By the way, the Federal Reserve stopped updating this information in 2013 and this graph ends at that point. Below is a shorter-term graph of 1-year CD rates going back to 2009. Even from the low level of seven years ago, roughly 1%, rates have fallen still further to nearly 0% today.
For past savers who were willing and able to lock away their money for five years, the rewards were even greater. Here are average interest rates on 5-year CDs over the last 32 years according to Bankrate.com. Before interest rates were sharply lowered in the early 2000s, 5-year CDs were a good way to save in a safe way and earn a fairly generous return. Even though interest rates had already begun declining by 1984, the average interest rate on 5-year CDs over the last 16 years of the past century was 7.05%.
With such attractive yields in safe and non-volatile investments, prospective investors did not have to speculate in the stock market to earn a return that comfortably stayed ahead of inflation. In the past, investing in CDs, or even bank savings accounts, was a viable way to accumulate assets for retirement or shorter-term financial goals.
Today it’s a different story. Even for those savers willing to commit to parting with their cash for five years, the financial rewards from Certificates of Deposits are small. The average 5-year CD rate in the U.S. over the last decade was just 1.9% and for the past five years, around 1%. Even by the government’s flexible definition of inflation, such returns don’t even keep up with inflation, even before taxes are considered. Given today’s yearly rates of just 0.2% on short-term CD rates and about 1% on longer-term CDs, it’s something of a mystery why Certificates of Deposits still exist at all. Given the hassle factor of going to a bank, the often large minimums required and nearly-0% interest rates, it seems that few would want to part with their cash for such returns.
While not having access to safer savings alternatives is an obstacle for those saving for retirement, it’s especially harmful to those in retirement trying to live off accumulated assets. There are tens of millions of retirees in America who saved for decades with the expectation that their saved assets would provide a safe and liquid source of retirement income. In past decades safe investments like CDs generally provided stable and generous returns. Today’s rates are a small fraction of those from the past. For the last half of the 20th century, there were almost no periods that a saver could not earn 5% on even short-term CDs. What a shock then for past savers, and today’s retirees, to see CD rates for their accumulated assets earning 1% instead of 5%, 6% or higher.
While there are many factors that go into retirement satisfaction, undoubtedly, financial security is one of them. The amount of retirement income, as well as the level of accumulated assets has been highly linked to financial satisfaction. A study from the Employee Benefit Research Institute found that the percentage of retirees reporting a “very satisfying” retirement fell from 60.8% in 2002 to 48.6% in 2012. It’s interesting to note that this decline coincides with the drop-off in CD rates (and interest rates in general). Since the interest earned on safe investments directly relates to income and economic security, it seems reasonable to suggest that at the very least, low interest rates make retirement more difficult financially, and therefore less satisfying.
The same study finds a very high correlation between the amount of financial assets saved before retirement and satisfaction during retirement. The percentage “very satisfied” with retirement ranged from 71.5% in the highest quartile of financial assets to 33.1% at the lowest. But financial assets will provide ease during retirement only to the extent that they provide an income during retirement. Given the often 30+ year lifespans during retirement, as well as the frequent desire to provide some assets for charity or family, nearly every retiree with accumulated assets and wanting a high standard of living during retirement will depend on income earned from their investments to fuel their retirement. And the more income, the better. The EBRI study found that regardless of assets, retirement satisfaction declined over the decade. Perhaps the decline in interest rates on savings (and thus income) was one factor.
Looking in more detail at the increased difficulty of earning an adequate return on savings accounts, the chart below shows how different interest rates and assets deliver varying amounts of income. When considering retirement income, one usually works backwards from the amount of income desired to the necessary assets required. And that level of necessary assets is directly related to the expected interest rate earned on those assets.
For example, let’s say that to maintain my standard of living in retirement I will rely on Social Security and earning an income stream off of my saved investments. I might have an income goal of $50,000 a year in retirement. If I expect to receive $20,000 in Social Security income, that leaves a necessary $30,000 a year to come from my investments. Since my lifespan will hopefully be long, and I want to have the flexibility to bequeath at least a part of my assets to children or charity, I am hoping to live completely off the income from my assets. In other words, not dipping into my principle at all.
