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Risks Retirees Face Continued

In June, we addressed the three major risks retirees face - inflation, withdrawal rate and longevity.  This month we will discuss four additional risks that affect retirees.

June blog

Retirement Spending – In retirement, spending habits and needs will change. As discussed in the previous blog, medical expenses will increase for retirees, but there are offsets. For example, having your mortgage paid off or downsizing could offset some increases in medical costs. What retirees need to pay attention to is how they will replace the income that they are losing by retiring. The three pillars of retirement income include Social Security, pensions, and personal investments and retirement accounts like 401k/403b or an IRA.  A retiree needs to keep in mind that, for example, they don’t have $1mm to spend rather they have $1mm from which to create an income.

Market Volatility – During the Accumulation Phase (while working) market volatility is not as harmful to investors because it allows them to dollar-cost average into the stock market picking up more shares when stocks are on sale which lowers the average cost per share. That all changes in retirement. While in retirement (Distribution Phase), the opportunity to purchase additional shares is limited to tactical rebalancing. The challenge is that an investor will need to have the emotional fortitude to sell bonds and buy stocks just when things are at their worst.  Another means for reducing portfolio volatility is a greater allocation to bonds and/or income producing assets.

Savings - In retirement it is widely recommended to maintain 18 months to two years worth of savings in safe investments like CDs, money markets, and savings or checking accounts.  These assets can be drawn upon to fund spending during down markets rather than selling equity investments when they are temporarily depressed. At Von Holt Financial Advisors, we follow this rule in a slightly different way. For retirees in the Distribution Phase, we maintain several years worth of spending in low duration and high-quality bonds as a safety net with the added benefits of increased returns and regular income production.  Although the bonds have higher volatility, we actively monitor the portfolio so as to manage the additional risk. It is our opinion that it is worth the extra risk in order to capture the higher yields and income for a long-term investor. 

Solvency - Private pensions that are offered by companies have been decreasing rapidly over the last few decades so for most retirees their primary fixed source for retirement income will be Social Security.  As Social Security runs into funding issues personal investments and retirement accounts will be front and center for anyone that wants to have a financially secure retirement. With estimates that the Social Security Trust Fund will be depleted by 2034 retirees are expected to receive only 77% of their anticipated benefits after 2034.  As a result, personal investment and retirement accounts will account for a growing portion of a retirees income sources. This argues for starting to save for retirement earlier and saving a larger portion of your income to offset these other risks.

Risks Retirees Face

This blog will be presented in two parts. In the first part, I will discuss the three most substantial risks retirees face, and the second part will discuss four other risks.

June blog

Inflation – As discussed in a previous blog about real return, inflation plays a large role in the ability to maintain your standard of living in retirement. Historically, average annual inflation has been from 3.0% to 4.0% depending on the time frame considered. We are currently using a long-term inflation rate of 3.25% when forecasting client total expenses. The rule of 72 is a simple calculation to show how long it would take your money’s value to halve due to inflation or double based on returns. You just divide 72 by the rate of inflation (or return) to see how many years it would take to halve (or double) in value.

Withdrawal rate – The rate at which you withdraw from your retirement assets is a primary factor when determining how long your assets will last. Below is a graphic showing the probability of your money lasting through a 25 year retirement at different withdrawal rates and asset allocations. We usually assume a life expectancy of 97 so we tend to invest slightly more in stocks to produce additional growth to protect our client’s purchasing power.

 June blog 2

Longevity – With advancements in medical treatments and technology retirees are living healthier and longer lives. This means that your money will need to last through a longer and more active retirement. With a longer life expectancy, the rate of inflation and your withdrawal rate will play an even greater role in determining your chances for long-term financial security. At the same time, medical advances will increase your total medical expenses which have generally outpaced the rate of overall inflation. Below is a chart showing the probabilities of a 65 year old living to various ages.

The inflation rate, your withdrawal rate and your longevity are linked together and will play a major role in determining your long-term financial success.  

June blog 3

Dangers of Market Timing

Investors who attempt to time the stock market run the risk of missing periods of exceptional returns. This practice may have a negative effect on a sound long-term investment strategy.

