Monday Morning: Retirees need new advice as rates fall

The lower interest rates engineered by the Federal Reserve may ultimately help the economy recover from the collapse of the Internet bubble and the Sept. 11 terrorist attacks, but in the meantime, they are taking a toll on retirees.

Many senior citizens live on a combination of Social Security and the interest generated by their savings. Now the interest from those savings is plunging. Senior citizens who had their savings invested in maturing 30-year Treasuries have seen the rates when they reinvest plunge to 4.8%, from 5.5% just three months ago.

And more interest rate declines are to come, says Robert Smith, chief investment officer of Smith Affiliated Capital in New York, which manages $831 million in institutional and individual assets, most of it in fixed-income investments.

going down

Mr. Smith says that there could be two more interest rate cuts by the Fed before the bottom is reached, and that could take the long-term Treasuries down to 4% or below.

What should a financial adviser tell such retirees if they come looking for advice? What should he say if they want to plunge more heavily into the stock market to catch some of the current gains?

The first thing is to prepare for deflation, says Mr. Smith. That’s deflation, not just disinflation. Disinflation is when the rate of inflation slows – that is, the rate of price increases slows. Deflation is when prices actually decline.

Mr. Smith sees many signs that deflation is a threat. Last month, for example, the producer price index declined significantly.

That is, the prices that producers are receiving for their goods and services are declining. And, Mr. Smith says, the lower prices are spreading into the service sector.

Theoretically, deflation cuts prices for consumers, not just producers. But unfortunately, says Mr. Smith, people on fixed income don’t do a lot of discretionary spending. Their spending is on such things as food, rent and medical care, which deflation typically affects last and least.

So retirees are likely to be squeezed between fixed costs and declining interest income. Their financial advisers have to be especially careful about how they try to increase income to offset the squeeze in that kind of environment. “You need a new set of tools,” Mr. Smith says.

Those tools include being able to “rifle shoot” equities. The equities that investors should be looking at are those that have positive cash flow, no debt and significant flexibility to cut costs, he says. Companies with debt are going to get squeezed between the debt and declining prices for their goods and services.

Companies with the old defined-benefit pension plans are going to be hit with increased contributions at the worst possible time, he says. Because of the low interest rates, many of the funds are now underwater, and the companies have to begin to fund their liabilities over 15 years, just when profitability is being squeezed.

On top of that, they will have to begin paying premiums to the Pension Benefit Guarantee Corp. So investors will have to pick companies carefully.

On the fixed-income side, because yields are so low, maturity is now more important than yield, Mr. Smith says. Each new cut in interest rates will raise bond prices, providing capital gains that can be harvested to substitute for the yield.

For those willing to take some risk, carefully selected distressed debt could be an alternative to equities.

Mr. Smith expects the economy to stay flat for some time, and so it will be a long time before corporate profits revive, “well into ’03,” he says.

Regardless of whether Mr. Smith’s projection of deflation and a slow recovery is correct, financial advisers should be thinking of strategies for their retired and near-retired clients that take account of the worst-case scenario.

Mike Clowes is the editorial director of InvestmentNews.