The Future of Retirement Income Planning

As we reflect on the conversations with clients in the last year, one question emerges as the most common among our retiring clients. Where am I going to generate my income from in retirement? Even for clients who have worked with us for years as accumulators, there are serious questions as to how things will work once they are retired. It seems that for generations, retirees have been moving their money to more conservative investments to live off the “income” and no longer put their principal at risk. This was indeed more prevalent 30 years ago when interest rates were higher, but as we will see in this discussion, it likely wasn’t the best strategy even then.

First, let’s describe the typical retirement. A couple aged 62 is actuarially determined to have a joint life expectancy of 30 years. In English, this means that on average at least one of the spouses is going to live to age 92 (emphasis on the “average” as many are living into their 100’s as medicine and technology extend life). The challenge for the couple facing their 30-40 year retirement is the cost to maintain their lifestyle is constantly going up. At trend line inflation of 3%, a couple that has a lifestyle of $10,000 per month today, will be looking at a lifestyle cost of $24,000 per month at the end of retirement without increasing their standard of living! Thus it becomes critical to invest in a manner that can at least keep up with the rising cost of living.

Since fixed income investments historically yield more than stocks, it is understandable that retirees would favor these investments as they believe they need income more than growth. However, as we will see in the chart, that can be a dangerous assumption. The chart illustrates a $10,000 investment in both the S&P 500 (stocks) and the Barclays Aggregate Index (bonds) from 1976 until 2013 – a duration not at all different from a retirement horizon. It is assumed that the dividends from the investment are spent each year on living expenses. As you can see, at the outset, bonds were yielding significantly more than stocks ($745 or 7.5% vs. $461 or 4.6%). One can imagine that newly retired couple in 1976 choosing the investment with the higher yield. However, after leading for a few years, the bond yields start to lag the stock dividends, and by the time you reach the year 2013, the stocks are yielding almost 15 times the income provided from the bonds ($4,058 vs. $272).

Market historians will note that this time period coincided with the largest cycle of declining interest rates in memory – and they would be right. So just to make it fair – let’s assume that the yields on Bonds stayed the same for the entire period at 7.5%. This would mean that the Barclays Aggregate would still be yielding about $800 vs. the S&P 500 yielding over $4,000! How did that happen?

If you look at the End Portfolio Value it tells the tale. Despite yielding less than 2% in 2013, the stocks as represented by the S&P 500 were now worth over $200,000 due to capital appreciation. Therefore that sub-2% yield still equaled over $4,000 in income. Meanwhile, despite lower interest rates (which are positive for bond prices) the Barclays Index was only worth $10,952 and at its current yield of 2.5% only resulted in $272 in income. The fallacy is that investing has to be about Growth or Income, when in reality investing for retirement is all about Growth OF Income. In the big picture, the total return is far more important than the income yield of your portfolio.

As you make your plans for 2015 and sit and talk with your advisor, have this conversation and make sure your portfolio is built to maintain your purchasing power, not just generate a yield. Don’t be surprised if your advisor recommends a significant portion of your assets still be allocated to equities for the years ahead. Bonds still have their place in a diversified portfolio and you may own some as part of your strategy for distributing income while your stock holdings are allowed to continue their long-term growth. However, we caution you against getting too conservative and seeing your purchasing power suffer as a result. In the quest for “safety” many investors have put their purchasing power at risk by not allowing their investments the opportunity to grow above their cost of living.

TR#1082192 DOFU 12/2014