Cost of Retirement Income Q3 2018 Update

Real U.S. interest rates have shifted upward YTD in 2018, with a larger shift on the short end than the long̬̬—producing a flatter curve. Exhibit 1 shows the real yield curve (from 5 to 30 years) at the end of each quarter since December 2017 and also includes data as of Oct. 9, 2018 to reflect a recent move since September 2018.[1]

The curve shift produced lower present values of inflation-adjusted cash flow streams for future retirees. These changes are quantifiable and shown in Exhibit 2. Each bar represents a cost decrease of 25-year, inflation-adjusted cash flows, commencing at the respective 5-year increments indicated on the horizontal axis for the year-to-date through Sept. 28, 2018 period.[2]

What is the significance for retirement savers? When rates decline (increase), static wealth levels buy less (more) income. For example, the cost of income commencing in 2030 declined by $1.51 (to $19.58 as of September 2018 from $21.09 in December 2017). For a given wealth level, a 2030 retiree can expect to generate almost 8% additional income. Here’s the arithmetic for a $100,000 hypothetical account.

As of December 2017: $100,000/$21.09 = $4,742.24 of inflation-adjusted income per year starting in 2030

As of September 2018: $100,000/$19.58 = $5,108.34 of inflation-adjusted income per year starting in 2030

($5,108.34/ $4,742.24) – 1 = 7.7%

A key lesson is that uncertainty comes in more flavors than market risk. The cost of future income, driven by interest rates, can be a major source of uncertainty. Even if a portfolio has not changed in value YTD in 2018, the amount of future income one could buy currently would have increased by almost 8% due to the shift in interest rates. On the other hand, had rates moved downward, the opposite would be true, which is tricky because most investors tend to feel safer if their investments do not change in value. The takeaway is that when investors are trying to provide future income for themselves, low portfolio volatility does not typically equate to low income volatility due to movements in interest rates.

How can one manage such variability? One way would be to gradually allocate more assets to a portfolio structured to hedge interest rates. The trade-off is that when you hedge interest rates, or the future variability of the amount of income you’ll have, you give up the opportunity to participate in the long-term growth of stock markets. This trade-off is one of the central long-term risks that retirement investors should consider carefully and develop an investment policy to manage.

[1] U.S. Department of the Treasury. https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=realyield

[2] For more information, see S&P STRIDE Metrics.

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