Each week I encounter nice people with deeply flawed retirement plans. Many have been aided into misguided thinking by financial sector marketing and sales people, planners, even their accountants. This is a problem, because faulty assumptions in money management tend to end in a nightmare. Working with sober return and withdrawal expectations is the best antidote, and that means facing facts as they are rather than as we wish them to be. Appreciating that investment conditions have changed over the last 30 years is an important place to start. Here’s a recap.
Principal-secure, interest-bearing assets, with defined rates and maturity dates - bonds, bank deposit certificates and accounts - have long been acknowledged as the most appropriate place to build and hold savings for individuals. Up until the early 1990s, they were also considered prudent for the bulk of funds held in pensions, insurance companies and other essential institutions. Payouts (liabilities) were provided by prescribed contributions, and the reinvestment of income payments received (the engine of compound growth).
In the 1980s, rates on government bonds and guaranteed investment certificates (GICs) in Canada averaged more than ten percent a year. At 10% yields, one could withdraw or pay out 5% or 6% a year in retirement and still leave 5% or 4% for reinvestment and compound growth. This allowed withdrawals to rise with the cost of living and not rapidly evaporate the principal.
In the 1990s, as rates moved lower, the same deposits now averaged just over seven percent a year. At that point, one could withdraw 5% annually in retirement and have a percent or two for fees and reinvestment (growth).
In the 2001 recession, central banks slashed base rates and government bonds, and GICs fell below five percent. By 2007, heading into the great recession, rates were less than four. A decade later, in 2017, the same assets were paying less than one percent.
By 2018, interest rates managed to move higher, and investment-grade notes yielded nearly 3%, before falling over the last year to two percent and less.
Notwithstanding present yields, most pension and individual retirement plans are still assuming compound returns in the 5-7% a year range and calling their assumptions "conservative".
Wanting this dream, many have thrown safety to the wind and moved into principal-insecure equities and high-risk corporate debt (or funds and ETFs), where income may be 3 or 4% a year, and the next bear market is likely to knock 20-70% off current prices (100% should an individual issuer go bankrupt). Also, unlike interest payments that are contractually prescribed on bonds, dividends on equities can be cut at any time, when a company needs to.
This shift into high-risk assets has happened even where the owners cannot afford to lose money, nor spend years after that hoping to grow it back.
Also, those now holding risk and hoping to collect 3% or 4% a year in income are typically paying a percent or three in annual fees on these accounts (hidden and not), while still hoping to withdraw 4-6% a year in retirement. This math doesn’t follow! Rational savers cannot afford to pretend that it will.
For most individuals, a wise course is to continue controlling risk and preserving liquidity - keep doing the right thing to protect capital. Steer clear of highly overvalued equity and corporate bonds, and stick with the most secure deposits even at low rates. Reinvest income and postpone withdrawals to not start before our mid-60s where possible.
If income withdrawals are needed now, they should be no more than 2% a year in present conditions, unless you plan to erode principal. Yes, 4% and 5% withdrawals used to be possible, but as I’ve explained above, they are no longer reality. Tell your loved ones. If your advisor is still telling you that they are, find a new one.
If 5%+ income withdrawals are necessary, annuities that can guarantee such payments for life may be an option for some, but you do give up claim on the principal to buy them.
For those who can keep financially disciplined in this environment, better yields lie ahead once equity and corporate debt markets fall into the next bear market. At that point, bargains are destined to be plentiful, and risk assets investment-grade once more. But first, you need to get from here to there, very carefully.
Disclosure: No positions.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.