Will Low Interest Rates And Longer Lives Reduce Living Standards In Retirement? Not Likely

Summary

• The prevalence of low inflation helps to offset the negative effects of low bond yields.
• Adaptive distribution strategies will help retirees enjoy a higher living standard.
• Conventional wisdom about asset allocation for seniors needs to be revisited.
• Retiree spending declines with age.

Interest rates throughout the developed world have remained at historically low levels for seven years. Today, the US aggregate bond index offers a prospective yield of 2.4%, well below its long-term average. The Fed's accommodative monetary policy has rattled older investors, as they rely heavily on bond interest in their retirement years.

Americans are living considerably longer today. The average 65-year old lives almost three years longer than his counterpart from 1993. If life insurance companies and pension administrators are changing their assumptions based on mortality shifts, shouldn't individuals do the same?

Persistent low bond yields and long lives do complicate matters once a person stops working. However, there are some reasonable measures investors can take to maximize the value of their accumulated wealth. We'll examine some of recent research on retirement outcomes in this article. Not all the news is bad.

Conventional Retirement Distribution Rules

Financial planners have been trying to estimate sustainable retirement income levels for some time. One of the earliest practitioners to write substantively on the topic was William Bengen. His key paper appeared 20 years ago in the Journal of Financial Planning. He inferred the survivability of various withdrawal rates based on historical asset returns for a balanced portfolio of 50% stocks and 50% bonds.

Bengen concluded that a 4% initial portfolio drawdown could be taken in year one and adjusted upward for inflation thereafter. Such a strategy preserved wealth for each rolling 30-year period starting in 1926. A 30-year retirement takes the individual to age 95, which was plenty old to readers in the 1990s. While Bengen's paper never made mention of a 4% rule, later interpretation of his findings gave rise to the convention that 4% was the largest safe withdrawal rate with a balanced portfolio. The term "4% rule" was born.

The New Math

Recent practitioner research in this same area has raised doubts about the 4% rule. Wade Pfau and Wade Dokken have published a paper that suggests sustainable distribution rates should be closer to 2%. They, and other researchers, point to the stubborn low interest rates as a valid reason to reduce income expectations.

Pfau and Dokken have also underscored the necessity to model retirement incomes for periods in excess of 30 years. The Society of Actuaries says that there is a 43% chance today that at least one spouse survives past age 95. This is a substantial improvement over the last 20 years.

Low interest rates do matter. And good research supports the notion that the best estimate of future return of bonds in the intermediate term (5-10 years) is the initial yield at which they are purchased. Thus, the expected 10-year return of a diversified high-quality US bond portfolio is about 2.4% It may therefore be appropriate to revise expected returns downward to reflect diminished yields.

The good news is that low bond yields are typically associated with low inflation. The developed world has wrestled with stagnant price levels since the subprime crisis. America's average inflation rate has been about 1.3%, below the Fed's modest target rate of 2.0%.

Not only has the historical inflation rate been low, but market-based expectations of inflation have been muted as well. Today's Treasury yield curve and the associated TIPs real yield curve imply an expected inflation rate of 1.6% over the next 10 years! While flat or falling prices may be bad for an economy as a whole, they are very helpful for retirement outcomes.

Most retirement planning scenarios assume an initial distribution amount, which thereafter increases with the price level. Strong price increases early in the retirement cycle sabotage the planned amortization of the nest egg. Bill Bengen's 2012 article has a nice discussion on the topic. In fact, inflation experience is about the most critical variable in the simulation process. It is associated with bond price declines and, of course, outsized retiree distributions. Both of these phenomena are injurious to a retiree's financial health.

Longer life spans also complicate the retirement planning problem. Most retirement scenarios, however, are systematically flawed in that they almost universally assume that distributions increase throughout the life cycle. The data doesn't support this notion.

After a certain point, people just stop traveling and become less active. Non-health related expenditures decline in real terms. Recent research from J.P. Morgan indicates that retirees reduce spending in real terms by 20-30% as they age from 65 to 85. In a 2005 FPA journal article, financial planner Ty Bernicke argued that Department of Labor surveys pointed to a consistent spending decline in later years as well.

Spending pressures in retirement are almost certainly not as intense as traditional modeling indicates. Good planning should control for healthcare requirements once the couple stops working. Beyond that, it is reasonable to project distributions that decline in constant dollar terms.

Don't Sit Still

The asset allocations modeled by Pfau and Dokken were static over time. Yet, there are compelling reasons to believe that dynamic asset allocation in one's later years can improve retirement outcomes.

Risky assets play a constructive role both before and after retirement. Most conventional retirement planning strategy holds that investment portfolios should gradually reduce risk as the investor ages. Many rules of thumb suggest that one's allocation to bonds should increase over time. A declining investment horizon traditionally calls for a greater weighting to lower-risk bonds at the expense of stocks. An example "rule" states that individuals should hold a percentage of stocks equal to 100 minus their age. So, for a typical 60-year-old, 40% of the portfolio should be in equities.

More recent simulations of the retirement planning problem have taken issue with the strategy of gradual portfolio risk reduction. Wade Pfau and Michael Kitces found that the objectives of retirement saving are best met when portfolio risks are minimized at the time of retirement. This is the point of greatest financial vulnerability, and should be accompanied by a correspondingly low-risk portfolio.

