For investors in or nearing retirement, having a strategy in place to generate reliable income in retirement is critical for meeting your essential needs and lifestyle goals. However, how you derive that income in the years ahead may require a few changes in your strategy. That's because traditional methods for generating income in retirement are being challenged by a range of market and economic factors, including increased market volatility and the potential for rising inflation, interest rates and taxes. Below we look at several factors that will continue to influence your ability to generate the income you need in the months and years ahead, and why that has led many investors to consider adding annuities to their portfolios now.
It's getting harder to derive income from traditional sources
As stock prices continue to surge, many investors are concerned that equities may be overvalued and due for a correction. According to IMG Chief Portfolio Strategist, John J. Canally, Jr., CFA, a correction of 20% or more can be problematic if you're close to retirement. However, he also reminds investors that corrections are a normal part of market cycles and generally happen several times each year.
"Typically, we'll see a 5% correction, at least once a year," he said. "However, we've actually seen a stock market correction of at least 10% during 12 of the last 21 years, from 2000 to 2020.1 That speaks to the fact that it's really hard for investors to time the markets."
Nonetheless, Canally acknowledges that the 90% run up in stock prices since March 20202—during an historically short period of time—implies that a lot of good news has already been priced into the markets, and the easy money has been made. While this doesn't mean we're headed for a recession, Canally believes it indicates that the early phase of the market recovery and business cycle is likely over. He reminds investors that the middle and end of an economic cycle are always the more difficult periods to generate large gains, and the current environment is expected to last for several years.
"The midpoint of a market or economic cycle tends to be more volatile and produces lower returns," he said. "It's also common to see the Federal Reserve (Fed) raise interest rates during this phase of the cycle."
That can make it more challenging for investors who are taking income from their investment portfolios in retirement to generate the future income they may need from traditional sources. Twenty-five years ago, many investors relied on dividend-paying stocks to provide regular income in retirement. However, in more recent years, companies have increasingly returned cash to shareholders via stock buybacks, which helps to increase stock prices, rather than through dividend payments.3
"That doesn't mean you can't get income from stocks anymore, but to find income, you have to take more risk, and you don't want to increase risk to generate income," Canally said.
Bonds are providing very modest returns
As investors approach retirement and prepare to draw down on their investment assets, many adjust their holdings to increase the amount of assets allocated to the fixed income investments, and decrease the portion allocated to equities to help reduce overall portfolio risk. While bonds and other fixed-income investments are not without risk, historically, they have proven less volatile than equity investments over time. In fact, going back to 1977, the bond market has only posted negative returns in 3 of 44 years.4 However, past performance is not indicative of future results and it is possible for investors to lose money in any investment.
While including bonds in your portfolio can help provide a hedge against equity market volatility, a portfolio that's too conservative poses its own risk: the inability to generate enough income to outpace inflation. In a low interest rate environment, it can be difficult for bond investments to generate the same amount of income investors may have relied upon in the past—especially when faced with rising inflation.
According to Canally, over the next 10 years, investors should expect to see very modest total returns, in the 1-2% range, on a broadly diversified bond portfolio. That's a big difference, compared to the unusually high 9% returns on bonds that we saw in 2019, and 8% in 2020.5
Rising inflation is a growing concern
Economic uncertainty continues to permeate the markets, elevating concerns about rising inflation. Inflation occurs when the price of goods and services rise. It decreases the purchasing power of your dollars, and can have a damaging effect on stocks, bonds and other financial assets.
"For the most part, inflation has been dormant for 30 years," Canally said. "However, there is some concern that we have entered a new paradigm for inflation, driven in part by recent fiscal stimulus and monetary policy."
That has markets debating whether or not current run ups in input costs for raw materials, such as lumber and steel, are part and parcel of the economic reopening, or will be permanent and lead to persistently higher inflation for years to come. For now, Canally says, the Fed and the markets see this as transitory, but that could change.
Another consideration is whether the Fed will raise short-term interest rates, and if—and how much—longer-term rates may rise, as a result of inflation, economic growth, supply and demand, and other influencing factors.
The prospect for higher taxes is another potential threat
With stocks at all-time highs, the prospect for rising taxes poses a threat to equity prices. The President has proposed a top federal tax rate of 39.6% on long-term capital gains and qualified dividends. While a potential hike in the capital gains tax can be particularly concerning for those taking income from their portfolios in retirement, the highest U.S. rate applies to relatively few taxpayers, the top 0.3%.
How annuities can help
Having a reliable income stream in retirement that is insulated against market swings, as well as rising inflation, interest rates and taxes, can not only help you meet the full range of your retirement goals but provide income you can't outlive. However, how retirees will obtain income in the months and years ahead may require a different approach than in the past.
For those in or nearing retirement, using guaranteed income sources, including Social Security and a pension (if you have one) to build an income floor is an effective strategy for ensuring your essential needs will be covered in retirement. However, if there's a gap, you may want to consider a fixed, guaranteed annuity, which can provide regular income, similar to a pension.
Fixed annuities aren't impacted by the ups and downs of the financial markets. You receive the same amount every month, regardless of what the stock market is doing. That helps to "market proof" your retirement with guaranteed growth during the accumulation phase, and guaranteed income during retirement.6
Variable annuities, on the other hand, are designed to help capture market gains, which can help you keep pace with inflation. While they can play a role as part of a diversified income stream in retirement, they are generally not recommended as part of an income floor. Since returns will rise and fall with the market, variable annuities won't provide a guaranteed amount of income.
Since, both fixed and variable annuities grow tax-free until funds are withdrawn, annuitizing a portion of your assets in retirement may enable you to leave more of a nontaxable legacy.
Key take-aways for investors in or nearing retirement
As we emerge from the pandemic and businesses and industry open to full capacity, most of the good news is already priced into stocks, making it harder to realize large gains from traditional sources going forward. Investors close to retirement need to consider that the post-pandemic surge in assets prices is ending and the next phase of the market cycle is likely to be more volatile for both the equity and bond markets as uncertainty continues, and Fed rate hikes are likely in both the mid and late phases of the current economic cycle.
A diversified approach to structuring lifetime income, that includes Social Security, a pension, fixed and variable annuities and the growth potential your investment portfolio can provide, can help insulate against the risks imposed by volatile financial markets, as well as rising taxes, interest rates and inflation.
Whether you're looking for additional sources of guaranteed income in retirement, or need help evaluating your retirement income needs, consider scheduling time to meet with your financial advisor to discuss:
- How you will derive income in retirement from sources including Social Security, a pension, and other lifetime income options.
- Ways to build a dependable income floor.
- How a combination of fixed and variable annuities can help create a tax-efficient income stream that you can't outlive.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Watch for additional information and insights on the markets and economy from IMG in future issues of In Balance. To learn about ways to optimize your planning to remain on course toward your important financial goals, schedule time to meet with your TIAA advisor.
1 Source: Bloomberg and IMG.
2 Source: Bloomberg and IMG; data through June 18, 2021.
3 Source: IMG and FactSet Financial Data and Analytics, December 1995 through June 2020.
4 Source: Bloomberg and IMG.
5 Source: IMG and FactSet Financial Data and Analytics, December 2010 through June 30, 2020.
6 Guarantees are based on the claims paying ability of the issuer.
