Ultra-Low Interest Rates: The Elephant in the Room
“Got $1 million? That’s what it takes to retire nicely in Orange County” was the title of an article in the 2/21/2016 Orange County Register. Citing data from the U.S. Government Accountability Office analysis of the 2013 Survey of Consumer Finances, the author (Teri Sforza) notes that the majority (52%) of Americans older than 55 have no retirement savings at all. Among the 48% with savings, the median value is about $150,000. This means that 76% either have no savings or have less than $150,000. In fairness, a good number of these people are covered by a defined benefit pension plan, but the majority of those do not provide inflation protection.
One of the most vexing decisions in creating a financial plan is choosing an estimated future rate of return. While our first temptation may be to look at historical returns and use those as a proxy for future returns (and many advisors do this), it is our strong belief that this approach will result in overly optimistic projections and potential under-saving for retirement. At Clarity, we would rather err on the side of caution, so our projected future returns accept the reality of the very low interest rates we have had since 2008. And yes, future equity returns will almost certainly be affected. To say otherwise is to assume that the risk premium enjoyed by equity investors will be far higher than its historical average, and there is no reason to make this assumption. Please note that this does not mean that we won’t have great years for stocks, as we did in 2013.
Just how much lower can interest rates go? In Japan and much of Europe they are now negative, and Fed Chair Janet Yellen does not rule out this possibility for the U.S. As an actuary for 18 years, I modeled insurance cash flows under different interest rate scenarios, and my colleagues and I never anticipated rates getting as low as they are today and would have laughed at even the suggestion of negative rates, yet here we are! It’s not just the governments that can charge investors for the privilege of owning their bonds. European firms are now able to borrow at subzero rates, according to a front-page article in the Wall Street Journal of 9/7/2016. As of Sept. 5, over 30% of the entire Eurozone investment-grade corporate bond market traded at negative yields. This includes companies like BP, which taught us the meaning of company-specific risk with the Deepwater Horizon oil spill in 2010.
Yes, we know it is still possible for investors in negative-yielding bonds to get a positive real return (assuming negative inflation, i.e. deflation) or they can even get a positive nominal return if interest rates become even more negative. Also, American investors in foreign negative-yielding bonds can get a positive return, depending on a number of factors such as currency movements and hedging decisions. However, in the end, there is no hiding from the fact that if bond investors around the world have accepted a very low return for the next few decades, it is foolhardy to assume that equity investors will get returns commensurate with long-term historical averages.
So, how to get to $1 million in a world of lower returns? Well without being too much of a Captain Obvious, we will all have to save more and keep a very close eye on costs, including annual costs paid to investment advisors. While some of us might reach for more yield in bonds or even shift from bonds to high-dividend stocks, we cannot lose sight of the fact that higher yield entails higher risk. If you need assistance in setting a savings goal, you may want to check out Clarity’s Financial Calculators. On the “Becoming a Millionaire” calculator, we ran a 55-year-old with $150,000 of savings who wants to have $1,000,000 by age 67. With an assumed rate of return of 8%, the required annual savings would be about $28,000 (indexed for 2% inflation). If we bump that down to a more realistic 5%, the required annual savings jumps to $40,000. Quite a difference! If you would like to learn more about Clarity’s approach to saving and investing for retirement, please call us at 800-345-4635 or e-mail us at firstname.lastname@example.org.