COLUMN-How retirees can cope with Fed's 'new normal'

Tue Dec 18, 2012 10:58am EST

By Mark Miller

CHICAGO Dec 18(Reuters) - If you are still wondering whether we are in a "new normal" investment climate of ultra-low interest rates, wonder no more: Federal Reserve Chairman Ben Bernanke settled any lingering doubts last week when he guaranteed rates will stay near zero at least through the middle of 2015 -- or until the jobless rate falls to at least 6.5 percent, or the inflation rate jumps above 2.5 percent.

Bernanke's unprecedented announcement(see) might be good for the economy, but it is bad news for retirees, who already have suffered through four years of historically-low interest rates.

Ultra-low interest rates have inflicted all manner of pain on retirement.

Insurance companies have raised the price of annuities and long-term care policies as a result of low returns on bond-oriented investment portfolios. Pension plans have had trouble meeting their investment objectives, forcing them to reduce their funded ratios and creating political and fiscal havoc for plan sponsors.

The most direct problem facing retirees, however, is how to generate income from retirement savings. The traditional reliance on low-risk bonds and certificates of deposit just does not work in this rate environment, and higher-yielding products come with unattractive levels of risk.

However, now that we know the "new normal" is here to stay for at least a few more years, there are several low-risk options for retirees, and people who expect to retire soon, and a low-risk option is by far the best approach one can take in uncertain times .

1. Delay retirement

It's not possible for everyone, but working a few additional years can boost retirement income in several important ways.

First, it allows you to delay filing for Social Security, adding roughly eight percent annually to monthly payments when you do finally file. Think of this as "buying" a higher annuity amount from Social Security; the "cost" is the amount you spend from current income on living expense in lieu of Social Security payments. Delayed Social Security filing makes sense as an income-booster even if it means drawing down your nest egg in the early years of retirement for living expenses.

If you are able to work longer, it means fewer years of living on your retirement nest egg, and one hopes more years of contributions -- and investment returns -- from your 401(k) or IRA.

2. Adjust spending

A new normal for low-risk return implies a new normal for spending, says Michael Kitces, partner and director of research for Maryland-based Pinnacle Advisory Group.

"We often talk with our clients about re-evaluating this. How many vacations do they really need to take? Should they reevaluate where they live? Moving from an expensive metropolitan area to a less expensive suburban or rural area could reduce their monthly costs or free up a great deal of equity that can be used to reduce or eliminate a mortgage."

In the best of all circumstances, it would allow a person to enter retirement debt-free.

3. Focus on investment expense

In a low-return climate, it's more important than ever to control factors that you can control -- and investment fees are a prime example. Low-cost passive index funds offer a great way to do just that, Kitces notes.

"The good news is that we're seeing a lot of investment management companies duking it out aggressively to bring costs down, so it's a consumer-friendly environment. There's plenty of opportunity to really manage costs lower and lower," he says.

That's been the market direction for some time now, as the November Lipper FundFlows Insight Report shows. Diversified equity funds showed their 19th consecutive month of net redemptions, while low-cost index and exchange-traded funds saw growth. Bond funds also enjoyed strong growth.

4. Go alternative

If you're comfortable taking substantially more risk, consider alternative investments that aim to generate higher return. One approach is through mutual funds that invest in a mix of high-yield bonds, dividend-oriented stocks, emerging markets or mortgage-backed securities.

For example, the JPMorgan Income Builder Fund aims for a high yield with a blend of high-yield bonds, income-oriented equities, emerging market investments and "non-agency mortgages" -- mortgage-backed securities that are not backed by a federal agency, including subprime and jumbo loans. The fund's three-year annualized return is 9.82 percent as of November 30, 2012.

"The challenge is how to get a good trade-off between risk and income," says Michael Schoenhaut who manages the fund. "When we do get higher yield, we're being paid to take more risk."

But an alternative fund should not be more than a small slice of the portfolio mix for pre-retirees, or anyone already retired, he cautions. "For retirees, we'd combine this with other assets to bring down risk."

And seniors should stay away from privately-offered, unregulated "alternatives" for deals such as construction loans or real estate developments that often are pitched as replacements for traditional yield products. "There really is no free lunch," Kitces says. "If it sounds too good to be true, it probably is."

5. Go long

Investing in bonds with longer maturities will bring higher yields. The risk here, of course, is that a jump in interest rates will tear into the principal on your bond investments. Even though Mr. Bernanke has assured us rates will stay where they are, that will not be any comfort for the risk you'd need to take to get higher return.

Says Kitces: "It's one thing to say this is how it's going to be for a few years, but that doesn't mean you'll be happy holding bonds maturing in the 2020s or 2030s."