"To be too certain of anything is the beginning of bigotry." -- Novelist Abdulrazak Gurnah

Sunday, October 5, 2014

Do Low Interest Rates Cut Your Income?

     Honestly, a lot of my friends (not to mention B) are sick of me bellyaching about low interest rates. But as many of you know, while low interest rates are a boon to 20-somethings who want to buy a house -- if only 20-somethings wanted to buy a house -- they make life difficult, and often poorer, for those of us who are retired.

     Why? Because you can no longer go to the bank, deposit your savings in a CD, and get 5.0% interest, which might provide some decent income in retirement. Instead, you buy a CD (as I did last week) and you get 0.15% interest.

     So, for my $5,000 CD I will receive $7.50 in interest for the year. Not a lot to live on.

     But low interest rates don't just affect those of us who want to keep our retirement savings in a safe, secure, federally insured bank deposit. They mean less income for retirees who buy an annuity, less income for retirees who sign up for a reverse mortgage. And they certainly bring less income for people invested in bonds or a bond mutual fund . . . while exposing them to a lot of risk.

     My problem is that I don't know what to do about it -- other than to bellyache. Or, as the Journal of Financial Planning says much more eloquently, "Turning [someone's] wealth that has been accumulated over a lifetime into a sustainable paycheck throughout retirement is one of the most important investment challenges for retirees . . . "

     All I can say is, amen to that. Especially if you don't have a lot of wealth.

     So I decided to turn to my friend, and financial guru, Jeremy Kisner of Surevest Wealth Management in Phoenix, AZ, to get some insight about interest rates. (He previously gave us some good info. on the question Is Long-Term-Care Insurance for You?).

     He explains things quite well, and may even make us more financially secure:

      Low interest rates have plagued fixed income investors for the past several years. Each year, analysts predict that rates will go up, and then ... they stay low or decline even further. Many consumers see this when they walk into a bank and are offered virtually zero interest on their savings and checking accounts.

     Coincidentally, banks just announced near record quarterly profits. Apparently, charging 4.5% on loans and paying 0% on deposits is profitable. However, banks don't really set interest rates. Rates are set by the demand for Treasury bonds from investors (many of them from other countries) and somewhat influenced by the Federal Reserve. It seems that investors will continue to buy bonds regardless of their yield. See graph below:

     If you think it is bad in the U. S., where the ten-year government bond is yielding around 2.4%, do not look over to Europe. Earlier this month, the yield on the ten-year German bond fell below 1.0%, and even economically challenged Spain borrows ten-year money at 2.1%.

     You might be thinking, "Okay, interest rates are low, but what's your point?" I have a few:

     1.  There is real risk in the bond market. Prices move in the opposite direction of interest rates. This has been good for bond investors over the past 30 years, but is likely to go the other way sometime soon. It feels similar to the bubble that formed in residential real estate in the mid-2000s, which was overvalued for about three years before the market finally crashed.

     2.  Never design your investment plan looking in the rearview mirror. Many investors stick with a 40 - 60% allocation to U. S. government or investment grade corporate bonds just because that is what worked in the past. Today, you might want to diversify the bond portion of your portfolio by using other assets that have an equal or higher yield and also have the potential to appreciate. Some examples are: Real Estate Investment Trusts (average yield 3.25%); Oil and Gas Pipelines (ave. yield 6.0%); Covered Call Strategies (ave. yield 6.0%).

     All these asset classes can be purchased easily through ETF's, which are fully liquid and trade just like stocks. However, some may present more complicated tax issues, and different risk profiles, so it's best to consult a financial adviser before jumping into these more sophisticated issues.

     Finally, you can also think globally with your bond allocation -- not to Germany or Spain, but to emerging market debt which has an average yield of 4.4%. Are these markets more risky? Maybe. But many of these countries run budget surpluses, rather than deficits like the U. S., which suggests that they will gain economic strength as time goes on.

     3.  A retiree's income portfolio should always be designed with a total return objective -- as opposed to building it for yield with a "live off the interest and don't touch the principal" strategy. In other words, if someone has, say, a $1 million portfolio, and needs $50,000 per year, many people will buy bonds and other investments with yields of 5% or higher.

     But this can be very dangerous, especially in these days of low interest rates, as many high-yielding investments can be more volatile. You are better off designing a portfolio where you expect a total return of 6 - 7%, but the yield from dividends and interest may only be 3%. This means that you will need to sell some investments and re-balance periodically. There will be years when your portfolio will decline in value and you will be using some of your principal. However, there will also be years when your returns are higher than your long-term average.