When work stops at or about age 65, the investor's human capital is exhausted, while their remaining investment horizon remains long. An analysis of retirement investment paths reveals one of the common attributes of "unsuccessful" scenarios is poor real portfolio returns early in the individual's retired life. Makes sense. After all, very few octogenarians have been financially derailed by a bad stock market. By that point, most of their consumption is behind them.

So, what is the magnitude of improvement? Pfau and Kitces ran lots of simulations. The benefits are small, but helpful. Typically, a sustainable initial distribution rate (one with a 90% chance of success) might increase by 0.1% or 0.2%. Moreover, the portfolio shortfall is a little bit smaller for those scenarios that do fail.

We've already mentioned that retirement distributions are smaller than simple inflation adjustment would suggest. Distributions can also be smarter. Spending levels can be adapted to changes in mortality and portfolio performance.

Corey Hoffstein reviewed some dynamic distribution strategies in a recent Financial Advisor article. He simulated some of these innovations and compared them to the standard inflation-adjusted withdrawal schemes commonly referenced in the literature.

The results argued persuasively for the superiority of adaptation.

Hoffstein evaluated various withdrawal strategies against $1 million in assets over a 30-year time horizon. Three measures were compiled: probability of failure, present value of surplus, and present value of withdrawals.

Any withdrawal scenario that exhausts the initial endowment of $1 million was considered a failure. Clearly, the lower this probability, the better the strategy. The present value of surplus was a computation of the average residual value of the portfolio at the end of 30 years. Generally, the goal is to minimize the value of "leftover" assets. At the same time, anyone's reasonable objective is to maximize the present value of their actual lifetime withdrawals. That last measure should be as high as possible.

The baseline or control withdrawal strategy required a $40,000 distribution the first year, with subsequent withdrawals adjusted upward for inflation (Strategy A). This is similar to William Bengen's original "4% rule."

One of the many adaptations to this rule that Hoffstein reviewed was to determine the withdrawal amount based on the size of the current portfolio balance divided by the number the couple's joint life expectancy adds up to. It's simply a matter of referencing an IRS table and rounding off a fractional number. The withdrawal rate was capped at 10% of the balance (Strategy B). Such a strategy would have intuitive appeal in that it allows for larger distributions when the portfolio returns are good and pares them back during lean years.

Comparatively small shifts in spending habits can increase survivability of a portfolio, while "wasting" less of it on heirs. It's not a holy grail. Strategy B may not fail, but it may deliver inadequate resources to beleaguered seniors who experience poor portfolio returns or high inflation early in the retirement cycle.

The 4% rule is challenged by today's high capital market valuations. But there is hope. We live in a chronically low inflation environment that is a headache to central bankers, but a godsend to older folks. A compelling case can be made to take larger distributions from a portfolio during the early years of retirement. Thereafter, smart distribution strategies and more stocks should support more modest material aspirations in later life.

Putting it all Together

After all this, one might reasonably ask what a feasible retirement projection really looks like. I re-specified the typical retirement model in a manner that, hopefully, comports better with the evidence.

Capital market expectations are a key input to the model. The expected stock market returns start with the 80-year average compiled for US stocks in Dimensional Fund Advisors' Matrix Book. I subtracted 2% to reflect the (unsubstantiated) belief that future results will be poor due to high stock market valuations. The model, thus, has annual expected stock market returns of 9%. As described above, the model relies on the current aggregate bond index's yield to maturity of 2.4% as its expected bond return input.

Volatilities of asset classes should not vary much with the valuation levels of the underlying asset class. I used trailing 10-year volatilities of the Vanguard Total Stock Market Index (NYSEARCA:VTI) and the Aggregate Bond Index (NYSEARCA:AGG) to obtain the model's volatility inputs.

As the recent research recommended, the model portfolio increases its allocation to stocks as the retiree ages - 40% in stocks at retirement, shifting to 60% at age 75, and 80% beginning at age 86. Here are the expected portfolio returns and volatilities at various ages.

To model expenditures in retirement, I divided expenses into Medical and non-Medical areas. Healthcare increases with inflation, while other expenses would remain constant in nominal dollar terms. The initial medical outlay is $10,000, which is intended to cover Medicare part B premiums plus two Medicare supplement plans. Expected inflation is 2.0%, with a volatility of 1.3%.

Non-medical expenses are pegged at $27,500, so the blended rate of increase in portfolio distributions lags inflation substantially. Overall expenditures drift downward in real terms in the manner generally described by J.P. Morgan research and the Department of Labor.

The model couple is assumed to retire at age 66, and the surviving spouse dies at age 97. They have $1,000,000 at the onset of retirement. The objective of the nest egg is to fund initial expenses of $37,500, for an initial drawdown of 3.75%.

The results, produced using the Flexible Retirement Planner, are good. The nest egg has a failure rate of about 10%. Even those failed scenarios collapse late in life, suggesting that the overlay of some adaptive distribution rules could enhance the results even more.

The bottom line is that changes in capital market expectations and life expectancy do impact the retirement planning model. However, other key factors help to offset the impact. The 4% rule is not dead yet. It just needs constant "medical" attention through smart asset allocation and adaptive distributions. A steady drip of low inflation also helps.

Analyst’s Disclosure: I am/we are long VTI, AGG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.