as the benefits, and why someone might consider one.

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Fahlund:Peace of mind--first and foremost--peace of mind. Also longevity. It reduces your risk exposure, and maybe you will use it for long-term care, who knows? But I think the SPIAs are one alternative, but another really good one is a tax-deferred annuity--you get to choose when to activate it down the road.

Benz: Let's discuss another topic that falls under the heading of very low yields. I've recently been seeing some discussion among planners that maybe the standard advice about asset location, what types of assets you put in which accounts, doesn't matter so much these days, because if your bonds are yielding 2%, what does it matter if you have to pay income tax on that payout. What do you say about asset location and where people should hold various types of assets?

Fahlund:Well, I think what we tend to focus on today is not so much the tax-sheltered environment and where you locate them, but about those RMDs.

Benz: So the required minimum distributions.

Fahlund:Required minimum distributions at [age] 70 1/2 is significant, because they're required. So if you have a low-interest environment, and you put your bonds in your tax-deferred account, well, at least it's not increasing the size of your RMDs during that period. So, there is a silver lining to that.

Benz: OK.So the standard planning advice is that you keep income-producing securities--so bonds mainly but maybe also things like REITs--keep that within the confines of the tax-sheltered, tax-deferred vehicles, your traditional 401(k)s, traditional IRAs, and so forth.

Let's talk about what you want to put inside of Roth accounts to the extent that you have them.

Fahlund: Well, you go right back to that RMD story, because Roth IRAs don't have RMDs. So that means you're not required to take any money out until you want to. Also, when it does come out, it's income-tax free. So that's the place to locate your most-aggressive equity securities. That's absolutely where those ought to go, because whenever you get those spurts of growth, it's going to be in the best place possible.

Benz: Because you won't have to take those required payouts.

Fahlund: You don't have to take them out. And when they do come out--hey, more assets to take out tax-free.

Benz: And just to take it full circle, let's talk about what types of assets you think one should put within a taxable account?

Fahlund: Yes. Certainly individual securities where you control the appreciation and the recognition of the cap gains.

Also, municipal bonds of any kind. Certainly tax-efficient funds, ETFs.

Benz: Broad market index funds.

Fahlund: Index funds, absolutely.

Benz: Let's also talk about the implications of the current low-yield environment for Social Security, and why you think very low yields make deferring Social Security an even smarter move than ever. It was before, but you think it's even more so right now.

Fahlund: Even more so right now, because if you know the yields on bonds, and you compare that to the formulas for Social Security, every year you delay taking your Social Security, that initial benefit goes up 7% to 8%. So that's a formula. It's not something that's dependent on the markets. You know right now that that's what you'd get. So take advantage of what you know and capitalize on it.

Benz: You have also noted, though, that in other market environments, specifically down market environments, even though maybe your intention was to delay receipt of Social Security as long as possible, in some cases it might actually make sense to speed up that date a little bit.

Fahlund: It could absolutely, because there's nothing more important to us than sequence of returns for our portfolios. If you happen to retire into a down market, it looked great when you were ready to retire, but three or four months later, everything has changed, it could very well be that you don't want to exacerbate a bad situation by simply taking more withdrawals than you have to.

How can you reduce the size of those withdrawals and maintain your budget? Accelerate the payment of Social Security. If you're married, maybe accelerate the payments from one person's Social Security.

Benz: Chris, it's always great to hear your insights. Thank you so much for taking the time to be here.

Fahlund: It's a pleasure to see you again.

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