Investing For Success in Retirement
As you prepare for retirement, there are many tax and investment considerations that need to be addressed. However, one of the most important aspects of any modern retirement plan will be the development of your personal investment strategy.
In this article, we will provide you with a variety of investment-related concepts and thought processes that we view as fundamental elements to any successful investment strategy. From understanding your risk tolerance to managing inflation trends to exploring the benefits of diversification, we will cover it all!
Let’s get started with some basic but critically important investment concepts that will help you to better define your various investment objectives in retirement.
Funding Your Spending Need
How many years will my retirement savings last?
To answer this question, let’s review a very basic illustration that perfectly captures the main financial objective of every retiree.
Meet Jack and Mary, a 65-year-old couple with $1M in savings and a desire to spend $100,000 per year in retirement. The couple has $60,000 of Social Security income and they expect to live until Age 90 based on family history.
This means that Jack and Mary will need to withdraw $40,000 each year from their investment portfolio. Fortunately, Jack and Mary have saved up $1 million for retirement which leaves them with just enough to fund that $100,000 spending goal over the next 25 years ($40,000 of annual withdrawals x 25 years = $1M).
While the fact pattern here is a simple one, it helps to illustrate how your savings will translate into spending over time.
Keeping Pace with Inflation
However, Jack and Mary are unlikely to retire in a world of 0% inflation. Let’s now review how inflation can impact their retirement plan over time.
If we were to assume that Jack and Mary experience a 2% inflation rate over time, in Year 20, the couple will need $58,272 to buy the same goods and services that cost only $40,000 in Year 1. This means that $1 million in savings is no longer enough when we account for long-term inflation trends.
The good news, however, is that by earning just 2% in annual investment returns, Jack & Mary can once again fully fund their plan.
While the fact pattern is once again simple, it helps to illustrate how even a low level of inflation can erode the value of your savings over time.
Identifying the Right Approach
Now let’s review how Jack and Mary’s plan would look look if their investments earned annual returns that exceeded inflation over time.
If we assume that Jack and Mary earn 5% per year when annual inflation is 2%, the favorable results leave Jack and Mary with a few solid options to chose from.
For instance, Jack & Mary might decide to:
Build their savings cushion: They could stick with the $40,000 withdrawal rate and use extra $942,000 in excess savings for unexpected expenses.
Increase their annual spending: They could increase their annual withdrawals to $50,000 and still retain $331,000 at Age 90.
Invest more conservatively: They could stick with the $40,000 withdrawal rate but invest more conservatively by targeting a 3% annual return in safer investments.
In this example, we can see how the details of Jack & Mary’s retirement plan is very much interconnected with the investment decisions and strategies that they pursue.
Avoiding Large Losses
Incurring a large investment loss in the early years of retirement is one of the most problematic risks faced by any retiree.
Let’s assume that Jack and Mary elect to increase their spending to $50,000 per year by targeting a 5% annual return over time. As discussed in our prior example, if they earn exactly 5% each year, their plan looks good.
However, it is unlikely that Jack and Mary will earn exactly 5% every year. If we were to assume that Jack and Mary still earned that 5% average annual return but did so by losing 35% in Year 1 and then earning 7.1% annually for the next 24 years, the results are very different. Instead of a fully funded plan, they would be out of money at Age 84.
Incurring a large loss is a problem for retirees because most retirees have an ongoing need to sell their investments to fund their spending and, do so, even if it isn’t a great time to sell. As such, investing with a focus on avoiding large losses is a critically important for today’s retirees.
Shifting to a Wealth Management Mindset:
As you start the process of saving and building wealth, it is very common to adopt a return maximization mindset. The logic behind this mindset is quite straightforward. In those early years, you will have a limited amount of savings and many future years of saving ahead of you. This means that the risk of incurring a large near-term loss is unlikely to outweigh the benefit of growing your savings at a faster rate over the next 20 or 30 years.
However, at a certain point in your life, you begin to think differently about the impact a large loss might have on your future finances. For many, this shifting mindset is often driven by the realization that prudently managing your existing wealth is more important than trying to chase higher returns in riskier investments.
To highlight this concept, consider a 40 year old with $200,000 in his 401K vs. a 60 year old with $2 million in her 401K. If a 30% loss occurred, the 40 year old would realize a $60,000 decline in his 401K account which is unlikely to have any meaningful impact on his financial future.
However, for the 60 year old, a 30% loss would result in a $600,000 decline in her 401K account. This, of course, would represent a major problem for the 60 year old who would likely need to alter her financial plans as a result of the loss.
The Wealth Management Mindset
Someone with a wealth management mindset recognizes that their accumulated wealth is an asset that needs to be both protected and productively managed.
To highlight this concept, consider a 65 year old couple who has accumulated $3 million of retirement savings. In a 5% interest rate environment, this level of savings could generate $150,000 in annual income with little risk of loss.
