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Financial Insights

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Low Interest Rates Squeeze Guaranteed Incomes

1 January, 2016

When it comes to interest earnings on savings deposits, there hasn’t been much difference between your local bank and your mattress. In September 2015, the posted rate online from a national bank for a basic savings account was 0.1 percent. Incentives for new accounts, higher balances, and longer holding periods bump the rate a bit, but even the best offers for short-term, FDIC-insured accounts rarely exceed 1.5 percent.

This extended period of low interest rates has severely challenged some long-standing retirement planning conventions. Robert Powell, author of the newsletter Retirement Weekly, explained the problem in an April 11, 2011, New York Times article:

(R)ight now, we’re in a negative real interest rate period, and many Americans, especially older Americans, who can’t afford to lose money in the market and who must also keep pace with inflation, are being penalized for saving.

And that means the era of safe investing is over for that class of investors, at least for the foreseeable future. They either have to take on greater risk with their investments or fail to keep pace with the cost of living.

And the only good news is that this cycle won’t last forever. The bad news though is that we don’t know how long it will last.

That was 2011, and Powell was right about the bad news; now it’s 2015 and historically low interest rates are still with us. But is taking on greater risk the only recourse for retirees who want a secure income? Maybe not.

The lament of low interest rates, & the annuity answer 

It’s easy to see how low interest rates can hobble retirement strategies predicated on income from safe, interest-bearing accounts. Suppose a retiree projects an average annual rate of return of 4% from low-risk investments; on a million dollar account, that’s $40,000 in annual income. Annual interest rates will certainly fluctuate, but as long as they remain around 4%, there is a reasonable expectation of steady future income. If interest rates are a bit higher, the extra can be added to the principal to make up for years when returns might be a bit lower. As long as rates don’t drop too low for too long, the numbers work.

But when interest rates run significantly below historical averages for extended periods, these projections fall apart. At 1%, annual income is reduced to $10,000 a year. If a retiree’s living expenses are based on receiving $40,000 each year, they face a no-win dilemma: live on less income, or consume significant principal to maintain the current standard of living, leaving less to generate interest in future years.

Since consuming principal creates a downward spiral for future income, many retirees feel compelled to take greater investment risks. But perhaps these risk-averse retirees should consider buying an annuity1. Insurance companies can match or exceed historical benchmarks for guaranteed incomes2 from low-risk investments, even in extended periods of low interest rates, because they pool the resources of many retirees to deliver incomes based not just on today’s rates, but on returns from conservative, diversified, long-term portfolios. They not only invest with a longer time horizon, but also have reserves to smooth out interest-rate fluctuations. In true insurance fashion, each retiree becomes part of a larger group of income recipients, thus minimizing or eliminating many of the individual challenges to deriving a steady income.

Consider this: Based on September 2015 quotes from several highly-rated insurance companies, a 65-year-old male could secure $40,000 in guaranteed annual income for the rest of his life for about $630,000. And this is for a contract specifying that should the annuitant die before receiving 20 years of income, annual payments of $40,000 will be paid to a designated beneficiary until the end of the 20-year period, a total of $800,000.

A lifetime annuity is not really an interest-bearing investment, but a guaranteed drawdown of principal and interest, with a promise to continue payments as long as the annuitant lives. So it’s hard to say that the above example is an apples-to-apples comparison. Still: on one hand, there’s trying to squeeze $40,000 each year from $1 million, knowing the ongoing challenges of fluctuations and potential exhaustion of principal. On the other, there’s paying an insurance company $630,000 to provide a guaranteed annual income of $40,000 for life – with $370,000 left for other investments. These numbers don’t prove annuities are the better option, but they should prompt retirees to take a closer look at these insurance products, and see if they might benefit from including them in their retirement plans.

As the next generation of American workers approaches retirement, fewer will have employer-sponsored pensions to provide a guaranteed income stream. Instead, they will be personally responsible for devising plans and selecting financial products to deliver a monthly check to their bank accounts. If safe, steady income is a primary retirement objective, it may be desirable to pay an insurance company to do the job.

For those either already retired or on the cusp, a few closing thoughts:

  • How hard will your money have to work this year to provide an acceptable guaranteed retirement income?  
  • How comfortable are you with the ongoing decision-making responsibility for selecting the investments to maintain this income?

If you don’t have good answers for those two questions, it might be worthwhile to find out if an annuity can be part of the solution.