Unraveling the Retirement Income Mystery

Portfolio StructureOne of the most constant queries we receive from new (and some not so new) clients is how they will be able to shift from asset accumulation into current income for retirement. How will they make their retirement work financially? Like many financial questions, the easiest way to find the answer is to “unravel” the various building blocks of the portfolio to determine both purpose and risk.

Money is Money

Years ago, many of the investment texts recommended dramatically changing investment portfolios upon retirement from mostly stocks into mostly bonds (fixed income). Over time, this view has changed due to longer life expectancies and inflation concerns. Simply stated, it is not financially feasible to achieve inflation protection with a fixed income portfolio that likely earns less than the inflation rate. Over a potential 30 year retirement, living expenses are likely to double. Therefore, a portfolio of solely fixed income amounts to a strategy to “go broke” slowly.

I wrote a short “one-pager” a few months ago that some of you have seen titled Money is Money The main point of this piece is to drive home the dual realities of risk in the fixed income markets and the long term premium returns in stocks. Most of us need both, not one or the other. The other point of emphasis is that all accruals within an investment portfolio, regardless of what these accruals are named, equate into dollars available for withdrawals. The reason we save and invest is for a future goal. Just because the investment produces capital appreciation or gain instead of interest or dividends is of little importance. It is still a resource that can be utilized for that purpose.

Is Fixed Income the Answer?

Fixed income investments are tied to interest rates. Interest rates have been declining for more than three decades but this is likely to change at some point given the very low level of rates for the past few years. Those trying to out-guess the fixed income market (or in reality the Federal Reserve), are taking on substantial risk indeed. Short term price movements in the fixed income market can far exceed volatility within the stock market at times. The proper role of fixed income is to smooth out overall returns and to be a place where withdrawals can be made when stocks inevitably move backwards.

Fixed income investments take many forms of course. Money market funds; corporate bond funds; tax free bonds /funds; and even certificates of deposit. Municipal tax free bonds often appear attractive to investors nearing retirement. Individual municipal bonds , however, can be a forbidding place to most investors. The costs and the risks are not always clear.

The reason many investors think they want a portfolio of mostly fixed income is the perception of low risk. This perception may differ sharply from the current reality. Investors have dual risks in terms of very low yields and the prospect of losing principal value once rates rise. In many ways, the fixed income market is presently a place with moderate to high risk and low returns. This is not a favorable combination of risk and reward.

The “Best Bet”

That brings us back full circle to solving the mystery of retirement income. As outlined already, a long retirement will require a substantial (and what constitutes substantial is where personal financial planning comes in) permanent allocation to stocks. There you have it. The most reliable method of obtaining protection from inflation rests in the stock market. About eight decades of data support that conclusion that it is the “best bet” despite all the short term noise. At normal allocation levels, stocks actually reduce risk compared to a fixed income portfolio.

Over long periods, we expect stocks to rise about 70% of the time.  Perhaps some context will help. Coach Ray Tanner (now Athletics Director at University of South Carolina but previously the 2 time National Champion baseball coach), compiled a career winning record of just under 70%. At the time of his retirement from coaching last summer, he ranked 8th among active coaches in winning percentage.  I think most would consider Coach Tanner’s record outstanding. The “winning” percentage in the market should be considered in the same manner. The market won’t be up every day…but it will be up most days. A broadly diversified (and regularly re-balanced) portfolio will accrue capital gains over the long term and retirement withdrawals can be made from these gains. In times where stocks are down, we turn more to the fixed income side of the portfolio for the regular withdrawals. We use fixed income as a buffer.

You save and invest for a purpose and your overall portfolio should serve that purpose. What individual components of the portfolio are named doesn’t matter. Everything is income for purposes of solving the retirement equation. Transitioning from saving to consuming can be a scary proposition. Looking at the investment portfolio as a whole can help make it less so.

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