Broker Check

Investing For Income When Interest Rates Are So Low

Past Traditions
Traditionally investors realize their retirement goals via long-term investments in equities with growth potential. Once you have enough of a nest egg for you and a spouse, you may wish to batten down the hatches with at least part of your portfolio directed to safer income investments. Traditionally, this means an allocation to bonds or immediate annuities for income. More recently, "alternative investments" have been popular.

Today these traditional options are challenged by our longer expected lifetimes, interest rates at near all-time lows, and bonds that lose value if future rates increase.

Longer Life Challenges
With advancements in medicine, many folks should make financial plans to live to perhaps age 100+.  With what is now a serious medical condition may be more easily treated in the future with new medical advances - for example, in gene therapy, cancer treatment etc.

Today living too long has replaced dying too soon as the key risk for many investors who need enough potential growth investments to provide many years of active retirement for both spouses.

Another factor with longer lives is the dreaded potential need for long term care (LTC) in older age. Most long-term care is not covered by Medicare and traditional long-term care policies are prohibitively expensive. Decades ago, insurance companies underpriced LTC policies, which seemed affordable then but rates have now skyrocketed as so many folks need LTC. 

Both my parents wound up in nursing homes and both died close to age 90. They sold their mortgage free home, yet LTC costs consumed all their retirement money. They were forced to go under Medicaid with the State paying for their care.  I have a client whose mother in Chicago was wiped out of over $1 million in assets due to her LTC expenses.

Today, the only practical LTC option for many is LTC protection bundled with an annuity or a life insurance policy. Annuities have other costs and yields are based on interest rates, and are not as favorable as a few years ago when interest rates were higher. For bundling LTC with life insurance if you are over age 50, the required life insurance mortality cost might be too expensive compared to the ability to combine it with early access to part of the death benefit for LTC.  Some folks with grown and independent children do not need more life insurance.

While lots of these policies are being sold as LTC solutions, when I dig into them and run illustrations, I usually do not see them as favorable options for most clients – unless they also desire more life insurance coverage.   

Income vs. Real Returns
Your real return on income assets is the amount of return that exceeds the inflation rate. If inflation is 3% while you are getting 3% income you are only breaking even. Actually it is worse than this, since it is taxed as ordinary income, not capital gains - including in a qualified plan like an IRA other than a ROTH, since the income is fully taxable as you take it out. Therefore, your after-tax-real return on 3% income is negative.

Fed acts to control inflation rates and has set targets

U.S. Core PCE Price Index YoY ChartIn August 2020 at the online Jackson Hole conference, Fed Chair Jay Powell announced a revision to the Fed’s long-run monetary policy framework by re-framing the 2% inflation goal as an average inflation target of 2% over the long run. With this new framework, the FOMC is communicating that it will tolerate inflation above its target for a period of time to offset periods when inflation was below its target. In other words, the FOMC is targeting average inflation of 2% in the long run.

The chart shows FOMC’s preferred inflation measure, the core personal consumption expenditures index (core PCE), in blue and the 2% target in red. This new policy suggests that, if inflation can return to a range above 2%, the Federal Reserve will have to tolerate higher inflation than it has for much of the past 20 years—and tolerate it for significantly longer periods. Comments by Matthew Famiglietti and Carlos Garriga November 2020

What this potentially means for investors: With the huge federal deficit as well as many countries decreasing their holdings of US debt - and turning more to Japan - our $trillions of massively increasing US debt is more reliant on mostly US investors. A lower demand could cause higher interest rates.  Since most other rates move with US Treasury rates, it is expected that eventually interest rates will move up from current near all-time lows and therefore bonds would lose value. Inflation is also expected to pick up in 2021-2022 as vaccinations allow closed businesses to open, and travel, restaurants and much of the economy to rebound.  Many economists expect a potential economic boom from the pent-up demand and increased savings that have built up in 2020.  

The potential result is both higher interest rates and higher inflation – a double whammy notably to bond holders, whose bonds could lose value and real returns decline even further.  

Chart of 10 yr. Treasuries since 1980 – Currently near all-time lows

Price impact per 1%  rise in interest rates
Even “Safe” US Treasuries that guarantee principal may be very risky unless held to maturity:
30 yr. US Treasury loses 16.9% for every 1% rise in rates to get yield of 1.53%
10 yr. US Treasury loses 6.2% for every 1% rise in rates to get yield of 0.83%
Source: Bloomberg as of 11/20/2020

Income Alternatives

Immediate Annuities
The results will vary with age and different policies. For example, I ran an illustration for  $100k premium from a strong insurance company – one of the few with a limited additional withdrawal option. For a joint and 100% survivor immediate annuity at ages 63 and 61 as of 11/22/2020 the monthly payout would be $362.22. If I were more of a salesman, I could tell you how great a deal this was since this represents a guarantee for your life and that of your spouse since this is 4.35% income return on $100k. At least this might be better than bonds with no interest rate risk and a better returnHowever. most of this is nothing more than your own money being returned to you. The IRR “Internal Rate of Return” was only 1.77% in the illustration. 

