A common question I receive when speaking to groups of financial advisors is whether it is a bad time for clients to purchase individual bonds or income annuities in today’s low-interest-rate environment.

My answer to this question is no. It is a tough time to retire using any strategy, and I do not think that low interest rates should discourage the use of fixed-income assets more than the alternatives. Saying it is a bad time to retire no matter what you do often draws laughter from the audience, but I do not mean this as a joke. My point is not that clients should avoid retirement. It’s a reality check about the conservatism necessary for any type of retirement income strategy today.

To understand this point, a bit of background is in order. One of my common speaking themes is the two diametrically opposed schools of thought about retirement income. I call them the probability-based approach and the safety-first approach. Probability-based approaches focus on the client’s overall lifestyle spending goals and seek to meet these goals using a conservative withdrawal rate from a portfolio of diversified financial assets with a fairly aggressive asset allocation. Assets are invested using a total returns portfolio perspective.

William Bengen developed the so-called 4% rule of thumb, which was originally the 4.5% rule. It indicates that, based on the worst-case scenario in U.S. history, an individual could have withdrawn 4% or 4.5% of his or her retirement date assets, subsequently adjusting this amount for inflation, and sustained this spending pattern over a 30-year retirement period using a portfolio of 50% to 75% stocks. Probability-based advocates are fairly comfortable linking retirement withdrawals to what would have worked historically.

Moving away from this total returns perspective, the safety-first school relies more on matching assets to liabilities. Spending needs are differentiated between essential and discretionary, with the idea that essential needs should be covered by assets that are safe and secure. This means holding individual bonds to maturity or using income annuities.

Only after covering essential needs with dedicated assets should a retiree think about investing in the stock market. Stocks would be targeted to discretionary expenses. It is less catastrophic if all of these expenses could not be met, so it is reasonable to seek greater upside potential for the risk of downside losses. Sustainable retirement income spending should not be based on what would have worked in the past using an aggressive portfolio, but rather on what the current market environment suggests is feasible.

Market Returns And Retirement Income
The general problem with attempting to gain insights from the historical record is that future market returns and withdrawal rates are connected to the current values of the sources for market returns. Future stock returns depend on dividend income, on the growth of the underlying earnings and on changes in the valuation multiples placed on those earnings. If the current dividend yield is below its historical average, which it is, then future stock returns will also tend to be lower.

When price-earnings multiples are high, markets tend to exhibit mean reversion, so relatively lower future returns should be expected. Returns on bonds depend on the initial bond yield and on subsequent yield changes. Low bond yields will tend to translate into lower returns because there is less income and because there is a heightened interest rate risk associated with capital losses if interest rates rise.

The reality for today’s retirees is that interest rates are very low and stock market valuations (as measured by Robert Shiller’s cyclically adjusted price-earnings ratio “P/E 10”) are high. Sustainable withdrawal rates are intricately related to the returns provided by the underlying investment portfolio. The returns experienced in early retirement will weigh disproportionately on the final outcome. Current market conditions are much more relevant than historical outcomes.

To help illuminate this matter, Figure 1 plots the historical maximum sustainable withdrawal rates over 30-year retirements using a 50/50 asset allocation, against PE10, at the retirement date. Historically, market valuations have performed fairly decently in explaining subsequent sustainable withdrawal rates. Without incorporating the role of any other variables, retirement date market valuations explain 53% of the historical fluctuations in withdrawal rates.

In the figure, I also include a best-fitting curve for the historical data. On June 27, 2014, the PE 10 was 26.3. The curve suggests that a best guess about the sustainable withdrawal rate for someone retiring today is 4.2%. It is important to emphasize that this is not a conservative guess about a safe withdrawal rate but the best guess based on the historical relationship between withdrawal rates and market valuations. It could end up being more or less, which we will not be able to confirm for 30 years. To be conservative, a lower withdrawal rate is required. This is especially the case when we consider that interest rates are also low.

What about interest rates? Using wholesale pricing data from The Wall Street Journal for June 27, 2014, I estimate that buying $10,000 of real income for 30 years using TIPS would cost $268,844. This implies a 3.72% withdrawal rate from retirement date assets, which is really the closest we can come to estimating a truly safe 30-year inflation-protected withdrawal rate (ignoring that today’s retirees may end up living beyond 30 years). I must re-emphasize here that because of the portfolio volatility, using a 50/50 portfolio could result in a sustainable withdrawal rate that is less than this, so the withdrawal rate is safe only if holding individual TIPS to their maturity. Meanwhile, using Treasury Strips and incorporating an assumed annual inflation factor of 3%, 30 years of income would cost $285,222, which represents a 3.51% withdrawal rate from retirement date assets.

As for bond funds, today’s yields are the best predictor of subsequent returns. Increasing interest rates would mean higher subsequent bond fund returns, but also capital losses for the bond fund in getting to that point. Which factor looms larger for a client depends on how the duration of the bonds compares with the duration implied by the retirement spending needs. Nonetheless, one should be cautioned against estimating higher withdrawal rates from portfolios of bonds than the numbers described earlier, as any stretch toward higher yields by tilting toward lower credit quality or longer maturities increases the risk for the bond portfolio.

The payout rate from an income annuity is determined by mortality forecasts and the current interest rate environment. Annuitized assets are generally invested heavily in fixed income. When interest rates are low, the payout rates for income annuities will also be low. Using Cannex, I find that the current best deal for a CPI-adjusted joint and 100% survivor income annuity for a 65-year-old couple is 3.85%.

Is It A Bad Time To Buy Bonds Or Income Annuities?
Now we can return to the initial question: Should clients wait for interest rates to increase before buying individual bonds or income annuities? A proper strategy will most likely involve laddering purchases of bonds or annuities over time. This will help reduce any exposure to interest rates at one particular date. But I do not otherwise think that holding assets in a diversified portfolio is a better choice only for the reason that interest rates are low.

While waiting for rates to rise, if and when that happens, retirees will be spending their principal when spending exceeds interest, dividends and capital gains. Because of the current market environment, there is an increasing likelihood that dipping into principal will be necessary. Even if rates do rise, clients may not be able to purchase more income, because at that stage they are multiplying a higher rate by a smaller pool of assets. Waiting entails risk.

Today’s retirees face a difficult situation. The traditional 4% rule of thumb is closer to being a best guess for a new retiree’s sustainable withdrawal rate, rather than serving as what is meant to be a conservative or “safe” withdrawal rate. The decision about whether to use a probability-based strategy or a safety-first strategy should depend on the comfort level and goals of the client. A realistic assessment about today’s market environment does not suggest a unique reason to favor one strategy or the other.

Wade D. Pfau, Ph.D., CFA, is a professor of retirement income in the Ph.D. program in financial services and retirement planning at the American College in Bryn Mawr, Pa. He is also the director of retirement research for McLean Asset Management and inStream Solutions. He actively blogs about retirement research. See his Google+ profile for more information.