By holding short-term rates near zero for the past three years, the Federal Reserve has punished savers so that banks can borrow cheaply and corporations can raise enough capital to keep themselves from failing. With inflation running anywhere between 2% and 4% and short-term rates near zero, those who invest in short-term bonds or money market funds are essentially losing 2% to 4% in purchasing power every year. At a rate of 3% inflation, these savers will lose 27% of their nest egg over a 10 year period.
Using my company’s Retirement Planner application, I ran a scenario where a 55 year old couple has $400,000 saved, will retire at age 65, has annual expenses of $60,000 and invests only in a short-term money market fund returning 0.5%. Four years ago when money market funds were returning at least 5%, this couple would not have run out of money until they were 84 years old. But with returns now at 0.5%, they will run out of money when they are 76. Low short-term interest rates have reduced the amount of time this couple has to live off of their funds by 8 years. Looked at another way, if the Federal Reserve would just let rates rise to where they were in 2007, this couple could extend their retirement savings by 8 years.
Unfortunately, there is no relief in sight for those who want to invest in relatively safe short-term bonds. The Federal Reserve has already said that it intends to keep rates “exceptionally low” until at least 2013. With economic growth expected to be sluggish for the next decade, it’s a good bet rates will be very low for a long time.
So the question becomes, what can people do as they approach retirement if they want keep a substantial portion of their money in short-term bonds? Many advisers are telling their clients to increase the size of their stock holdings relative to bonds. But this goes against the strategy that many retirees have of keeping their money safe. As we have seen more than once in the past four years, the stock market is not a safe place to be, especially for retirees.
Instead of shoving more money into the stock market and praying that stocks go up, there is a better way to handle this situation; one that gives the individual the control rather than hoping and praying that the stock market rises.
I ran a scenario where this couple pushes out their retirement until age 68. This helps the situation somewhat by extending their age when funds run out to age 81 (a 5 year increase). But let’s say their goal is to not run out of money until at least age 84. What else can be done? Most retirees factor in multiple vacations and other activities that add to their annual expenses, but can be cut back. Unlike returns, expenses can be controlled by the individuals. If this couple simply cuts their annual expenses in retirement by 10% (in addition to pushing out their retirement age to 68) they will have extended the time that their money lasts until they are 84 years old. With two relatively simple steps that are completely under the control of the individual, this couple has completely changed their retirement situation and extended their funds by 8 years.
It's easier than most people think to regain control of their retirement situation. And it's much safer to change things you can control rather than depending on stock market returns coming back to where they were a decade ago.