We talk with folks daily about what they want their investments to do for them during retirement. Many presume their time horizon ends at retirement, rather than stretching over an entire lifetime or beyond, depending on their spouse’s age, beneficiaries, and long-term goals. In any case, the usual No. 1 response is not wanting to risk their hard-earned assets. While a reasonable request, the challenge to us is that most investors are confused about what type of risk they are most concerned about.
Of course, the risk most often brought up is market risk, the potential for a downturn to reduce your assets. Further, most investors are still looking over their investing shoulders at the drops in 2008-2009 and again through the first part of last year. But there are other risks, not so readily considered or understood. For instance, there’s interest rate risk, as in when and in which direction interest rates may move. Reinvestment risk is your return when an issue comes due that won’t match what you’ve been getting.
And then there’s the one that can really be a problem over your two- to three-decade retirement: buying power risk or inflation risk. This refers to not creating enough growth to stay ahead of inflation and taxes.
And here’s where we as advisers have to deal with the consensus view of most American investors—the view that when you retire, you should be more conservative with your money. Again, to most, that means, “I don’t want to watch my value drop.” Not unreasonable, but what value do you mean?
Is it that you don’t want the printed numbers on your statements to get smaller? No one wants to have their retirement goals jeopardized. This conventional wisdom, which came about as a result of the Depression, is to put most of your retirement savings into some type of bond or certificate of deposit to protect those assets. Their cash flows are predictable and, therefore, “safe.” In addition, you get back the same number of dollars as you invested. A further demonstration of this belief is that the current favorite asset of many larger retirement plans is target-date funds. Those assets automatically move the money they hold for you more into bonds and bond-type funds as your retirement date moves closer.
We disagree. Folks have frequently gravitated to bonds and other low-volatility assets in retirement because they think avoiding loss is most important once they’ve stopped accumulating and started taking distributions. We think this misses the tradeoffs between owning stocks and bonds and how those evolve as your time horizon lengthens.
While bonds should be included in your holdings—to some extent, investing most of your retirement assets in cash, bonds, CDs, or fixed annuities to name a few, could actually increase your retirement risk due to this overexposure. What is essential is to earn a total return to provide you results that will allow you to have an income to support the retirement you want after taxes and allowing for the hidden tax of inflation. Your total return is your growth, plus any dividends or interest you earn.
Further, in investing for your retirement, it’s important to understand that no asset is totally safe. All have some risks attached. Most times, in my experience, just getting your principal back—even with interest—won’t be enough to meet your longer-term needs.
Your retirement is not, hopefully, a short-term situation. For most today, it can last 20 to 30 years or more.
To do your best to meet your plans and goals over that time, you have to invest to both maintain your buying power and protect your principal. There’s no “right” answer about how. It’s about what mix of assets will allow you to do that. You use your strategy to help create this mix.
A recent World Economic Forum report highlights the issue. It estimates the average American 65-year-old has enough savings to cover only about 10 years of retirement, despite rising life expectancies, with similar shortfalls in other advanced countries. By 2050, the WEF warns, there will be a several hundred trillion dollar global retirement savings shortfall. Shortfalls and retirement income are incompatible.
But mostly, if you want to reduce problems with risk, you need to stop thinking that there’s some class of investments that are risk-free. Nope. U.S. Treasuries are risk-free in the sense you will get your money on the due date. However, if you had to sell bonds before they come due, you could realize a loss.
Stocks are volatile in the short term, but over time, this volatility evens out, and bear markets fade. With at least two decades likely ahead of the average American at retirement, long time horizons give many retirees significant flexibility to own stocks and pursue a growth-oriented investment strategy. For those with time horizons of 20 to 30 years and longer, stocks have historically delivered the growth necessary to close the kind of gaps the WEF documents.
For example, stocks’ steady upward trend makes them a go-to hedge against inflation. As measured by the S&P 500, stocks have returned an average annual rate of 10%, pretax, or about 7% after tax, for nine decades, even as returns are all over the place. If you don’t want to deal with individual companies, investing in stock mutual funds, exchange-traded funds, and unit investment trusts will work.
It’s impossible to account for all the variables that could change during a decades-long window, likely in ways no one can imagine today. But we’re only talking averages here. Everyone’s circumstances differ, which renders straight-line predictions about individual people’s situations even less certain the further forecasters look out.
To help protect yourself, the WEF suggests placing a greater proportion of your savings into “return-seeking assets,” for example, stocks, rather than “lower return-seeking allocations,” like bonds. WEF said this could go a long way toward relieving peoples’ potential retirement savings gaps. That said, the WEF makes a useful point, in our view: Many investors increase their own retirement risk by being overexposed to cash and other “safe assets.” As their report says: “One of the biggest risks to a retiree is outliving their savings once some retirement capital has been built up. While saving consistently is critical, earning a return on savings also has a substantial impact on retirement outcomes.” This shows why “safe” is a misnomer.
We know that the cost of living has gone up in just about every year of our lives. Indeed, the consumer price index has been compounding at around 3% annually for the last century. Were it to continue to do that during your three decades of retirement, you could expect to see your living costs go up very nearly 2 1/2 times.
A purely fixed-income investment strategy—focusing as it does on preventing your principal from fluctuating—may leave you seriously exposed to the long-term erosion of your purchasing power. Put simply, no asset is really “safe” if holding it means you run out of money before your time. Often, simply getting your principal back—even with interest—won’t cut it. Bottom line: Unless you have a great deal of money, a mostly fixed-income strategy may not sustain you through a long, retired life of rising living costs.
With at least two decades likely ahead of the average American at retirement, long time horizons give many retirees significant flexibility to own stocks and pursue a growth-oriented investment strategy.
From your financial standpoint, retirement really has only two possible outcomes. One is that your money—or at least your income—outlives you. And the other is that you outlive your money. All the smiling retirees you see enjoying a full and active life in the TV commercials can only be doing so if they’re reasonably convinced that, on present trends, their capital and the income it produces will last them to the ends of their lives.
That may also afford them the opportunity to be helpful in the education of their grandchildren and be able to leave significant legacies to the people and institutions they love.
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