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Navigating a Low-Yield Environment in Retirement

With very low yields, it's important for retirees to refocus on cash flow, use high-quality bonds as a shock absorber, and hold some cash in their portfolios, says Christine Benz.


Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Even though the Fed may raise rates as soon as September, the low-yield environment is likely here to stay. I'm here with Christine Benz, she is our director of personal finance, with some tips for retirees in navigating this low-yield world.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: So, obviously, this is nothing new. The very low rate policy has been with us for some time and could be with us for some time. Let's just take a look at the landscape, of what kind of rates we're seeing in the marketplace right now and what investors can expect?

Benz: Yeah. When you look across various asset classes, yields are very low by historic norms. So, money market mutual funds, the yields are in the neighborhood of 25 to 50 basis points currently. If you are willing to look at some sort of a CD product where you have to tie your money up for a period of time, you can earn a higher yield. One-year CDs are yielding as much as 1% today. I generally think that for investors who have cash investments, the best option is some sort of an online savings account and there you can find daily liquidity as well as yields of about 1%, but still really low relative to historic norms.

Bonds, yields are a bit higher. So, the Barclays Aggregate Index is currently yielding about 1.75%. If you are willing to take on a little bit more interest-rate risk or credit-quality risk, of course you can pick up a little more but not appreciably more.

And stocks, it's somewhat curious. The yield on the total U.S. stock market as well as the yield on the S&P 500 today is a bit higher than the Barclays Aggregate Index. So, that's right around 2% currently. That's a somewhat interesting relationship because typically we do see bond yields higher than equity yields, but that's where we are today, that's kind of the baseline. And obviously, these are some really low numbers; they are not livable yields for most retirees.

Glaser: Because if you're a retiree, and you have kind of a normal portfolio, you're looking at maybe that 2% yield. You think that 4% rule still holds for most people that you should only take 4%, or that you need to take 4% out a year to make it sustainable. So, what do you do? How do you make up the shortfall?

Benz: Well, I think, one key thing to keep in mind is refocus a little bit on cash flow versus current income, that current income at today's yields is probably not going to get it done for most retirees. So you want to take a step back. And what I've always said in constructing model portfolios for retirees is, the name of the game is that we are going to try to produce the best total return from this portfolio that we can, and then when it comes time to take withdrawals from the portfolio, we're not going to get too hung up on whether those withdrawals come from current income or whether they potentially come from harvesting appreciated parts of the portfolio. The retirees shouldn't really worry too much about where those distributions actually come from. So, I think that that's sort of the key piece of advice that I would impart, that if you build a portfolio with what you think is the best combination of risk and return characteristics, the logistics of where you go for those withdrawals is really immaterial.

Glaser: So, it's not time to reach for yield-y, for riskier assets in order to get that 4% level?

Benz: Absolutely not. And it's an evergreen message, but I would encourage retirees to remember any time you do see a yield that's significantly above what you can earn on some of these high-quality instruments, whether stocks or bonds, it's your responsibility to do due diligence on what sort of risks are attached to that yield. And I think master limited partnerships are a great recent example where investors were very enthused about the asset class, they liked the yield, and for many investors they didn't fully investigate the downside potential. And we saw that on full display last year, though they've recovered a little bit so far in (2016).

So, whatever investment type you're looking at, if you see that above-average yield, do that investigative work about the risks that might be attached to it. So, long-term bonds, I think, most investors are aware of the risks of reaching for above-average yields with long-term bonds. You want to look at the sort of interest-rate sensitivity that such a portfolio would have. Vanguard Long-Term Government Index, for example, today has a yield well over 2%, but it also has an 18-year duration. And we often use duration as kind of our proxy for interest-rate sensitivity. You need to bear in mind that such a portfolio would have significant losses if interest rates went up even just a little bit.

High-yield bond yields today are currently in the neighborhood of 5% or 6%. That is well above the 2% yields we've been talking about for high-quality bonds, but you also have a lot more sensitivity to what's going on in the economy, what's going on in the equity market. So the typical high-yield bond mutual fund lost something like 25%, 26% in 2008. You need to bear that in mind, that in those equity market shocks, in those economic shocks we will not see good performance from high-yield bonds. We will tend to see big losses in such environments.

Glaser: You mentioned earlier, we're in this bit of an unusual situation where equity yields are higher than the Barclays Aggregate. Does that mean that maybe it makes sense to swap some bonds for stocks? I know a lot of retirees have looked into that.

Benz: Yeah, potentially around the margins of the portfolio, but I think even though bond yields are underwhelming, are disappointing today, I do think that bonds, high-quality bonds, serve a valuable role in a portfolio, namely, as a shock absorber. So, if you're looking at yields of 1.5% to 2% today, that's sort of what you can assume will be the return for that asset class over the next five or 10 years. But you do need to bear in mind that in that equity market shock nothing in your portfolio is likely to perform as well as the high-quality bond piece. It's been a reliable source of downside protection in a whole variety of market catastrophes and that happens for a couple of reasons.

One is that investors tend to view U.S. high-quality bonds as a safe haven in market shocks and the other reason is that investors are less nervous about interest-rate hikes when we see big economic or market shocks, and that's another reason we see high-quality bonds go up in such environments. So, I do think that they serve a role even though investors might think about nudging a little more of their portfolios into equities than they otherwise would simply because the return potential over a long time horizon is apt to be higher.

Glaser: Now, another thing that can help kind of insulate your portfolio a little bit is a cash holding. But with yields so low does it still makes sense to have a sizable position in cash if you're a retiree? Should you be looking at short-term bonds?

Benz: Probably not a sizable position in cash, but I do think that retirees should hold some cash as a portion of their portfolio. As you know, I'm a big believer in this bucket approach to retirement portfolio planning and the basic idea is that you are holding a cash piece of your portfolio in addition to your long-term holdings. And that gives you some insulation. So the bond and stock components of your portfolio can move around a little bit, they might go down a little bit. But you know that you have your near-term income needs set aside. So, I'm a still a believer in holding some cash. You might also hold a little bit of cash if you are an investor who is concerned about current market valuations, you think that there may be some better opportunities down the line, you might have reason to hold a little bit more in cash.

Glaser: Finally, you say that retirees shouldn't lose track of inflation throughout thinking about this environment.

Benz: That's absolutely right. So, we have seen very benign CPI rates, but I think retired investors should bear in mind their own consumption baskets. And a couple of things we've been looking at, one is that even though healthcare inflation isn't particularly high relative to where it was, say a decade ago, the consumption basket for retirees tends to weight healthcare expenditures a little more heavily. So bear that in mind. We have seen healthcare inflation running above CPI. While at the same time retirees haven't benefited as much from lower energy prices because they don't generally drive around as much as people who are working. So those are a couple of things to keep in mind.

I do think it's important to make sure that you include in your retirement portfolio direct inflation hedges like Treasury Inflation-Protected Securities as well as securities that simply have the potential to out-earn inflation over time. So, cash and bonds are unlikely to out-earn inflation over the next decade. Stocks probably will out-earn inflation. So, you want those direct inflation hedges as well as securities that have the potential to out-earn inflation.

Glaser: Christine, thanks for your perspective today.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.