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Aug. 25, 2011, 12:01 a.m. EDT
By Robert Powell, MarketWatch
BOSTON (MarketWatch) "” Interest rates are down and inflation is up. For retirees who depend on interest income from their fixed-income investments to pay living expenses, these are rock-and-a-hard-place times.
The yield on the 10-year U.S. Treasury note is about 2%, or one-half its yield in February. The yield on the two-year note is 0.22%, about two-thirds its yield at the beginning of 2011. Meanwhile, inflation has risen 3.63% over the 12 months ending July 2011.
Let's put this in perspective. If in February you had a $500,000 portfolio of 10-year U.S. Treasury notes throwing off $20,000 in income to fund your living expenses, and for some reason you had to reinvest all that money in the 10-year notes being issued today, your portfolio would generate only $10,000 in interest income. Meanwhile, the cost of goods and services that your $20,000 in interest income once paid for has now risen to $20,600.
In other words, to maintain the very same standard of living you need to generate another $10,600 in interest income "” which is impossible to do without taking on more risk "” and/or start dipping into your principal, which could put your living standard in jeopardy later in life. Or you might consider reducing your standard of living today and wait for interest rates to rise again.
What's a retiree to do?
Among the items high on your to-do list: Get a handle on the risks you will face in retirement "” be they longevity, inflation, interest rates, and/or the stock market. Next, determine which of those risks will have the greatest impact on your retirement, and then develop a plan to deal with it or them.
Doing this on the fly, while you're in a state of duress, isn't ideal but it's better than making rash decisions and chasing yields only to expose yourself to another risk for which you are unprepared. If you already have a strategy in place, now would be the time to revisit what, if any, changes you might want to make to your plan. Planning for interest-rate risk is one thing; living through it with real money at risk is a whole nother story.
We often think of fixed expenses in retirement as being just that "” fixed. But experts, including Dan Weinberger, a vice president of retirement product strategy and behavioral finance at MetLife, suggests that retirees should use this low-interest-rate environment to revisit their fixed and discretionary expenses.
"It's tough. People will be faced with hard decisions," Weinberger said. "People don't want to compromise on essential expenses. People aren't afraid of making compromises on wants "” but not on needs."
It might be that you can cut some expenses that are more "wants" than "needs," and thus reduce the need to make up lost interest income. "Now is a good time to figure out what's essential and what's not," said Craig Lemoine, CFP, an assistant professor of financial planning at The American College.
Lemoine noted that the low interest rate environment is a double-edged sword: Interest rates on investments are low but so, too, are rates on loans. "Now would also be a good time to take advantage of opportunities to refinance your mortgage or unsecured debt," Lemoine said.
Now might be a good time to consider a reverse mortgage, Weinberger said. The reverse mortgage, even if you don't use it right away, would have a low interest rate and could be a source of much-needed money to pay for living expenses at some point.
For his part, Dan Keady, director of financial planning for TIAA-CREF, recommends a two-part strategy for retirees looking to generate income. First, retirees ought to determine their monthly income needs for the basics "” food, housing, and the like "” and see how much of that Social Security and existing pensions will cover. Second, retirees should consider "annuitizing enough of [their] savings to create a guaranteed income floor to take care of those basic expenses," Keady said. (More about annuities in a bit.)
Robert Powell writes about retirement issues and produces the "Retirement Weekly" subscription newsletter.
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