Tags: Federal Reserve | interest rates | retirement planning

The Federal Reserve recently said it will keep short-term interest rates near zero for about three more years, and that it may resume buying longer term bonds to lower yields. Though stocks rallied on the news, it poses a problem for retirees and other income-oriented investors. How will a long period of low interest rates affect retirement portfolios?

Just how big a problem is low interest rates for those invested in fixed-income? To get an idea,

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I ran a few scenarios in our retirement planning application.

I modeled a plan using a couple where each person is 62 years old, they plan on retiring when they’re 65, and they have 50% of their money invested in Treasury bonds earning a 1% yield and half in equities with an assumed rate of return of 5% per year. Between the two, they have $600,000 in investments and will receive a combined $30,000 a year in Social Security. Inflation is assumed to be 2% each year and their annual expenses are $50,000. Here is what we learned:

Under this scenario this couple will have a little over $640,000 when they retire and they’re projected to run out of money when they’re 94 years old. It’s not a terrible situation, but running out of money at 94 is early enough to give a lot of people stress. Let’s take a look at their situation if 75% of their funds are in fixed income.

Life just got a little more stressful for this couple. And this assumes that inflation stays relatively low at 2%. It used to be that those approaching retirement could count on bonds giving them enough income, combined with social security and pension payments, such that they wouldn’t even have to dip into their principal most years. Let’s take a look at just how important a higher yield is for a retirement plan that is invested mostly in fixed income. Using our retirement planner’s scenarios capabilities, I came up with the following results:

If interest rates simply move back to where they were in 2007, and inflation remains stable at 2%, this couple would see their funds extended by 10 years in retirement. Needless to say, bond yields can significantly impact retirement plans.

What is an advisor to tell clients in this situation? Many will have their clients move more of their funds into equities. But a lot of clients flat-out refuse to move more funds into stocks after being burned in 2008 and 2009.

That leaves an advisor to work with a client on variables clients can control.