In this article series, we are exploring a few ways that I believe some clients and financial professionals may have a disconnect in their conversations about risk—especially when planning for retirement. When clients are primarily wanting to grow and save their assets FOR their retirement years, the risks they should consider are different than some of the risks they’ll face DURING their retirement years. In this post, we are going to explore how clients should carefully consider the impact that inflation combined with low returns can have on their purchasing power over the long run.
“I’m not so much concerned with the return on my capital as I am with the return of my capital.” — Will Rogers
The quote above, in my opinion, is a fair representation of the investment persona for many folks who are entering the retirement phase of life. Of course, this is not to suggest that investors suddenly stop caring about returns. As an investment professional, that certainly has not been my experience! What I have found, though, is that retirement-minded investors can become much more concerned with avoiding losses, especially as they exit the workforce and begin living off of their savings. As I shared in the last article, the concern about major market losses is still valid in retirement.
If you consider the scope of resources we now have about “successful” investing, one of the key themes that is repeated over and over is that we should allow investments to have TIMEin the market. Yet, once people enter retirement, they seem to forget that retirement is a phase of life that can last up to 30 or 40 years if you are healthy! This sudden shift from working to being retired can be a shock, and it can cause some investors to significantly alter their investment allocation. The result can be the tendency for some retirees to adjust their investments to invest too conservatively, not accounting for increasing longevity in today’s society.
Believe it or not, I have a relative on my wife’s side of the family—Uncle Pete—who has been retired longer than he actually worked! #GoPeteGo
This idea about the potential length of one’s retirement years is huge. In fact, longevity—or living a long time—often acts as a risk multiplier for retirees. The longer you live, the more likely many different things can happen: bear markets, inflation, healthcare issues, tax or legislative changes, etc.
At the beginning, I mentioned we were going to focus this article on the combined effects of inflation and low returns. To be clear, I’m not referring to low returns because of a poor investing outcome (although the same thought process could apply). My frame on low returns is coming from where investors, who are entering retirement, decide to invest their money too conservatively. By doing so, they make it very difficult to earn real returns on their funds. Instead, their overly conservative investments may cause them to actually have low or zero real return when you consider inflation.
Let’s dive in with an example:
We’ll stick with our couple from the previous article—Joe and Janice. Joe and Janice are in their early 60’s and have now retired. They did a great job of saving, and they now wish to use their nest egg of 1 million to enjoy their retirement years. In the initial visit with their advisor, they shared that both of them have longevity in their family. In fact, Janice’s mother is still living at age 90.
Now that they’ve retired, Joe and Janice really want to make sure that they don’t take too much risk with their money. They are much more concerned with losing principal than they are making gains with the stock market. After sharing their concerns and completing the risk profile, the advisor confirms that they are definitely in the conservative category.
They tell the advisor that they would really like to invest their assets and just live off of the income—meaning they don’t want to touch principal if at all possible. Their advisor explains that income investing is extremely challenging, and he offers a compromise—they will choose a mix of conservative investments, heavily investing in short-term bond funds. They also agree to keep roughly $100,000 in money market funds, which serves as their emergency fund. The remaining $900,000 will be invested.
Let’s give them the most pristine environment as possible and assume they can generate average total returns of 5% per year (gross). The total cost of their advisory fees and the internal expenses on their mutual funds will shave 1.6% off of their returns, which means they should expect an average net return of 3.4%. I even give them 1% on their money market!
Again, we are looking at a pristine scenario, so I’m going to assume that Joe and Janice see zero downturns or major market volatility. Instead, they earn the full 3.4% every year like clockwork. In the meantime, they continue their withdrawal of $45,000/year.
At the end of 12 years, here’s how it plays out for them:
Joe and Janice are now almost 74, and they are still enjoying their retirement years. They now have $699,415 invested in their bond portfolio, with another $112,216 in cash. Total remaining investments are $811,631. Not bad if you want low volatility and peace of mind, right?
Before we get too excited, let’s consider the impact of an inflation rate of just 2.5%…
By taking the $811,631 and discounting it back today’s dollars, it equates to $603,493.
In a span of 12 years, Joe and Janice have lost almost 40% of their purchasing power!Despite the smoothed returns and low risk, they have lost money due to the impact of the fees, low returns, and inflation. If you want to take this a step further and assume that Joe’s initial $900k investment was an IRA, you can reduce the real purchasing power of their assets by their effective tax rate.
Now consider their ages—they are only in their early 70s. It’s quite possible that both of them will live another 12 to 15 years. Perhaps one of them even lives into their 90s? Continuing down this path could be a significant challenge, especially if you consider other elements of risk that we didn’t discuss—cost of healthcare or long-term care risk, interest rate risk, market volatility, higher inflation, etc.
The point is this- retirement is a complex phase of life, and it’s imperative on workers to enter their retirement years with a comprehensive retirement income plan. Simply altering allocations or getting more conservative to protect principal may feel like a wise decision; however, it opens up the household to some long-term effects that may be undesirable. Creating a comprehensive retirement income plan is the key component to having peace of mind in your retirement years. This doesn’t mean that a plan will solve all of the challenges in retirement; however, having a plan will give you a great framework for how to make adjustments and decisions as you move through your retirement years.
Note: The example used in this article is hypothetical and oversimplified on purpose. It should only be considered as an attempt to educate readers on the concept of sequence of return risk.
Investment advisory and financial planning services offered through Planners Alliance, LLC, a SEC Registered Investment Advisor. Sub-advisory services are provided by Advisory Alpha, LLC, a SEC Registered Investment Advisor. Insurance, Consulting and Education services offered through Vertex Capital Advisors. Vertex Capital Advisors is a separate and unaffiliated entity from Planners Alliance, LLC and Advisory Alpha, LLC.