Managing Post-Retirement Risks: The Stock Market

Stock market losses can seriously reduce retirement savings. But common stocks have substantially outperformed other investments over time, and thus are often recommended for retirees' long-term investments as part of a long-term investment mix.

Predictability

Individual stocks rise and fall based on the outlook for the stock market and the specific company. Individual stocks are more volatile than a diversified portfolio.


Stock index funds are diversified, but they still are exposed to the ups and downs of the stock market.


Managing the Risk

Stock market investors should diversify widely among investment classes and individual securities, and be prepared to absorb possible losses. Because it may take many years to recover losses, older employees and retirees should be especially careful to limit their stock market exposure.


A variety of polled investment "funds" exist, ranging from mutual funds and exchange-traded funds to managed accounts to hedge funds.


Hedge funds, which are private investment funds that participate in a range of assets and a variety of investment strategies, may offer some protection, but they can be complex and have high expense charges.


Stock funds offer opportunities to invest in both U.S. companies and international stocks.


Conclusion

Some financial products let an individual invest in stocks and guarantee against loss of principal. However, expenses on these products may be high, and the financial firm may limit losses by shifting most funds to bonds, thus reducing the stock exposure.


Younger workers can afford to take more risks because they have time to make up short-term losses and can postpone retirement. Older individuals might want to allocate a smaller proportion of assets to the stock market.


Target-date (or "life-cycle") funds gradually shift some of their assets out of stocks as the investor gets older. In target-date funds designed by different fund managers, the allocation to stocks at a given age varies. Proposed regulations would increase disclosure to consumers about target-date funds to bolster understanding of what these funds do and don't do.


When significant personal assets are in company stock, the risk of job loss is compounded by possible loss of savings if the company does poorly or goes out of business. Even if a company appears strong, it is safer to diversify those assets among other investments.$


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Managing Post-Retirement Risks: Interest Rates

Lower interest rates tend to reduce retirement income in several ways:

• Workers must save more to accumulate an adequate retirement fund.
• Retirees earn less spendable income on investments such as CDs and bonds; any income reinvested earns lower rates.
• Payout annuities yield less income when long-term interest rates are low at the time of purchase.

Predictability

Long-term and short-term interest rates can vary within a wide range. Underlying forces that drive interest rates include expected inflation, government actions and business conditions.




Managing The Risk

Income annuities provide retirees with a guaranteed fixed income, despite changes in the interest rate environment, but most do not adjust the income for inflation.


Prevailing interest rates will impact the amount of annuity payout the retiree can purchase from a given lump sum.


Investing in long-term bonds, mortgages or dividend-paying stocks also offers protection against lower interest rates, although the value of these investments will fluctuate. The risk is that rising interest rates will reduce the value of such assets available to meet unexpected needs.




Conclusion

Long-term interest rates often move up or down at about the same rate of inflation.


Higher real interest returns, above rates of inflation, usually make retirement more affordable. this occurs when retirees' assets include sizeable amounts of interest-paying bonds, CDs, etc.


However, some retirees have adjustable-rate mortgages or substantial consumer debt, so higher interest rates are an added burden. For such retirees, the higher interest rates that accompany increased inflation may reduce their spendable income just when it's most needed.


Low interest rates in some recent years make it clear that retirees relying on income from interest-bearing investments are subject to interest rate risk.$




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Managing Post-Retirement Risks: Inflation

Inflation should be an ongoing concern for anyone living on a fixed income. In the recent era of relatively low inflation, workers may not know about or remember the double-digit inflation of 1947, 1974 or 1979-81. Even low rates of inflation can seriously erode the well-being of retirees who live many years.

Predictability

Average past inflation can be calculated from historical data, although actual experience over a typical period of retirement may vary widely. Past inflation data can provide some help in estimating retirement needs, but there is no guarantee that future inflation will match historical experience.

Managing the Risk

Many investors try to own some assets whose value may grow in times of inflation. However, this sometimes results in trading inflation risk for investment risk.

Investment returns from common stocks have increased more rapidly than consumer prices in the long run. But in the short term, stocks don't offer reliable protection against inflation. The historically higher returns from stocks are not guaranteed and may very greatly during retirement years.

Inflation-indexed Treasury bonds grow in value and provide more income as the Consumer Price Index goes up. Many experts say that retirees' investments should include some of these securities.

Inflation-indexed annuities, not widely used in the United States, adjust payments for inflation up to a specified annual limit. Annuities with a predefined annual increase also are available. These kinds of annuities cost more than fixed-payment annuities with the same initial level of income.

Investments in natural resources and other commodities often rise in value during periods of long-term inflation, but the values may fluctuate widely in the short run.

Conclusion

Inflation can be a major issue, especially as retirement periods lengthen. Inflation is not highly predictable.

