What Your Asset Mix in Retirement Should Be During Higher Interest Rates

Key Takeaways

• If you look at a graph of 10-year bonds, starting yield, subsequent returns, you just see a very, very tight correlation.
• The fact is that we now have safer, higher yields. The standard deviation of fixed income is so much lower than is the case with equities. And at the same time, equity valuations aren’t what they once were, especially when you’re looking at kind of a US core stock portfolio.
• In this latest review, we came out with a conclusion that a 4% starting safe withdrawal rate was a good amount to anchor on.
• If you have equities in your portfolio, what’s the next best thing to add? And one of the conclusions is that Treasuries, good old-fashioned US Treasuries, and cash are really great ballast assets for equity portfolios because they do really anchor that portfolio.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Yields on cash and bonds have shot up over the past two years. Should that affect how retirees think about their asset allocations? Joining me to discuss that question is Christine Benz. Christine is director of personal finance and retirement planning for Morningstar. She’s also host of The Long View podcast and author of a new book to watch for this fall, called How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement.

Nice to see you, Christine.

Christine Benz: Good to see you too, Susan.

The Relationship Between Interest Rates and Future Bond and Cash Returns

Dziubinski: Let’s start by talking about the relationship between interest rates and future bond and cash returns. Now, when rates go up, return prospects for both cash and bonds …

Benz: They do. And the reason is that as a bond investor, the biggest part of any return you earn is that yield. So, if you look at a graph of 10-year bonds, starting yield, subsequent returns, you just see a very, very tight correlation. With cash, the return prospects are a little more ephemeral because, of course, interest rates affect cash yields on an ongoing basis. So, there’s no guarantee that today’s, what, 5% cash yields will persist into the future. In fact, it’s very likely they will not. But if you have a longer-term bond and your yield is X, well, it’s a very good likelihood that your return over that maturity will be whatever that yield is.

Allocation in Retirement and Higher Returns From Bonds

Dziubinski: So then how should these prospects for higher returns from bonds, specifically, affect how retirees might be thinking about their allocations today in retirement?

Benz: It definitely embellishes the case for holding more fixed-income securities, maybe a little bit more cash. It’s very hard to pry older adults’ hands off their equities. We’ve had such a great equity market, some volatility, but not a lot since the exiting from the great financial crisis. But the fact is that we now have safer, higher yields. The standard deviation of fixed income is so much lower than is the case with equities. And at the same time, equity valuations aren’t what they once were, especially when you’re looking at kind of a US core stock portfolio. So, I do think that it argues for retirees bringing a balanced portfolio into retirement or at least adding some fixed income and cash to augment their equity holdings.

How Withdrawals Can Influence a Retiree’s Asset Allocation

Dziubinski: Christine, you and your colleagues have done a good deal of work looking at the relationship between portfolio withdrawal rates and asset allocation. So, in your most recent study, what did you find about that relationship, and how might expected withdrawals influence what type of asset allocation a retiree might have?

Benz: Yeah, it’s interesting. We run this study, well, we’ve done it for the past three years. In this latest review, we came out with a conclusion that a 4% starting safe withdrawal rate was a good amount to anchor on. But it’s important to understand how we think about our base case for those retirement distributions. We’re assuming someone wants a very stable stream of income throughout retirement, basically that they set that paycheck in the first year and then just inflation-adjust it thereafter. So, we’re asking our simulations for a lot of certainty in terms of the amount that will come out of the portfolio every year, and the simulations say back to us, well, given that, you need to stick with a safer-type portfolio because you’re seeking a lot of consistency in the cash flows. So, in the most recent run, our base case over a 30-year horizon pointed to the highest safe withdrawal rate corresponding to an equity allocation of just 20% to 40%, which is really low. And if you look at shorter time periods, so for people with like 20-year time horizons in retirement or 15, older retirees, it points to even lower equity allocations. But the key reason is that we’re basically saying this person wants this stream of income and basically never wants to revisit it. If, on the other hand, retirees are saying, “Hey, I’m OK potentially adjusting a little bit after a bad equity market and maybe taking more after a good one,” in that case, if you’re more flexible with your withdrawals, you probably should hold more in equities because you’ll have more growth at the end of the time period.

Which Subasset Classes Should Retirees Have?

Dziubinski: Let’s talk a little bit specifically about that fixed-income allocation. What subasset classes should investors be sure to have in that, and then maybe what subasset classes might not be necessary?

Benz: This gets back to a study that Amy Arnott and Karen Zaya and I recently completed where we looked at diversification, and we looked at the assets that are your best additions. If you have equities in your portfolio, what’s the next best thing to add? And one of the conclusions is that Treasuries, good old-fashioned US Treasuries, and cash are really great ballast assets for equity portfolios because they do really anchor that portfolio. They tend to have just a completely different performance pattern than stocks. In addition, I would say that retirees who are building their portfolios would want to have some short-term assets, so if their cash is exhausted, but they still need something to draw upon, I’d move on to the short-term assets, and then I would also hold Treasury Inflation-Protected Securities. In addition to those nominal Treasury bonds, I’d own some TIPS as well to provide that explicit inflation protection to help protect your purchasing power over time from those fixed-income assets.

Dziubinski: Got it. And the rest would just be not necessarily as much of a value from a diversification or usefulness standpoint really.

Benz: Yeah, in terms of what not to include, high-yield looks terrible from the standpoint of adding diversification, which is not to say you shouldn’t have it at all, but you’d probably want to limit it or think of it as kind of a third-tier asset. Bank loans, same thing, multisector. It’s interesting, even some core fixed-income types like our core-plus bond category, which is where a lot of fixed-income assets live, doesn’t look as great as, say, the intermediate-term core funds from the standpoint of adding diversification.

Risks of Overallocation to Fixed Income for Retirees

Dziubinski: Interesting. So, what are the risks of a retiree, say, overallocating to fixed income, given how good a lot of bond yields look, and to cash?

Benz: Right. That’s potentially another risk. I think, in general, retirees tend to want to gravitate toward more equity-heavy portfolios, but a couple of risks with being too conservative: One is just that inflation is going to take a bite out of those nice-looking yields. Though inflation has moderated a little bit, it’s still higher than it had been in the decade before. So, inflation is another factor. And then also, these are not high-returning asset classes. And so, if your goal, in addition to getting your own portfolio cash flows going and getting your own paycheck, if a goal is to have some leftovers potentially for heirs or charity or whatever the case might be, you’re going to have a much better opportunity to grow that portfolio if you do have ample equity exposure.

Should Retirees Have a More Aggressive Portfolio?

Dziubinski: Got it. So then when would you say, Christine, that maybe a retiree should downplay safer assets really in favor of a more aggressive portfolio?

Benz: Well, one really good example would be the retiree who is taking very modest withdrawals from his or her portfolio. This is kind of a rarefied situation, but we do encounter people with really nice pensions, for example, where they’re perhaps just pulling extras from their portfolio. And maybe the main goal is to leave that money to children or charity. In that case, you probably would want to run with a more limited stake in cash and bonds. Growing that portfolio for the next generation is really the main goal.

Dziubinski: Christine, thank you for your time today. It’s an interesting time to be a bond investor and a retiree, too, to have such robust yields in front of you for a change.

Benz: It is. A complete turnabout from a couple of years ago.

Dziubinski: Yeah, thanks for your time.

Benz: Thank you, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch 3 Risks Higher Interest Rates Pose to Your Retirement Plan for more from Christine Benz.