A husband and wife, soon to retire, were sharing with me everything they were looking forward to: lingering over morning coffee, taking some classes, seeing lots of matinee films. The wife then paused: “There’s one thing, however, I’m really dreading.”
“Qualifying for a senior citizen discount on those movie tickets?” I asked.
“No,” she said. “It’s no longer seeing that monthly paycheck deposit in our bank account.”
The prospect of consuming wealth rather than building it can be a frightening reversal for many retirees. This may explain their sense of urgency about retirement – the feeling that they need to do “something,” particularly when it comes to their investments. “Shouldn’t I be holding more bonds?” they may ask. We can’t afford to lose in the stock market the money we’ve worked so hard to accumulate.”
In this third installment of our “Living on Investment Income Series,” let’s look closely at the role of risk in the retirement portfolio. Most retirees think that stock market drops are their greatest enemy. However, time has proven to be an effective antidote to market slides. As long as the retiree does not dump everything and run for cover with a major market setback, he will likely be okay.
But time can work as a double agent: what it may give back in investment returns, it snatches away in other more devious ways. First is through inflation: the subtle, but powerful erosion of what the retiree’s portfolio dollars are actually worth. Over the span of a typical retirement, even an inflation rate as low as 2 percent annually can wipe out 40-50 percent of the real value of the portfolio.
Then there’s the simple fact of time itself. Just about every healthy 65-year-old worries about living too long and running out of money. When I do my own retirement projections, I am always unpleasantly surprised to find that ten more years of life cuts my chances of being able to live on my portfolio income in half! What good are those years if they are not worth living?
These latter two risks – inflation and longevity, rather than market volatility – should be given primary importance by a retiree in his investment decision-making. Taking shelter in Treasuries, or avoiding all stock risk, is not the solution. It could, in fact, make matters worse.
So what investments make sense in a retirement portfolio designed to mitigate these two risks?
- Cash: Yes, lowly, boring cash, in the form of money market accounts. Holding five to seven years of essential retirement expenses in money markets can, first of all, buffer against the risk of having to sell other securities – stocks or bonds – at a time when their values have declined. But just as important, money market rates of return are variable, and increase as inflation drives up interest rates. Not a perfect inflation hedge, but a darn sight better than long-term Treasuries.
- Inflation-Indexed Bonds: Unexpected inflation spells disaster to fixed income investments, especially long-term bonds. To mitigate against this risk, a retiree should include bonds whose principal value and coupon increases with upward moves of the consumer price index.
- Equities (including U.S. and international stocks, and real estate): The key here is to include assets that over time have expected longer term growth rates above the rate at which the retiree is withdrawing from the portfolio. At typical recommended withdrawal rates of 4 to 5 percent, it’s just not possible for most fixed income investments to consistently outpace these rates. Based on history, stocks – diversified between domestic, international and real estate – provide a much better promise of returns over 10 or more years that are well in excess of the 4-5 percent withdrawal threshold. A healthy proportion of equities is absolutely necessary for retirees expecting to live to 100 or more. Real estate equity offers the extra bonus of being a good inflation hedge.
So much for the traditional asset classes of cash, bonds, and equities. Now comes other investments that most retirees never really think about as part of a prudent retirement portfolio:
- Fixed annuities: These instruments are designed to provide income no matter how long the retiree lives. As such, they can also be usefully added to the portfolio to occupy the place otherwise held by bonds. They carry, in fact, an extra kicker that bonds do not: namely, over and above a stated interest return, an annuity also pays a “still living” bonus. Because annuities are structured for a pool of individuals, those who die before their life expectancy are penalized relative to those who outlive the charts. The returns that would otherwise have been paid to the deceased are instead recycled to the living, and have the effect of raising the pay-outs.
- Human capital: For retirees who, like the Energizer Bunny, keep going and going, there is always their human capital to draw on as a way to supplement their retirement portfolio. In other words, by putting their professional experience, skills, and availability back to work for some income, retirees can offset the ravages of inflation, as well as make the portfolio last longer. Earning just 10 percent of monthly living costs – practically “pocket change” – can add back some worth-living years to the retiree’s horizon.
- Social Security: Rarely considered an “investment,” Social Security may nevertheless pay some of the best returns available to risk-averse investors, IF they are willing to forego retirement benefits until they turn 70. By delaying benefits for four years after normal retirement age, a retiree can increase his benefit by 32 percent over what he would earlier receive. The pay-off to delay gets larger the longer the retiree lives, thus hedging his longevity risk. But that’s not all. Social Security, like Inflation-Indexed Bonds, pays more as inflation goes up. In this regard, Social Security comes out as a real winner for retirees who are dealing with the two-headed monster of longevity and purchasing power loss simultaneously.
All these investments are “ideas” for retirement portfolios. But that’s only the beginning of prudent portfolio construction for a retiree. Whether these ideas actually make sense, and how they should be implemented, depends completely on his individual circumstances. Here’s where another kind of investment may be needed: an investment of time and money to engage a CFP® professional to help build a portfolio that a retiree can truly “live with” for the many years of retirement ahead.
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