Annuity payout rates are closely tied to interest rates

Higher interest rates also mean that it takes less to secure the same retirement standard of living as before rates started rising.

It's an ill wind that blows no good, and that is true currently with higher interest rates. Though you'd never know it reading recent financial news headlines, higher interest rates in some cases can help investors as much as they hurt.

This is because a rough equilibrium exists between the stock market, interest rates and the cost of acquiring a guaranteed lifetime income. Though higher rates can cause stock and bond portfolios to suffer, those higher rates also mean that it takes less to secure the same retirement standard of living as before rates started rising.

The best way to illustrate this equilibrium is with annuity payout rates - how much monthly income you could purchase with a given amount of money. To be sure, annuities aren't the only way of providing guaranteed lifetime income. But it simplifies comparisons to translate complex portfolios into the annuity income each could support.

The above chart plots the monthly income that could be secured with a $100,000 premium. (In particular, the payout rate for a 65-year-old male with a 10-years certain annuity; data courtesy of ImmediateAnnuities.com.) Notice that this payout rate is closely linked to Moody's AAA-corporate bond yield, a benchmark for investment-grade bonds. That yield currently is higher than it's been in years, and so is the monthly income that could be purchased with such an annuity.

To illustrate the equilibrium that exists between the stock market, interest rates and annuity payout rates, consider an investor who invests in blue-chip stocks as represented by the Dow Jones Industrial Average DJIA. If we assume that, two months ago in early August, this portfolio was worth $100,000, it today would be worth approximately $93,700 (given the Dow's 6.3% decline since then).

If we focus just on just this set of facts, higher rates certainly appear to be unambiguously bad news. And that's what many investors believe. But if we take into account the increase over the past two months in annuity payout rates, the news is neutral. This hypothetical investor could today convert his $93,700 stock portfolio into almost the same monthly guaranteed income today as he could have with his $100,000 portfolio in early August.

TIPS ladders

This rough equilibrium is also evident in TIPS ladders, which in the past I have argued are superior to annuities in many respects. Currently, according to the excellent free website TIPSLadder.com, you can lock in an inflation-adjusted 30-year withdrawal rate of 5.2% - or $433 per month in current dollars - by using $100,000 to construct a ladder of different TIPS. The comparable rate two months ago, when interest rates were lower, was 4.9% - equal to $408 per month.

Notice what this means for our hypothetical investor with a stock portfolio holding the DJIA's blue chip stocks. Though his erstwhile $100,000 portfolio is now worth $93,700, with that reduced amount he can still purchase a TIPS ladder that produces monthly income of $406-almost exactly the dollar amount he could have locked in two months ago with the greater portfolio value.

Don't forget that the payout of the TIPS ladder is inflation-adjusted, whereas that of the life annuity is not. It's "inflation illusion" to assume that the $676 monthly income produced by a $100,000 is superior to the $433 produced by the TIPS ladder. Assuming the current inflation rate of 3.4% stays constant for the next 30 years, for example, the TIPS ladder's monthly income in 2056 will be $1,181, while the annuity's will still be $676.

The bottom line: Be careful what you wish for. While lower interest rates would likely be good for the value of your portfolio, it would simultaneously reduce the amount of retirement income into which you could translate that portfolio.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

-Mark Hulbert