Managing Volatility During Retirement
Written by Gregory Palacorolla, CFP ®
Before you can ride off to the Retirement Promised Land, you must battle some worthy and formidable opponents. Inflation risk, longevity risk, market risk, and “stagnation risk” are all adversaries capable of making your journey treacherous and full of unexpected twists and turns. In fact, if not properly addressed, they could completely derail you. But all opponents can be outmaneuvered with proper strategy and foresight.
Inflationary risk (also known as purchasing power risk), is the chance that cash flows from an investment won’t be worth as much in the future due to changes in purchasing power as a result of inflation—basically, the risk that inflation will undermine the performance of an investment. Bonds are most susceptible to inflation risk. They receive a fixed coupon rate that doesn’t increase. If an investor buys a 30-year bond paying a 5% interest rate, then inflation soars to 15%, the investor is rightfully in panic mode, as with each year, they are losing a significant amount of purchasing power.
To fight inflationary risk, investors can look to securities that adjust their cash flows for inflation to counteract changes in purchasing power. Treasury Inflation Protected Securities (TIPS) adjust their coupon and principal payments for changes in the consumer price index, providing the investor with a guaranteed real return. High-quality short-term bond funds within a portfolio will turn over quickly and can be reinvested again at higher interest rates. They act as a cushion for retirees with short-term needs. High-quality corporate bonds are often used for qualified (tax-advantaged) accounts and short-term investment grade-rated municipal bonds are often used for non-qualified accounts. Convertible bonds also provide some protection since sometimes they trade like bonds and other times they trade like stocks. Long-term bonds carry interest rate risk and therefore do not make a good choice when fighting inflationary risk.
The National Association of Insurance Commissioners (NAIC) defines longevity risk as “the risk that actual survival rates and life expectancy will exceed expectations or pricing assumptions, resulting in greater than anticipated retirement cash flow needs. For individuals, it is the risk of outliving ones’ assets, resulting in a lower standard of living, reduced care, or a return to employment.” What if a market correction occurs early in retirement forcing you to spend a larger portion of your investment portfolio? Increasing your contributions in the final years leading up to retirement and delaying Social Security are two strategies that help with this.
Another popular strategy used by many advisors is the “bucketing approach,” which includes three buckets. The first bucket would consist of cash, money market funds, and short-term CDs that would cover any basic spending needs during your first three to five years of retirement (not including other sources of income such as pension and social security). Bucket two would cover the time period from the 6th to 15th year and would consist of short and intermediate term bonds. The third bucket is built to be the last man standing. It would consist of stocks and bond funds. The second and third buckets are in position to replenish bucket number one if need be. This strategy provides a safety net to cover your spending needs should an early market correction rear its ugly head, as well as offers the long-term growth required to meet your overall retirement goals.
Market risk refers to the risk an investment may face due to market fluctuations. It is sometimes referred to as “systemic risk.” This risk involves factors that affect the overall economy or securities markets. Inflation Risk is considered a market risk, however, we felt it was important enough to give it its own category. Other risks that fall into this category are currency risk, liquidity risk, sociopolitical risk, and more. To explain market risk, here is an example:
You decide to buy a home. You have a choice whether you want to buy a home warranty plan to cover all the major appliances and systems. Your choice is dependent on several things. How much are you willing to spend on this plan? How experienced are you with making home repairs? Are you a first-time home buyer? How comfortable are you with the idea of risk? As you read through stranger’s comments and recommendations online as to whether they felt a home warranty plan was worth it, you will come to understand that whether you make the decision to purchase the plan or not, there are other risks you will be forced to deal with regardless which will impact you as a homeowner. Natural disasters such as tornadoes and hurricanes, hail damage, fallen trees, soil erosion, and more are all examples of factors that are out of your control. However, you can prepare and plan accordingly by purchasing insurance, cutting trees close to the home down, installing gutters with well-placed downspouts, and fixing your foundation grading.
Market risk is similar in that if you have a well thought out plan in place and are aware of the potential threats, you can mitigate the damages associated with this type of risk. Establishing a relationship with a reputable financial advisor and creating a retirement income plan is critical. They will also help you keep your emotions in check and avoid panic during market downturns. Many retirees make the mistake of selling depreciated stocks. Patience and understanding your risk tolerance are very important concepts to master. It is vital you know answers to questions like how much money are you willing to lose? How much money can you afford to lose before it affects your ability to withdraw safely from your portfolio?
Allocation of your investments and the best ways to diversify are also extremely important when striving for alignment with goals. One way to protect the third bucket (stock portion of your portfolio) is to reach beyond the domestic markets. Historically, many portfolios with an allocation to international stocks have faired well and experienced less volatility than stock portfolios comprised of U.S. stocks only. Many young retirees (within the first 10 years of retirement) have anywhere from 40-60% invested in stocks. The older segment of retirees (80’s and 90’s) tend to have 20% or less invested in stocks. A good rule of thumb is to have no more than 7-10% invested in a given sector. Again, working with a financial advisor will help you create an appropriate mix of investments to align with your overall financial goals, not to mention your all-important tax efficiency goals.
This is the risk associated with no growth. Usually, it is centered around lack of growth in the economy. However, it can occur with investors as well. Portfolios need to be reviewed periodically to ensure they are still in line with tolerance, goals, and the investor’s overall financial plan. They should be rebalanced to set the weight of each asset class back to its original state. Basically, rebalancing is done by buying and selling portions of your portfolio. The asset mix changes over time based on differing returns among various securities and asset classes. As a result, the percentage you’ve allocated to the various asset classes will change, which may increase or decrease your portfolio’s risk.
People’s goals change, markets change, and risk tolerance can change. We are living in a world constantly surrounded by change. As investors, we cannot be stagnant. Our lives are dynamic; therefore, our plans must be too. So, before you ride off into the sunset make sure you have a strategy in hand, as this will serve as your most powerful weapon.
Sources: Kiplinger/ Investopedia/ Money.US News/ Forbes
© Geier Asset Management, Inc. April 2019. Gregory Palacorolla, CFP ® is Director of Wealth Management for Geier Asset Management, Inc., a Registered Investment Advisor. The articles & opinions expressed in this material were gathered from a variety of sources, but are reviewed by Geier Asset Management, Inc. prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of April 2019 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual circumstances. In all cases, please contact your investment professional before making any investment choices. Geier Asset Management, Inc. is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.