The Low Interest Rate Environment

Historic investment returns are often used when stress testing a retirement income plan. This is despite prominent names within the asset management industry continuing to forecast considerably lower returns for the foreseeable future. The capital markets table below includes two sets of 10-to15-year capital market assumptions from JP Morgan and Vanguard and compares this to the longterm historic average for global equity, fixed interest and a 60/40 portfolio.

When looking at the attractiveness of an ARF through the lens of historic market returns it’s not difficult to see why it has become the default solution. Using the example of a 60/40 portfolio has generated an average return of 6.46% over the last 22 years. The problem is these returns represent a set of economic conditions that no longer apply today.

One aspect of today’s investing landscape that historic market returns underplay is the impact of low interest rates. Traditionally the role of fixed income within portfolios has been to dampen volatility and provide protection during periods of market stress. This protection is provided by yields falling and prices rising. The problem with this is that with yields already at very low levels, they don’t have far to fall, so the protection they offer is limited. As the chart illustrates, with yields at current levels it’s difficult to see how fixed income will generate the kind of returns that some clients will likely need to support their retirement expenditure over a 25-to-35-year planning horizon.

This creates a significant planning challenge. Within the context of retirement planning many clients would benefit from reducing their exposure to the low yielding, low risk assets but are constrained by their risk tolerance.

Inflation

Once we adjust for taxes and the cost of living, this strategy has fallen somewhere between a bad and catastrophic result for many people. In retirement we need a consistent real cash flow of income that not only meets our minimum day to day needs but also ensures that the income maintains its value in real terms allowing for the effects of increases in the cost of living so that we can maintain our standard of living throughout our retirement however long we might live.

Most of us might not expect to get richer in retirement, but we certainly shouldn't expect to get poorer each year.

However, if you design your portfolio based on trying to avoid the risk of short-term losses, that's exactly what is going to happen - a gradual year on year creeping loss of spending power which may be so small as to be imperceptible from one year to the next.

Graph of Consumer Price Inflation in Ireland since 1977

Source: inflation.eu

We can see that currently inflation is well above the trend of the last few decades and at levels not seen since the 1980s. Inflation isn't a risk for those in retirement, it's a statistical certainty.

Longevity Risk

Another significant risk for those in retirement is longevity risk. There is no “best before date” on your birth certificate.

In Numerous studies 4, retirees have been shown to underestimate their life expectancy and this should be taken into account when considering your retirement options.

In one such study, although some retirees did correctly identify average life expectancy at age 65 as around 17 years for men and 20 years for women, far too few appreciate that this means that half of them will live beyond these projections.

Life expectancy is also on average higher for those retired with benefits from an employer-sponsored pension plan.

4 For example: 2005 Risks and Process of Retirement Survey SOA UP 1994

Where you live can also influence your life expectancy. For example, if you take the tube from Westminster in London towards the East End of London, life expectancy declines on average by a year for every station you pass5

Today

9%

Source: UK Office of National Statistics

Source: UK Office of National Statistics

The investment decisions that we make are always about making trade-offs. The notion that capital security is always the most significant priority for all retirees can lead to catastrophic outcomes, in terms of both the income available during retirement and also the prospective legacies for beneficiaries.

We believe that the prudent approach for retirees is to seek to strike a balance between their personal income requirements and their desire to preserve their capital.

A practical example of how capital and income are really two ends of a spectrum can be seen in the fixed interest or bond market. When investing in bonds, if interest rates go up you feel better off due to increasing income payments, when in fact the capital value of your portfolio is going down. When interest rates go down, you will feel worse off; although the capital value of your portfolio value is going up.

In this example, falling interest rates make you worse off and your heirs better off and vice versa.

5 Source: UK Office of National Statistics