However, if this couple lost $1 million in a 33% stock market downturn, they would now have $2 million which can only generate $100,000 in annual income. Therefore, by realizing this large loss, this couple significantly reduced the future productivity of their savings.
Therefore, as you start to accumulate more significant levels of wealth, it can make sense to invest with a focus on avoiding large losses while working to earn a sustainable long term rate of return on your wealth.
The Three Classes of Financial Assets:
Investing in retirement tends to revolve around investments in financial assets.
When you own a financial asset, you allow others to use your savings in exchange for interest, dividends, or an expected increase in the investment’s value over time.
The three classes of financial assets are Cash, Bonds, and Stocks.
Investing in Cash
What is Cash?
Cash consists of bank accounts, bank CDs, and money market funds. When we keep cash in a bank account or a bank CD, the Bank is using our cash to make loans to other customers. When we move our cash into money market funds, we are now investing in a fund that makes ultra short-term loans to banks, blue chip corporations, and governments within the “Money Market”.
The return on Cash can vary amongst different Cash products such as a savings account versus a 12-month CD. However, a quality cash investment should pay interest at a rate comparable to the current Federal Funds Rate, a key interbank lending rate managed by the Federal Reserve.
Cash as an Investment:
The main benefits of cash include the assurance that it will not lose value on a day-to-day basis, it will remain readily accessible, and it will perform best during periods in which interest rates are rising to higher levels.
However, cash does present certain unique risks.
1) When interest rates are low, Cash can lose value relative to inflation.
2) When interest rates are high, Cash fails to lock in that high-interest rate level for an extended period of time.
In the example below, an investor is trying to choose between buying a 5-year bond or staying invested in Cash. As highlighted below, when future interest rate levels decline, the 5-year bond provides a more favorable outcome as the investor has locked in the higher rate for five years. However, when future interest rate levels rise, Cash provides a better return than the 5-year bond as Cash earns the future rate of interest which is higher.
What will you earn over time? In the very short term, you can generally predict the interest you will earn on a Cash investment as the Federal Reserve rarely makes surprise adjustments to the Federal Funds Rate. However, the Federal Reserve does adjust this key interest rate over time based on evolving economic trends. This means you never know what your long-term returns might be on a Cash investment as no one ever knows what the Federal Funds Rate might be a few years (or even months) from now.
Investing in Bonds
What is a Bond?
A Bond is a Financial Asset in which you loan your savings to a household, business, or government in exchange for an ongoing interest payment and the full repayment of your loan at the bond’s maturity date. The “Bond Market” consists of Bonds that range from the safest investments in the world such as a U.S Treasury Bond to more risky bonds issued by troubled borrowers that tend to pay very high rates of interest.
Bonds as an Investment:
High Quality Bonds can play an important role in an investment portfolio as Bonds generally offer a higher interest rate than Cash and more safety than Stocks. Bonds also provide investors with the ability to lock in the current market rate of interest over an extended period of time. This, of course, is an important benefit when an investor suspects that interest rates might decline in the future.
Understanding Bond Returns:
While the long-term return on a Bond investment is much more predictable than a Stock or Cash investment, a Bond’s day-to-day value will rise and fall as the market rate of interest fluctuates over time.
To highlight this concept, let’s assume that $100 is invested in a 7-year U.S. Treasury bond yielding 4% on January 1st. This means the investor is guaranteed to earn 4% per year before being repaid the $100 in full at the end of Year 7. Simple enough.
However, between Year 1 and Year 7, the market rate of interest will fluctuate up and down as economic trends evolve. When the market rates rise, a bond’s price will decline and when the market rates decline, a bond’s price will rise. The reason for this price change is that a Bond guaranteed to pay 4% is more valuable when rates fall to 2% as it pays 2% more than new bonds being issued at a 2% rate. However, if rates increase to 6%, a bond paying 4% is less valuable when compared to new bonds being issued at a 6% rate.
In the example below, the annual returns of the 7-year bond paying 4% in annual interest ranges from -6% to +20% based on the year-to-year change in the market interest rate. However, the current market price of a bond only matters if an investor has to sell the bond prior to maturity. For the investor who bought the bond in Year 1 and held it for 7 years, they would collect 4% per year until they are paid in full in Year 7.
Investing in Stocks
What is a Stock?
A Stock Investment is a Financial Asset in which you purchase an ownership stake in the current cash flow, net assets, and long-term prospects of a business. Unlike a high-quality bond in which you have a contractual right to be repaid in full, the future value of any stock investment is not guaranteed, your future return is unknown, and significant losses are possible. For this reason, any investment in a “Stock” or the “Stock Market” should be considered a higher risk investment.
Stocks as an Investment:
Historically, long-term investments in U.S. stocks have earned higher annual returns than the returns offered by Bonds or Cash. The reason for these higher returns is that the value of a Stock tends to increase as profits rise and profits tend to rise when the economy is growing. However, earning a high return in Stocks is not guaranteed. If economic growth stalls or you buy an overvalued Stock, you can be exposed to significant losses.
