December 8th, 2020 12:51 PM by Jackie A. Graves, President
Whenever someone asks me a business or economics question the answer is almost always, “it depends." I don’t say that because I don’t want to share the answer, but rather because it really does depend on the position someone is in. For example, a common question I get is, “Are low interest rates good or bad?” Well, that answer would shockingly be, it depends. Low interest rates are generally great for people who are buying a home or refinancing, for businesses requiring funds for capital expenditures and for investors. On the other hand, however, there is a group of people who actually don’t benefit from low interest rates — retirees and those close to retirement.
A retirement crisis has been impending for quite some time now. Add the current global pandemic and the more than 20 million Baby Boomers who are about to retire, and the timing, unfortunately, couldn’t be worse. We’ve been warned about the possibility of this for decades, yet the crisis sadly seems to loom even closer now. Factors such as the massive conversion of pension plans into 401k plans — which shifted retirement risk to employees — and the 2008 financial crisis, where state and local funds lost 35-40% of their value, have added to the looming threat. Moody’s investor service confirmed this assessment just two years ago in 2018 when it reported that public pension funds are underfunded by $4.4 trillion. Unfortunately, a low interest environment would make it even harder for these funds to recover their losses. Luckily, there is one way to invest that will keep retirees from experiencing the negative impact of a low interest environment: building a rental portfolio.
When someone gets ready to retire, he or she should expect payment from three potential sources: Social Security, a pension plan, and a savings account, which includes both 401k plans and IRAs. I like to look at these sources as a three-legged stool since they all work together. However, for the sake of this article, I’ll focus on retirement savings, since it is the one that would be most negatively impacted by a low interest rate environment.
With respect to retirement savings, there are typically four options that allow people to convert their retirement savings into a stream of income: bond ladders, asset withdrawals, annuity and rental portfolios (which are typically less discussed than the first three). In a normal interest environment, it is possible to assemble a portfolio of bonds with different maturity dates, called a bond ladder, that would generate a stream of income. In a low interest environment, that’s not a reasonable option.
The withdrawal method (also known as the 4% rule), works when you invest your funds in the stock market. You withdraw 4% of these funds annually as retirement income. If you consider that the average rate of return for the stock market is typically around 9%, this seems safe in the long run. It all just depends on how well your stock is performing. For instance, during times when your returns are lower than your withdrawal rate, you may have to reduce your spending.
When it comes to an annuity, I’m not a big fan of using it for distribution, and that's mainly because the payout percentage is very low compared to the premium. In a low interest environment, the payout percentage is reduced, making your payout even less attractive. In order to verify this, I ran a few calculations and estimated that an interest rate dropping from 4% to 2% could mean a whopping 20% payout reduction (assuming everything else stays the same). Therefore, if you’re relying on annuity to convert your retirement savings into a stream of income, a low interest rate environment is far from ideal.
The rental portfolio is my favorite method for converting retirement savings into a stream of income. Not only does it provide monthly passive income but the rental income is also adjusted for inflation, the property appreciates over time and you’re able to build more equity that can then be passed on to your children. This type of investment provides even better returns during a low-interest environment because it reduces financing costs. The fact that rental property investments have significant tax benefits as opposed to other forms of investment, is why I recommend that everyone invests in turnkey rental properties as early as they can.
While most people assume that low interest rates are always a positive thing, it’s important to note that “it depends” on the situation. As mentioned above, low interest rates, especially when it comes to retirement savings, can actually be detrimental. On the other hand, rental portfolios are a great way to convert retirement savings into a stream of income that generates higher returns with low interest rates.
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