- Doug Oosterhart, CFP®
Low Interest Rates: Great for Borrowers, Bad for Retirees - Why You Should Care
Have you noticed how low mortgage rates are? I'll bet you have - some lenders are backed up on refinancing loans by as much as three months. Getting your mortgage for 3% or lower allows the borrower to buy a more expensive home. A principal and interest (P&I) payment for a $300,000 home at 5% is about $1,610 per month on a 30-year loan. What about 3%? It's only $1,264 per month.
With a 2% decrease in the borrower's rate (using the case above), they could get a $400,000 home at 3% for roughly the same payment as a $300,000 home at 5%.
There are a couple of takeaways from this:
If you haven't looked at home refinance in a while, you might want to.
Sure, rates are great for borrowers, but who do they hurt and/or affect? Answer: Retirees.
Retiring in a low-interest-rate environment.
The classic portfolio that a retiree has been told to have in retirement is allocated 60/40 - that means 60% stocks and 40% bonds. The thought with a 60/40 portfolio is that you'll earn enough return to take out 4% of your portfolio per year, every year in retirement, and never touch your principal. The portfolio will also be less volatile (in theory) than the overall stock market because bonds tend to be less volatile. Sounds great, right?
The issue is that the bond market has been in a 40+ year bull market. Meaning that over the past 40 years, they have been a great safe haven for investors, historically. But what about now and into the future? With interest rates being so low, investors that counted on a 4-6% yield on their bonds are getting less than 0.75% yield on a 10-year treasury note. What does that even mean? It means that a $100,000 investment that yielded $4-6,000 per year now yields $750 per year. We're talking about yielding less than inflation, which can destroy an investor's portfolio over time - especially if they have 40% of their portfolio allocated toward bonds.
So what can investors do if they're retiring in the next few years?
Let's start with the one's that people won't like -
Spend less in retirement
Those aren't very fun to think about, but they're often the variables that affect the plan's success rate the most. If you work an extra three years, and also spend $8,000 per month in retirement instead of $10,000 per month, the plan's success rate changes dramatically.
On the other side of the coin, imagine if you retired early, spent 6% of your portfolio annually (instead of 3.5-4%), and felt like you had to invest more conservatively (meaning more bonds) because you are fearful of running out of money? That's a triple whammy and recipe for disaster.
What are some other options?
Did you know - Apple stock is yielding roughly the same percentage (.68%) as the 10-year treasury (0.75%)? Although Apple is more volatile than a government bond, it's also returned 35% on average over the past 5 years. I wouldn't argue that Apple is even a dividend stock - that's how low interest rates are! What are the pros and cons of holding dividend stocks are a bond replacement?
Pros: potential for higher yield; the potential for higher returns.
Cons: not very tax efficient in a taxable account; more volatility (SPYD, the SPDR Dividend ETF is down 26% this year, but yields 5.46%).
Talk about a controversial strategy. People tend to be pretty opinionated on annuities. I take the approach that all strategies are around for a reason and those strategies fit in *some* cases for *some* investors.
Pros: a guaranteed income stream that can increase with inflation (great for people that want to take a portion of their assets and "buy a pension" with those assets that they will get for life); peace of mind that you will get a payout every month/year for as long as you live.
Cons: sometimes they can be illiquid, have high fees, surrender charges, and be complex to the investor.
I did a post about Innovator's hedged ETF strategies back in September 2020 that briefly explained this strategy. Basically, the investor buys an ETF that is based on an index (like the S&P 500). The ETF manager then uses an options strategy that buffers your downside and caps your upside as an investor.
For example: one of their offerings buffers your downside at 15%. Let's say you buy the November ETF on November 2nd, 2020 (it's an ETF that resets after 365 days - so 10/31/2021). If the market finishes down 15% on 10/31/2021, the investor would be down 0%. If the market is down 17% on that date, the investor is down 2% (17%-15%). On the other hand, the growth is capped as well. We don't know the exact cap yet, but let's say it's 10%. In this case, if the market goes up 10% over the next year, the investor is up about the same. However, if the market goes up 20% in the next year, the investor's growth is capped at "only" 10%.
Pros: allows for some protection should the market go down; good for those on the cusp of retirement that don't want to take a large loss right before they retire; good for those that think the market has a bearish outlook.
Cons: can be confusing at first and especially if you are a DIY investor; if the index is down and you sell before the 365-day reset is over, you take the loss; if the market has massive gains, you'd lose out on them.
However you look at it and whichever strategy you choose, low-interest rates are definitely something to think about and be aware of. Have a plan.