The Federal Reserve has moved aggressively to establish low interest rates in response to the COVID-19 economic shock, and the public comments from the central bank demonstrate its willingness to maintain low rates long term. Retirees rely on bond interest to finance basic needs, lifestyle, and healthcare costs once they've stopped working, so low rates represent a major challenge in planning. With limited room for error, retirement investors need to deftly avoid major pitfalls while considering some shrewd and creative allocation strategies in response to the new reality. 

Falling rates are going to drive appreciation in existing bond portfolios due to the inverse relationship between interest rates and bond prices. Holders of fixed-rate bonds have experienced this boon, but bond yields and bond fund returns are likely to suffer moving forward. Moreover, the interest income generated in savings accounts, money market accounts, and certificates of deposit will also shift downward. Retirees need more savings to generate the same passive cash flow that they enjoyed prior to the rate crash. That's a major problem for any financial plan that had assumed a certain fixed rate of return, and it forces investors to make some difficult choices.

Retirement age man and woman with gray hair looking at financial statements and laptop with concerned expressions.

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Volatility is not your ally in this situation

Some retirement investors will no doubt be tempted to take on additional risk in response to these changes. A higher rate of return from increased equity exposure or lower-grade bonds could certainly bridge the gap of lost income. That tactic involves hoping that the stock market goes up and less creditworthy entities avoid default. However, investors have no control over either of those dynamics.

Sequence of returns and portfolio volatility play a major role for retirees. Accounts that fall significantly or experience successive underwhelming years in the early stage of retirement will never fully recover, as investors are making withdrawals and reallocating increasingly toward bonds. A very modest increase in risk may be suitable, but this is usually a major violation of planning principles that should be avoided until it becomes the last resort.

Adjust allocation without adjusting risk

Unfortunately, the 4% rule is no longer valid for planning, and it seems that many retirees will be forced to reduce their withdrawal rates. All else being equal, this means that they will have less income for living expenses, which may not be feasible in instances of tight budgets or meaningful medical expenses. Luckily, there are some creative solutions that could improve cash flows.

There may be some relatively simple moves to marginally improve rates of return, such as utilizing online banks for higher interest rates or shifting CD and savings account holdings to medium-term treasury bonds. Retirees may also want to consider adjusting the allocation within the equity portion of their portfolio to prioritize income. Stocks that pay stable and growing dividends, preferred stock, real estate investment trusts (REITs), and dividend exchange-traded funds (ETFs) may be suitable alternatives to equity holdings that do not yield as much income. However, investors should be aware of the risks inherent in each security type, and they should also consider the potential appreciation lost by shifting away from higher-growth stocks toward dividend payors. Dividends are also taxed as ordinary income, which would not have a major impact on qualified accounts but could have major ramifications for funds held in regular brokerage accounts.

Reduce expenses and withdraw advantageously

Investors should be sure to review the costs incurred in their portfolio and make sure that any account or fund-management fees are delivering commensurate value. Taxation is also a major erosive factor that can be reduced in several ways. Municipal bonds are popular options for non-qualified assets, because interest on these securities is often tax free, which might make them a good alternative for corporate bonds. 

Retirees should be careful to source funds in a tax-efficient manner. Withdrawals from qualified accounts are taxed as ordinary income, whereas other assets are subject to capital gains. Years with large withdrawals for lifestyle or medical expenses might push retirees into temporarily high-tax brackets, making 401(k) and traditional IRAs sub-optimal in those years. Finally, investors with sufficiently large portfolios should look into tax-loss harvesting to reduce tax liability.

There are a number of creative and savvy solutions to improve returns and reduce cash outflows in retirement, and these should be prioritized over any major changes to risk and volatility. Don't fall into the trap of chasing returns that can wipe out years of smart planning.