What Ultralow Yields Mean for Your Financial and Retirement Plan
With cash and bond yields so low, the "safe" return of other nonportfolio assets is even more attractive.
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Yields have been declining since the 1980s, and they appear likely to remain low for a good long while. In an effort to fight the economic weakness precipitated by the novel coronavirus crisis, the Federal Reserve has pushed its target interest rate near zero, and it’s not likely to let up until a turnaround is well underway. And even if the federal-funds rate were to jump up because of improved economic activity--by 1 percentage point or even 2--rates will still be near historic lows.
Retired investors looking to live off the income distributions from cash and bonds feel the pressure of low yields most acutely. The net effect for them is that wringing a livable yield from their portfolios means they’ll need to take more risk. That’s a key reason I’m a believer in a total return approach to retirement-portfolio withdrawals, which allows retirees to stay flexible about where they source withdrawals so they’re not so dependent on what prevailing yields are like.
But lower yields have an impact on many other aspects of retirement and financial planning, too--borrowing, of course, as well as Social Security claiming decisions and in-retirement withdrawal rates. Here are some of the key considerations to bear in mind with respect to each of these areas.
Social Security Claiming: Delaying More Attractive
Amid the current crisis, investors plotting their own retirements may be primarily focused on the losses they’ve experienced in their equity portfolios. Do equity losses turn the conventional wisdom about delaying Social Security filing on its head, given that equity returns could be better in the future and that trimming depressed assets to meet living expenses is rarely a good idea?
But David Blanchett, Morningstar Investment Management's head of retirement research, argues that one of the big swing factors in Social Security claiming decisions are bond yields, not what’s going on with the stocks. That’s because the 8% annual return you pick up for each year of delaying past full retirement age is a guaranteed rate of return, making similarly safe investments like cash and bonds the best point of comparison. From that standpoint, the benefits of delayed filing look like an even better deal amid very low interest rates, as it’s impossible to touch 8% with high-quality bonds, let alone anything that’s guaranteed.
Of course, the right time to claim Social Security depends on the individual: his or her health and other sources of cash flow in retirement, among other factors. Roger Wohlner, a financial advisor and writer based in the Chicago suburbs, emphasizes, "There is no pat answer. It’s in large part a numbers decision, but can also be an emotional one. Financial advisors always have to listen to what their clients are saying (and maybe what they aren’t saying) about their feelings about risk and other factors."
Mortgages and Other Debt: Refinancing, Paydown More Attractive
It goes without saying that lower interest rates make refinancing debt--mortgages, student loans, and even credit card debt--more attractive. Of course, refinancing may not be an option for the people who need it most; employment status and debt/income ratios can affect who is approved for a loan and at what rate, and lenders are being picky given the current economic weakness. But if you’re in good financial shape, refinancing debt when rates plummet is close to a no-brainer, provided you can do so without incurring a lot of additional costs.
At the same time, lower yields--somewhat counterintuitively--embellish the case for getting rid of debt altogether, provided you have the wherewithal to do so, have safe (read: low-returning) assets in your investment portfolio, and don’t need the liquidity of those assets. As with the Social Security claiming decision, the return on “investment” that comes along with mortgage paydown is guaranteed. Thus, the only valid point of comparison for mortgage paydown is other safe assets.
Tax considerations are in the mix, too. You receive tax breaks for contributing to tax-sheltered accounts like IRAs, which enhance the take-home returns of investing in those vehicles and in turn the case for putting money into them instead of retiring debt. If you're a property owner, you may also receive a tax break on your mortgage interest. In the past that was a greater argument for holding a mortgage than is the case today, however, in that most taxpayers use the standard deduction rather than itemizing. (Mortgage interest is a type of itemized deduction.)
Of course, it’s worth noting that the calculus completely depends on whether you actually need “safe” investments at all--whether cash, bonds, or a paid-down/retired mortgage. For younger investors who have long time horizons and little need for bond and cash holdings in their accounts, the case for mortgage paydown or other safe investments is weaker. But for people getting close to retirement whose alternative is shoveling more money into safe assets, the case for mortgage paydown is stronger. That’s because they’d be hard-pressed to exceed their mortgage interest rate with safe portfolio assets.
Finally, the investor’s need for liquidity and peace of mind are in the mix, too. Needless to say, paying down the mortgage won’t make sense if there's a chance you might need those assets an time soon; once the money is in your house, you can’t draw it out with the same ease that you can from a bank account or short-term bond fund.
Additionally, different people derive peace of mind from different decisions: Some might take comfort in a paid-off home, while others might be fine carrying a mortgage at a low interest rate if it means that they have a plump savings account.
Withdrawal Rates: Lower Is Better
Finally, one rather sobering aspect of today’s low bond yields is what it means for portfolio returns and in turn withdrawal rates for people who are retired or getting ready to. Retirement researcher Wade Pfau made this case succinctly in the most recent installment of The Long View podcast that I co-host with my colleague Jeff Ptak: “[E]ffectively, future bond returns are going to be very close to today's bond yields. And that means spending from bonds is going to be lower mathematically. And for the 4% rule, it's just based on U.S. historical data, where we've never seen interest rates this low. The one time we saw, for example, the 10-year Treasury yield fall below 2% was just very briefly in the early 1940s.”
Pfau went on to say that in previous periods of low bond yields, equities “rescued” retirees’ plans and made withdrawal rates of 4% or even higher successful. But given not-cheap equity valuations, that may not necessarily be the case for new retirees today. The constraints on withdrawal rate sustainability for new retirees argue for adopting a flexible withdrawal system (especially taking less in weak markets) and maximizing other lifetime sources of income like Social Security, as discussed above.