Retirement investors faced numerous investment headwinds in 2020. In addition to heightened volatility in the stock market, they had to cope with falling interest rates on both regular and inflation-indexed bonds. Real interest rates, interest rates that have been adjusted to remove the effects of inflation, are especially relevant for retirement investors because lower real interest rates reduce the inflation-adjusted income a given account balance can support.
For instance, if the 10-year yield on Treasury Inflation-Protected Securities (TIPS) is 1%, an investment of $0.91 today would be needed to fund a dollar of consumption in 10 years.1 If the same yield was 2% instead, an investment of $0.82 would suffice. When real interest rates increase, future consumption becomes cheaper. Conversely, when real interest rates decrease, as they did in 2020, future consumption is more expensive to fund, and a fixed balance translates into a lower standard of living.
The S&P Shift to Retirement Income and Decumulation (STRIDE) Indices seek to measure the hypothetical ‘Cost of Retirement Income”. This measure is calculated by taking the present value of a hypothetical inflation-adjusted stream of cash flows, equal to USD 1 per year, starting at various retirement dates and ending 25 years later.2 Based on this approach, Exhibit 1 shows how much theoretical real retirement income a $1 million balance could have sustained in 2020. As a reference point, if real yields were zero at all maturities, the balance would support $40,000 ($1M / 25) in yearly consumption.
At the beginning of the year, TIPS yields for longer maturities were positive, and the balance would have generated around $42,000 in theoretical yearly income. Yields then decreased sharply: for instance, the 10-year TIPS yield stood at -1.1% at the end of 2020. At this point, the same balance of $1 million would have purchased $36,500 in yearly income, a 13% decrease. Managing this source of risk is crucial for retirement investing: as the numbers show, a fixed account balance does not necessarily correspond to a stable standard of living, an important objective for many retirees.
Fortunately, the S&P STRIDE indices measure an income-focused asset allocation that may help manage interest rate risk. Part 2 of this blog will show how the S&P STRIDE Indices fared under challenging conditions in 2020 (spoiler: they performed well).
1 Calculation based on a zero-coupon bond held to maturity.
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.
The S&P STRIDE Index Series was developed in collaboration with Dimensional Fund Advisors LP (“Dimensional”), an investment advisor with the U.S. Securities and Exchange Commission. Dimensional Fund Advisors LP receives compensation from S&P Dow Jones Indices in connection with licensing right to the S&P STRIDE Indices.The posts on this blog are opinions, not advice. Please read our Disclaimers.