Looking at the chart, we see that to receive $30,000 a year in interest income in retirement I will have to have accumulated $500,000, if I’m able to earn 6% on that money. If I earn 3%, I will have to accumulate $1,000,000. If I’m able to earn only 2%, I will have to have accumulate $1.5 million (interposed between data points), and if I earn only 1% then I need to accumulate $3.0 million. Obviously, those are significant differences. Since retirees typically invest the majority of their financial assets in conservative investments, the average interest earned on their investments are usually lower than the amount earned before retirement. And with current CD rates around 1% and below (as well as record-low bond yields and nearly 0% on bank savings), today’s retiree’s should expect significantly lower average returns than the previous generation of retirees.
Unfortunately, much of the areas highlighted in green are not realistic levels of interest rates for today’s retirees who want to invest in low or no-risk investments. Even a diversified portfolio of “risk-free” investments such as CDs, coupled with a smaller portion of bond funds and stock funds, are unlikely to deliver much more than 2% or 3% over the coming decade. Such levels of earned interest will require saved assets of a million dollars or more in retirement, to deliver even a very modest income stream.
Compare such asset accumulation expectations with average actual savings among today’s retirees. A 2015 Government Accountability Office study found that average Americans ages 55 to 64 have an average of $104,000 in retirement savings. A 2% yearly income on such levels would amount to $2,080 a year, or about $173 a month. Does $2,000 in yearly extra income add materially to retirement satisfaction? For some it will. For others it will be much less than expected.
Unfortunately, lower interest rates are not only requiring more assets to be accumulated to supply the necessary income, but they’re making it more difficult to accumulate those monies. While the amount of assets accumulated by near-retirees may be modest, today’s low interest rates, coupled with an historically expensive stock market, may lead to lower average savings for retirees in the coming years. Compounding lower savings before retirement and lower earnings during retirement will likely deliver the most challenging retirement environment in generations.
The vast majority of individuals saving for retirement primarily invest in a mix of stocks, bonds and cash (or cash-equivalent investments such as money market funds or Guaranteed Investment Contracts, or GICs). This mix tends to lean more heavily on stocks when individuals are far from retirement and more on cash and bonds as workers near retirement age. I went over this in more detail in my book Let Your Money Grow, but the evidence shows that only slightly more than half of individual retirement assets are invested in equities (stocks). For those approaching retirement, the percentage in stocks is significantly lower. Thus, the majority of savers will keep a minority in stocks over their investing lifetime. Even a fairly aggressive assumption of 50% stocks, 40% bonds and 10% cash over the coming decade or two does not suggest high average returns.
For nearly all long-term time periods, investors underperform the stock market, often shockingly so, by 4%, 5% or 6% a year. As I looked at in my book, even at the best of times, such as the Bull market from 1980 to 2000, average investor returns were very modest. Based on historical evidence, current low dividend yields and the elevated stock valuations of today, 5% average returns in the stock market going forward for the next decade or two will be a challenge for most investors.
As far as the bond portion of investor portfolios, interest rates can hardly go much lower. The 10-year Treasury bond is around 1.5%, with the majority of foreign government bonds yielding nothing or less than nothing (negative yields). Corporate bond rates, are slightly higher, but because of the push for yield, have been pushed to just 2% or 3%, despite the higher risk. And as noted, cash-like investments such as savings accounts and CDs pay almost nothing.
If we assume a 50%/40%/10% split of (generous) 5% yearly average stock return, a 2% return from a bond mix, and 1% cash, it would result in a roughly 3.5% average return on a portfolio of assets. To acquire the necessary savings for a modest income stream will require a significant yearly retirement contributions.
The chart below shows accumulated assets based on a 30 year time frame and based on various combinations of monthly savings levels and average savings rates. On the chart I’ve highlighted savings and investment return combinations which result in at least $1,000,000. We see that if average yearly returns don’t exceed 4%, then monthly contributions of more than $1,000 a month (about $1,460) will be required to achieve such a target.
Each person who intends to retire and live on accumulated money will need to evaluate how much they can save. Potentially, he or she will need to adjust expectations for standard of living compared to previous generations at similar income levels. If less can be earned through interest and capital gains, then more needs to be earned through work income and saved assets.