Decades ago, when I was analyzing tax sheltered real estate partnerships – pre 1986 Reform Act – I did articles on how deceptively high IRR values were given by real estate investment sponsors. IRR  assumes all the cash distributions (or tax savings from losses on real estate) are reinvested at the same rate.  No, folks do not usually reinvest their income at the same rate, often they spend it!

It bothers me that this is allowed to be used by Insurance regulators in illustrations and in sales presentations. To remind myself I Googled for the definition of IRR (Internal rate of return):

“Internal Rate of Return: The compound average annual rate of return that is expected to be earned on an investment, assuming that the investment is held for its entire life and that the cash flows are reinvested at the same rate as the IRR” and many other sites.

Fixed Multiple Year Guaranteed Annuity
Rates with various surrender charge years and from “A” or Better “Best” rated companies with the ability to take income up to 10% a year- or interest earned without a surrender charge. Rates are for a $100,000 premium. Rates differ depending on whether the company has a return of premium at death provision or a Market Value Adjustment discussed below.

Note these depressingly low rates are before inflation and taxes

3-year 0.85% to 1.70% 5-year 1.00% to 3.05% 7-year 1.00% to 2.30% 10-year 1.00% to 2.40% 
Source: by subscription only for licensed agents as of 11/20/2020

Many of these annuities require a market value adjustment (MVA).The MVA is a way the insurance company protects itself from significant losses when a policy owner terminates their contract prior to the agreed term. The insurance company is buying mostly long-term bonds, making a profit and with the MVA passes on the risk of higher interest rates if you surrender early. The MVA is in addition to the normal early surrender charge. The quotes for fixed annuities are more pure interest rates, not IRR’s discussed above with immediate annuities. However, they are before inflation and taxes.

While some might consider this a buying opportunity on real estate weakness, many REITs that I review that may have, say, a 6% distribution rate are not actually earning nearly this much. In addition, they have market risk, which those looking for fixed income are trying to avoid.  Some large REITs are paying as much as 6%, but that is often only because the average REIT is down in value 12.45% Year-to-date as of 11/20/2020 (Morningstar)

The problem with many REITs’ distribution rates is the same as when decades ago I was quoted in a Barron’s article about how REITs (or real estate limited partnerships) were often paying out distributions from cash reserves or from new investor money coming in – not from “cash flow from operations”. With the problems in today’s real estate markets I often see the same issue in reviewing their SEC filings.

There are many other income investments that I seldom recommend.  However, if you wish to investments in bonds, annuities, REITs, or other types of investments I can make recommendations.   The problem is that in today’s investment world it is difficult to have any real after-tax yield on income investments.

Action Plan Recommendations for income

I can discuss individually specific recommendations based on one’s goals, objectives, and risk tolerance.

For those seeking income or for the more conservative allocation in a diversified portfolio, I suggest various bond and annuity alternatives, without the high interest rate risk of many bonds or low returns in annuities at this point in the economic cycle.

Required Disclosures:  All guarantees, and protections of annuities are subject to the claims-paying ability of the insurance company. Past performance does not assure future results. There is no assurance that objectives will be met. Investments in securities do not offer a fixed rate of return. Principal, yield, and/or share price will fluctuate with changes in market conditions, and when sold or redeemed, you may receive more or less than originally invested.  No system or financial planning strategy can guarantee future results. REITs are subject to various risks such as illiquidity and property devaluations based on adverse economic and real estate market conditions and may not be suitable for all investors.  A prospectus that discloses all risks, fees and expenses may be obtained from 602-955-7500. Read the prospectus carefully before investing.  This is not a solicitation or offering which can only be made in conjunction with a copy of the prospectus.

The return and principal value of bonds fluctuate with changes in market conditions. If bonds are not held to maturity, they may be worth more or less than their original value. Although it is possible to have guaranteed income for life with a fixed annuity, there is no assurance that this income will keep up with inflation. There is a surrender charge imposed generally during the first 5 to 7 years or during the rate guarantee period. A diversified portfolio does not assure a profit or protect against loss in a declining market. Asset allocation, which is driven by complex mathematical models, cannot eliminate the risk of fluctuating prices and uncertain returns. Asset allocation should not be confused with the much simpler concept of diversification.

The views and opinions expressed are as of the report's date and are subject to change at any time based on market or other conditions. The material contained herein is for informational purposes only and should not be construed as investment advice since recommendations will vary based on the client's goals and objectives. Information is believed to be from reliable sources; however, no representation is made as to its accuracy. Hutchison Investment Advisors, Inc. is an Arizona registered investment advisor. Part II of Form ADV (Disclosure Statement) has been given to advisory clients and is available upon request, and is also at