     This may seem uncomfortable, but it is likely to give you a higher probability of not outliving your money. And if it makes you more comfortable, this strategy was validated once again by research published in this month's issue of the Journal of Financial Planning.

     4. Your short-term emergency fund money still belongs in the bank -- regardless of any other decisions about your investments, or long-term plans for retirement income, and despite the low interest rates currently being offered. You don't want to incur any risk with the money you need to live on over the next few years. But long-term money should find a better place.



DJan said...

When I retired, we put all our retirement funds into annuities, but we split them three ways: guaranteed (with no growth), global equities, and real estate. We lost a lot during the recession, but it's gradually coming back up. I can only move our money between different pots. It seems to be working. So far. :-)

Douglas said...

Excellent analysis! My current investment strategy is "hunker down." That is, my 401K is pretty much all bonds (which I was criticized for doing around 2002 but which turned out to be "smart" in 2008), I saw the bubble. I took advantage of the housing bubble to grab some equity while also moving to a lower housing cost (and cost-of-living) area.

Your best advice, in my opinion, is "Never design your investment plan looking in the rearview mirror." Something we all too often do and something the financial industry encourages with reports of how some fund or investment has done in the past... all the while disclaiming that very thing.
My advice is to listen to the financial advisors and then consider (strongly) doing the opposite.

Douglas said...

By the way, that 401K is providing me with a 2.5% return annually and will rise with interest rate hikes... which are coming.

Anonymous said...

I am at the lower end icome-wise so don't have a portfolio to speak of. I put part of my savings into an annuity when I retired, and have the rest in IRAs. I don't know if that's good or bad, and don't care anymore. We still have a mortgage, which I appreciate at tax time when I can write off the interest. We will probably never opt for a reverse mortgage, but when we refinanced our house a year or so ago, I was pleased with the low interest rate.

I have much more concern for the youngsters who cannot afford to buy a home. Making an hourly salary is tough.
At least my granddaughters don't have debt for their undergraduate years. I bought VEP plans for each of my them, and help them out with cash from time to time.

David and I have always been frugal. As they used to say, we can turn around on a dime and make change...well I can. David is working on it. Ha ha.

stephen Hayes said...

My mother has an account with a hundred thousand dollars in it and it's been locked in at 5% for ten years. She just received notice that it will be rolled over into another account at .35 percent interest. She's searching for a better place to place this money but no one is providing decent interest anymore. She'd might as well put her money in a coffee can under her bed.

Olga said...

I watched my aunt micromanage her investments and end up with nothing. My mother trusted her broker and had a nice nest egg. I force myself to look at my statements and find a few intelligent things to say when i meet with financial advisors. I have a year's living expenses in the bank and I would go beserk with worry if it fell below the magic number, but right now I actually have more than a year's worth so I am guilty of harboring lazy money. I suppose I better get off my duff and do something about that.

Linda Myers said...

We've had a financial advisor for years and generally take her advice. We're lucky to have pensions and an inheritance. Need to move some money from investments into the bank soon.

Thanks for the post!

Kirk said...

I had a fair amount in municipal bonds until a year or so ago; then I switched those into some MLPs that are yielding about 4.5% tax free. The rest of my investments are all in stocks, as they have been for 40+ years. I do have a lot of diversification there and can afford to ride swings up and down - just takes a strong stomach.

Pam said...

Good post, Tom. Financial planning has become such a challenge, but when you think about it, it's always been challenging because of the unknowns. Those "unknowns" have always haunted people. I watched my parents work hard, save diligently, and spend sparingly. They remembered the Depression Era and that affected their choices, greatly. Looking back,the single most impacting decision they made was to stay optimistic. Their faith in God kept them focused and stable throughout their lives. They were humble, uneducated, blue collar workers who practiced the Golden Rule. They believed in working hard, spending less than you earn, saving some, and sharing the rest. When serious illness rocked their lives, they held onto their faith in God, each other, and their friends. They're both gone now, but they won the financial war and left us with much. I'd be a liar if I didn't admit the financial gain was greatly appreciated, but their most valuable gift to me was the way in which they lived and loved.

Anonymous said...

Tom, last I looked many banks are paying upwards of 1.5% if you leave your money in the bank for at least 5 years. State Farm is paying 2.5%. If you need the money, perhaps you should open a ROTH IRA CD in the bank and withdraw the money without penalty when needed (you are above 59.5 yrs old?)
Some of the banks run sales, as in: if you sign up during a certain time period they will up the interest!
Do not despair. There are 'bargains' out there. You just have to look.
In any event, it still is difficult to live off the interest. That is why a part time job on the side (as in writing for a living) provides that extra needed income.