As shown below, we can see the returns for a hypothetical $1 investment in stocks, stocks minus the best 13 months (5% of the total time period), and Treasury bills. An unsuccessful market timer, missing the best 13 months of stock returns, would have earned a return similar to that of Treasury bills. How would an investor know, in advance, when one of the 13 months is about to happen? According to Warren Buffett, “The stock market is a device to transfer money from the impatient to the patient.”

Market timing

There are more important aspects of investing that will determine your long-term success such as; Understanding the purpose or potential use for the funds, your investment time horizon and risk tolerance, the allocations to stocks, bonds and cash, the specific asset classes chosen and, finally, the particular investments that are selected. Although successful market timing may improve portfolio performance, it is very difficult to time the market consistently. You have to be right twice each time-when to sell and when to buy again. The only way to guarantee that you capture 100% of the return of the stock market is to be invested 100% of the time.

 

Real Return

When it comes to measuring investment returns there is more than one method. The most common is nominal return which includes inflation. The other measure of return is called real return. Real return is measured by taking the nominal return less the inflation rate. Real return is vital because it measures the increase in purchasing power that your investments generate.

If Investor A achieves a 10% return and Investor B achieves a 1% return, most people would say that Investor A did much better than Investor B. Let’s now say that Investor A had to deal with an inflation rate of 10% and Investor B was in a 0% inflation environment. After inflation Investor A actually did not increase their purchasing power while Investor B added 1% to their purchasing power. This is important because even though Investor A had a nominal return that was 10x that of Investor B they can’t buy more than before. On the other hand, Investor B would have added 1% to their purchasing power. Meaning the 1% nominal return is actually better than the 10% return when adjusted for inflation.

Let’s take a look at how the three primary asset classes have performed before and after inflation.  As you can see, stocks have easily produced a positive real rate of return with bonds offering a real return equal to roughly one-third that of stocks and cash-type investments producing a fractional real return.

After inflation, taxes and a recommended maximum 4% annual withdrawal rate for retired clients the only asset class that will protect their purchasing power is stocks.  That is why stocks have to play an important role in a retirees investment portfolio. While bonds do not offer the same long-term growth potential they need to be included in a balanced portfolio.  They are a more dependable source of income and will serve as a ballast when stocks experience periodic setbacks. And while cash-type investments are safe in the short-term they expose an investor to the risk that their purchasing power will decline due to inflation.

Investor Behavior Gap

Morningstar has spent years studying the returns investors actually earn versus the returns the funds earned. Through this study, Morningstar has found that the behavior of an investor whether by attempting to time the market, selling during a downturn or buying after a rally has resulted in the same outcome - the average investor earning a lower rate of return.

Here’s an example - Imagine that a fund with $10 million in assets earns a 100% return from Jan. 1st to Dec. 31st. Assuming no one added or took money out of the fund it would start the next year with $20 million in assets. In the new year investors flocked to this fund adding $100 million on January 1st because of its previous years performance bringing its assets to $120 million. In year two, however, the fund loses 50% of its value.  An investor who invested at the beginning of year one has broken even over the full two years while those who entered into the fund in year two have lost 50% of their investment. As a group they gained $10 million in year 1, but lost $60 million in year two. Adjusted for the timing and amount of inflows, the average investor lost about 42% annually in a fund that officially reported a 0% return over the two year period. Simply put, it is unwise to chase performance.

The average investor has underperformed the fund investments they own by an average of 1.6% per year over the long run. Over a 10 year period an investor that underperformed by 1.6% per year would have earned about $300,000 less than the fund itself (assuming a $1,000,000 portfolio, an 8% rate of return by the fund, a 6.4% return for the average investor, and no withdrawals). The gap between the returns tend to be greater for funds that are riskier (equity funds) since they invoke more of an emotional response by investors due to their higher volatility. As financial advisors part of our job is to eliminate that gap for our clients by removing the behavioral mistakes resulting from swings in the market.

On average, trying to do better makes an investor do worse.  It feels great to buy more when an investment had been going up, and it hurts to buy more when an asset has gone down.  An investor that tends to raise their exposure to assets that have gotten more expensive (with lower future returns) and to reduce it when they are cheaper (with higher future returns) guarantees they will underperform.  Why is it that people want to buy everything else on sale except their investments?

In the end, emotional responses to market events significantly hurt the average investors performance.

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