Retirees can set aside assets that will permit a gradual increase in consumption.

Providing for expected inflation one way or another, although costly, is needed in any realistic plan for managing resources in retirement.

Delaying receipt of Social Security will build up valuable inflation-indexed benefits for retirees and spouses.

When housing values were increasing, homeowners seemed to have a hedge against inflation, but this has not been true in recent years.

Current and future retirees who have expected to use their home equity as a source of retirement income may be sorely disappointed, especially if housing values continue to decline. Strategies that rely on increases in the value of housing and selling quickly are very risky, since the value may not rise and it may take a long time to sell the house.$

Next Risk: Interest Rates

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Retirement: Five Financial Risks Ahead

In retirement, there are five major financial risks that must be accounted for. Your retirement income plan needs to have a solid strategy that helps you address and navigate these risks.

1. Interest Rate Risk. Traditionally, bonds were a great option to provide interest income to help supplement a retirees' Social Security or pension benefits. If a retiree required an extra $40,000 in annual income, and bonds were paying 4%, they would have to purchase $1 million worth of bonds. This would basically be an all-in strategy, where all of a person's savings went into bonds. That was ok when people retired at 65 and lived to age 72. Now, we have potentially 30-year periods in retirement. This leaves the retiree exposed to interest rate risk. Just what is interest rate risk? A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions. When market interest rates rise, prices on fixed-rate bonds fall. Interest rate risk is common to all bonds, even U.S. Treasury bonds. A bond's maturity and coupon rate generally affect how much its price will change as a result of changes in market interest rates. A bond's yield to maturity shows how much an investor's money will earn if the bond is held until it matures. If you have to sell your bonds before maturity, say when interest rates are rising, they may be worth less than you paid for it.
2. Market Risks. Another strategy is a mix of stocks and bonds. Bonds provide interest and stocks would give growth, providing a hedge for inflation. The problem with this drawdown strategy is that the markets have to cooperate. If you start taking income when markets are down, you are really decimating your portfolio. You're exponentially increasing the chances of running out of money in retirement. Stocks and bonds can be down at the same time. Market risk is the possibility for an investor to experience losses due to factors that affect the overall performance of the financial markets. Market risk cannot be eliminated through diversification, though it can be hedged against. The risk that a major natural disaster will cause a decline in the market as a whole is an example of market risk. Other sources of market risk include recessions, political turmoil, changes in interest rates and terrorist attacks.
3. Longevity Risk. Individuals often underestimate longevity risk. In the United States, most retirees do not expect to live past 85, but this is in fact the median conditional life expectancy for men at 65 (half of 65-year old men will live to 85 or older, and more women will). For individuals, insurers provide the majority of products designed to help individuals manage the risk that they outlive their assets. Individuals without defined benefit plans can ensure lifetime income by purchasing annuities within their defined contribution plans and personal retirement accounts.
4. Inflation Risk. Inflation risk, also called purchasing power risk, is the chance that the cash flow from an investment won't be worth as much in the future because of changes in purchasing power due to inflation. Although the record inflation of the 1970s is history, inflation risk is still a common worry for income investors. Inflation causes money to lose value, and any investment that involves cash flows over time is exposed to this inflation risk. The ramifications of this can be serious: The investor earns a lower return than he or she originally expected, in some cases causing the investor to withdraw some of a portfolio's principal if he or she is dependent on it for income. It is important to note that inflation risk isn't the risk that there will be inflation, it is the risk that inflation will be higher than expected.
5. Healthcare Risks. Inflation on healthcare costs coupled with living longer in retirement can spell disaster if not properly managed. Compounding this issue further is the rate of inflation on items such as prescription drugs and preventive care, which have historically exceeded the 3% general rate of inflation. According to a 2011 Fidelity Investments study, a 65-year-old couple would need $230,000 to pay for medical expenses through retirement, not including long-term care costs ranging from $35,000 for assisted living facilities and home health care, all the way up to $70,000 or more for nursing home care. These are significant expenditures which show no sign of decreasing. Traditional solutions such as Medicare and Medicaid are helpful, but they aren't always enough to meet an individuals needs. Around 69% of pre-retirees are very or somewhat concerned about having enough money to afford adequate healthcare; 51% of retirees share that level of concern. Additionally, 63% of pre-retirees are concerned about having enough to pay for long-term care; 52% of retirees share that concern.

If you are nearing retirement, or are already there, you need a strategy that addresses ALL of these risks. Professional mountain climbers know that most fatalities and injuries happen on the way down the mountain, not during the climb. Likewise, you have successfully navigated your way to the retirement savings summit. Now, you need a way to safely de-cumulate. There are a lot of risks to staying retired. If your current advisor is not helping you address all, or at least most of these risks, it's time for a second opinion.$

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