Are Low Interest Rates Hurting Your Retirement Plans? What Low-Risk Alternatives Are There?
An article in the Straits Times on 2 December 2020 titled ‘DBS, Standard Chartered to cut interest rates further on savings accounts’, reports that with effect from 1 Jan 2021, DBS will embark on its third interest rate cut to the bank’s Multiplier since May 2020. Standard Chartered will reduce interest rates for its Jumpstart savings account to 0.4% per annum on the first $20,000, down from the current 1%, whereas the interest rates above $20,000 will remain at a paltry 0.1%.
Such news abound recently, and depressed interest rates affect not just savings accounts, but have a ripple effect through the entire financial system, impacting all deposits.
For retirees and people who are planning on retirement, this has dire consequences, especially if they have been counting on interest returns to fund their retirement. The conventional wisdom previously was that if we could accumulate enough financial resources, say $1million, we could live off our interest of about $50,000 and be safe in the knowledge of ample returns with virtually no risk.
And indeed, before 1992, that was possible. During the 10 years before the turn of the century, even though they fluctuated, interest rates by and large hovered between 2-4%, so retirees could still live off interest income decently, if not as good as before.
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Fast forward to turn of the century, and interest rates went on the downward trajectory, spending a period briefly in the 2-4% range before trending down. The current environment is a global phenomenon and there are indications that low interest rates are here to stay. The Chairman of the Federal Reserve in the US has been quoted as saying that ‘we’re not thinking about raising rates, we’re not even thinking about thinking about raising rates’.
So, someone may have accumulated $1million for retirement but if interest rates are 0.1%, the interest return is only $1,000 a year. It is safe to say this is nowhere near sufficient, even for those who live simply. Given the prospects of prolonged depressed interest rates, how then, can people plan on the basis of low risk, but obtain better returns than current interest yield?
Reducing reliance on bank deposits does not mean taking on undue risk. There are options that do not take people out of their comfort zone in terms of risk tolerance.
Here, I present two alternatives to bank deposits which people can consider:
1. Short Duration Bond Funds
What is a bond? According to Investopedia, a bond is a ‘fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments’.
Short-term bonds fall on the safer end of the debt securities risk spectrum due to their short duration and subsequent near-cash status. A shorter duration or maturity date leads to less credit risk and less interest rate risk.
As there are numerous bonds are out there with varying maturity and degrees of risk, investors can consider investing in short duration bond funds as they offer such advantages:
As with buying shares, it is important, from the standpoint of risk management, to diversify and not put all eggs in one basket. There are many issuers of bonds out there. A bond fund buys into numerous bonds (>100 in some cases), so there is a spreading of risk.
B. Ease of Management
One does not have to actively manage the bond portfolio, or manage redemptions, or switching of bonds.
C. Expertise knowledge of fund managers.
The bonds within the fund are selected by managers who understand the pricing, value and risks of the bonds, something which most retail investors lack. The selection is then regularly monitored so that investors may enjoy good returns and risk mitigation.
While the bonds within a fund have different maturity dates, an investor is able to buy and sell a bond fund on any given trading day. Liquidity, or the ability to convert an asset into cash, is assured.
E. Fewer restrictions on purchase
Many bonds are available only to institutional investors, or Accredited Investors, who may have to fork out $250,000 for a single issue. Bond funds remove such restrictions, and investors are able to participate in the bond market more easily.
What are the disadvantages?
A. Expenses and management costs
Funds are managed actively by professionals with the required expertise, and as such, there are management fees and expenses. However, even taking into account these and sales charges and advisory fees if applicable, bond fund returns can still outperform the low interest rates we see in the market.
B. No guarantee and bond prices may actually drop
Bonds, as with equities, do not afford investors any guarantee. By extension, bond funds do not guarantee investors a return, or the capital itself. During the severe market meltdown in March 2020, even the better performing short duration bond funds were not spared. However, their prices dropped by about 1.5%, which was far better than the bloodshed in equity markets (-30%). Bond fund prices have now recovered and delivered positive returns on a year-to-date basis.
Short duration bond funds may thus be suitable for retirees with low appetite, or pre-retirees who want to park their money in safe instruments which yield a return that can beat savings or fixed deposit accounts. They also suit those who place a premium on liquidity.
According to Investopedia, an annuity is a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future. The cashflows are particularly helpful for someone during the retirement years, as they are regular and certain.
While annuities offer numerous strengths especially for retirement, I want to espouse the advantages of annuities in relation to interest rates.
A. Guarantee for the longer-term
With an annuity plan, the long-term interest rate in the form of a guarantee, is certain. Regardless of how global interest rates perform, the annuity holder is assured that he is locked-in, which gives him a peace of mind in retirement. The term of the annuity can be structured accordingly, and the holder can enjoy the luxury of a guarantee over a period of 10 years, 20 years, or 30 years, or even lifetime! Over and above that, the policyholder also enjoys a bonus component with his payout, which is certainly the icing on the cake.
B. Guarantee can be higher than current bank savings/fixed deposit account rates
It is possible, with a longer accumulation period, for someone to participate in an annuity solution and enjoy a higher guarantee than the prevailing bank interest rates. The key with an annuity plan, as with most insurance solutions, is to start early.
The one factor which requires consideration with an annuity plan is that early surrender will lead to losses, as with most solutions offered by insurance companies. It is a long-term commitment. However, we can see this as a positive as it imposes a discipline in terms of adhering to our retirement plans, so that we may reap the fruits at a later date when payout occurs.
Annuity plans are most suitable for a pre-retiree who has time to wait before the start of payout. They are also a good addition to the retiree’s portfolio is he has other streams of cash flow and can afford to wait a few years for the annuity plan to start paying out.
When considering whether one should branch into other safe instruments such as short duration bond funds and annuities, for retirement, one should consider the trade-offs involved, and a few other factors. Every individual’s circumstance is different, and there needs to be due consideration given.
This snapshot helps you form a better idea how a low/no risk solution in the form of short duration bond fund, or an annuity, can potentially yield a better financial outcome for you as you plan for retirement. It also provides indicative (but not guaranteed) yield of a short duration bond fund, as well as the guaranteed yield and bonus of an annuity. It gives you quick snapshot of the other factors at play, so you are able to judge how you can position your portfolio to benefit from such low/no risk options in the face of low interest rates. Please click HERE to download this Guide to Short Duration Bond Funds and Annuity.
As financial planning for retirement can be complex, and the options can be structured in different combinations and permutations, do reach out to your trusted advisor!
In conclusion, the current low interest rate environment, and indeed the outlook for interest rates in the foreseeable future, pose significant challenges to people who intend to rely on interest returns for their retirement.
There are however, alternatives available to the group who people who may not be comfortable moving up the risk scale in pursuit of returns. Instead of waiting and hoping (possibly in vain) that interest rates go back to previous levels, or gambling that interest rates would not tumble in their retirement years, people can seek out short duration bond funds, and annuities, to help their financial cause with little or incremental risk.
Article by Leon Loh
The writer is a financial consultant representing GEN Financial Advisory Pte Ltd