Kathy @ SMART Living 365.com said...

Hi Tom! My husband and I are both semi-retired and still bringing in income. However, our best retirement investment strategy has been real estate. We own two rental properties (1 commercial and 1 residential) that are both free and clear along with our home. And we also invested our 401K in real estate LLC partnerships (and have for the last 5-7 years). There ARE investment groups out there that can help raise the dismal returns offered by savings and cash but you have to seek them out. We average about 8% per year. Because both of our background is real estate, this is a natural to us. Unfortunately we've NEVER found a financial consultant who knew much of anything about real estate in a way that could suggest the many benefits we've gotten. I would strongly recommend that others educate themselves about what is available.

Anonymous said...

Geez when I read your e-mails from readers I feel very very poor..We lost both sets of parents young and I mean young I was 6 years old, dad took to drinking and we were in the system of foster care a hell on earth in Oregon, I went to college then my grandma died just
before I graduated but I did graduate..My hubs dad never was a husband or father he was the oldest of nearly 9 kids I say nearly one passed right after he was born, no one to work and feed the kids my hubs was the designated person to do so..We married over 40 years I saved like hell, he did to, one child she got a big scholarship money for college yet we kept it in a trust she never got it until her 30th birthday and she still has it..We do the very best we can but we nave never had much money, love and affection, and a child who is an adult most would give their life to have as a daughter..We travel when we can to a beach with childhood friends a tiny cabin we have a blast, but as for investments and this and that my hubs has put as much as we could away, he is fully retired I work 3 days and volunteer 4 days and my hubs volunteers 5 days..It is all relative, one can only do so much with what one is blessed to save, if you are not wealthy in this great country one is truly at the mercy of everything, we don't worry much about that! Life is to be enjoyed with love and affection and peace and joy, all the money in the world doesn't seem to make those billionaires in our country too happy and the movie stars and others who have tons of the dough seem to be pretty damn miserable, I speak of this cause our only works in the film industry and tells us plenty, no thank you bob! ciao!

Dick Klade said...

Tom, you could have gotten an absolutely safe return much better than 0.15 percent with your $5,000 and kept your money relatively liquid by laddering it into five CDs. Financial advisers don't like to talk about laddering, because when people who are ultra-conservative about their money do it they don't need advisers.

To ladder your five grand, you would select a credit union or bank paying 2 percent or more on a 5-year CD (there are lots of them). Then put $1,000 into a one-year CD, $1,000 into a two-year, $1,000 into a three-year, $1,000 into a four-year, and $1,000 into a five-year.

When your one-year CD matures, put it into another five-year. Continue the process, either reinvesting the interest or drawing it off to use as you choose each year.

Although we're creeping steadily downward from 5 percent total returns because of the great recession, as rates rise in the future we expect to steadily creep back up. Laddering has a cushioning effect when interest rates rise and fall.

Darkseas said...


I found your last point, on emergency funds, to be very unhelpful advice. Thinking that I had perhaps missed your earlier thoughts about emergency funds (I've only been reading for a year or so), I used Google's advanced search to see what you had previously said. Apparently you've said nothing prior to this post. If I'm wrong, you might want to implement your own search function on your site.

You haven't said how much should be in an emergency fund, though you appear to imply that it should be "the money you need to live on over the next few years." If we take "few" to mean three and "the money you need to live on" to be anywhere from $25K to $75K per year, we're talking about a substantial sum of money sitting around in the bank earning in interest, as you correctly point out, chump change. Depending on what values people set to "a few" and "money needed," we could be talking about over half of a retiree's savings.

The key to dealing with a financial emergency is having liquid financial assets. Yes, a bank account is highly liquid. You withdraw cash or write a check and there's the money. But any respectable brokerage account also allows the owner to write a check (and often withdraw cash). Most of the assets in such an account, stocks, ETFs, mutual funds, and to a lesser extent bonds, can easily be sold on the next working day to back up the check.

Even liquidity can be over-rated. Anyone with a credit card has instant access to liquidity up to the limit of the card with roughly 30 days to come up with the money before interest rates kick in. If you had laddered CDs, as another reader suggests, those 30 days would give you time to unwind the CD positions, albeit at a big hit to interest earned.

So if you're going to stick with your recommendation about putting an emergency fund in a bank where it will earn almost nothing, I think you have to explain in quite a lot more depth about the nature of the emergencies that the fund is established for, the amount of money that needs to be in it, and why other alternative places to keep the funds wouldn't be appropriate.

I'm looking forward to your thoughts along those lines.