With the Fed announcing that it will keep interest rates near zero for the next five years, your retirement may be at risk. Many current retirement plans are based on the lessons learned from decades of record-high interest rates followed by a bond bull market. With interest rates set to remain low for at least the next five years, it's time to rethink your strategy.
What's Happening to Interest Rates?
The Fed often lowers interest rates in response to economic crisis. With COVID-19 shutting down much of the economy, the Fed lowered interest rates to make it easier for businesses to obtain the capital they need to remain open while simultaneously encouraging savers to either spend more or move to riskier assets. The same thing happened following the 2008 financial crisis.
At a recent meeting, the Fed suggested that they would hold interest rates near zero for at least the next five years. In addition to predicting a longer economic recovery, the Fed is also attempting to make up for several years of below-expected inflation.
What Does This Mean for Your Portfolio?
Lower interest rates mean lower returns in the fixed income portion of your portfolio as well as lower income in retirement. Take a look at how $1 million invested in ten-year treasuries performed over time.
• 2020: 0.93% average yield, $9,300 in interest income.
• 2010: 3.22% average yield, $32,200 in interest income.
• 2000: 6.03% average yield, $60,300 in interest income.
• 1990: 8.55% average yield, $85,500 in interest income.
• 1980: 11.43% average yield, $114,300 in interest income.
• 1970: 7.35% average yield, $73,500 in interest income.
Portfolios that were generating very comfortable levels of income are now yielding below poverty levels. The good news for investors that were holding bonds as interest rates fell is that bond prices increase as rates fall. That's because an investor would rather have a 5% bond than a 1% bond unless the prices adjust so that either bond gives the investor the same return.
For every 1% drop in interest rates, bond prices typically increase 1% for every 1 year in duration of the bond. So as interest rates dropped from 1% to 0%, $1 million in bonds with a one-year duration increased 1% in value to $1.01 million. $1 million in bonds with a ten-year duration increased in value 10% to $1.1 million. The reverse happens when interest rates rise.
What Can You Do to Save Your Retirement Portfolio?
With low interest rates and the possibility of bond prices falling when interest rates go back up, there are three things you can do to make sure your retirement portfolio reaches your goals.
Increase Your Savings Rate
Your savings rate is the main determining factor in how much you will have in retirement. Saving $1,000 per year at a 5% return for 20 years will give you a retirement portfolio of $34,366.62. Saving $10,000 at the same return gives you a portfolio ten times larger at $343,666.20.
Of course, you can't always control your rate of return, and the only thing that makes up for lower returns is saving more. Here's how much you need to save per year to reach $1 million in 20 years at a given rate of return.
• 1%: $45,415.31
• 2%: $41,156.72
• 3%: $37,215.71
• 4%: $33,581.75
• 5%: $30,242.59
• 6%: $27,184.56
• 7%: $24,392.93
• 8%: $21,852.21
• 9%: $19,546.48
• 10%: $17,459.62
Increase Your Yield With Alternative Investments
Whether you're looking for higher returns to make your savings rate more manageable or to generate more income in retirement, you have several options.
• Real estate provides current cash flow and is a diversifier from the traditional stock and bond portfolio.
• Dividend stocks provide steady cash flow and often maintain more stable prices than growth stocks. Some portfolios replace part of the bond portion with dividend stocks as a potentially lower-risk way of increasing returns than simply increasing the growth stock allocation.
• Annuities are an insurance product that allow you to lock in a specific amount of future income for a fixed price.
Don't Abandon Bonds
Bonds still play a role in your portfolio even when their yields are down. Their price swings are often uncorrelated to or opposite of stock price swings, so you can use them to re-balance and buy low and sell high. You can also try to increase your returns by moving to slightly riskier bonds such as high-yield bonds and emerging market bonds that have higher interest payments.
Talk to Your Advisor
In uncertain times that require new ways of looking at saving for retirement, your advisor is here to help. We can help you build a portfolio that meets your needs now and in the future. Contact E1 Asset Management now to get started.