Of course, without knowing how the economy might perform in the future or how investors might value stocks in 5 or 10 years, it is virtually impossible to know what the stock market might return over the next 5 or 10 years. Therefore, any sizable investment in stocks reflects an investor’s core belief that the economy and corporate profits will continue to grow over time even though such an outcome is unknowable in the present.
With such uncertainty surrounding any stock market investment, how can an investor increase the odds of a positive outcome?
In the chart below, we show different 5-year returns for an investor who buys a stock at 20x earnings vs. buying it at 10x earnings based on different future assumptions. As the charts indicate, investing at higher valuations doesn’t leave an investor with much margin for error whereas investing at a lower stock valuation offers a broader range of positive outcomes.
Therefore, the most successful investors tend to focus on investing in stocks or the stock market when investments can be made at reasonable valuations. And when valuations appear excessively high, these investors tend to avoid making new stock investments and often elect to reduce some of their existing stock holdings.
Managing Investment Uncertainty
The challenge for any investor is that every investment approach has a unique set of benefits and risks. For instance, if you invest too conservatively, you might feel like your savings are secure, but over time the value of your savings might be negatively impacted by inflation.
Alternatively, if you invest aggressively and realize favorable results, it can support a higher level of spending and greater wealth. However, if a high risk approach results in substantial losses, it could result in having to greatly reduce your retirement spending.
What makes picking a course of action so challenging is that we don’t know how markets will perform in the future. Of course, if we did know that market would do well, it would be an easy decision to take more risk. On the other hand, if we knew a market downturn was imminent, we wouldn’t have to think twice about investing more conservatively.
However, the reality is that no investor can predict the future. This is why most prudent investors tend to invest in a diversified portfolio of Cash, Bonds, and Stocks as diversification allows you to participate in the benefits of each asset class while managing the each asset classes’ unique risks.
The Value of Diversification
In the chart below, we display the periodic returns that an investor would have realized in Global Stocks, 5-10 Year U.S. Government Bonds, and 30-day U.S. Treasury Bills which we use as a proxy for Cash. We also show what an investor would have earned if they invested equally in each of these 3 asset classes over time.
The Equal Weight Portfolio is composed as follows: 33.3% Global Stocks as represented by the MSCI All Country World Stock Index, 33.3% Bloomberg 5-10 Year US Treasury Index, and 33.3% in the Bloomberg 30 Day U.S. T-Bill Index. The Equal Weight Portfolio is rebalanced back to these ratios at the end of each year.
As expected, stocks earned the highest returns over the last 30 years and T-bills earned the lowest. However, stocks also experienced multiple periods of sizable losses. All in all, the results were as expected, in that higher-risk assets realized higher returns as well as larger periodic losses.
The only unusual observation in the analysis is the performance of the Equal Weighted portfolio as it earned 70% of the return of Stocks over the last 30 years even though it never had more the 33% invested in stocks at any time. This reduced exposure to stocks also helped the Equal Weighted portfolio’s performance during periods of stock market volatility such as the Dot Com Market Crash and the 2008 Financial Crisis.
The reason for the surprising performance of the Equal Weighted portfolio is explained by its balance across different asset classes. Over the last 30 years, investors have experienced stock market booms, economic downturns as well as rising and falling interest rates. Through it all, the Equal Weighted portfolio remained steady by participating when each asset class outperformed while always avoiding overexposure to large losses or low returns when an asset class underperformed.
While the Equal Weighted portfolio is just a hypothetical portfolio, it helps to demonstrate the surprising value that diversification can offer.
Your Risk Profile
The last part of the investment process is the evaluation of your unique risk profile. While a risk profile is sometimes confused with an investor’s desire to take risk, your risk profile actually consists of three unique considerations that must be carefully analyzed and weighed against one another.
Your Need to Take Risk:
First, it is important to understand the investment return you need to earn to fund your desired retirement objectives. If you could fund your most ambitious retirement goals with a conservative investment approach, this is a valuable insight to possess as you would have little to gain from higher-risk investments. Alternatively, if reaching an important goal does require a higher return, you may be more inclined to take more risk.
Your Capacity to Take Risk:
Second, not everyone can take higher levels of risk. Someone with a high capacity to take risk is generally someone who has a relatively long time horizon, no immediate need to access their savings, and the ability to earn back potential investment losses through other sources of income such as wages.
As you can imagine, most investors who are retired or approaching retirement do not tend to have a high capacity to take risk as most are highly dependent on the use of their savings to fund their retirement plan.
Your Willingness to Take Risk:
If you have the capacity to take risk, the last question to consider is your willingness to lose money in your pursuit of higher returns. In other words, if you know that your retirement plan is well funded, but you do have the capacity to take a higher level of risk, do you still want to pursue higher risk investments with the potential to produce higher returns?
For those in this favorable position, there isn’t a right or wrong answer… it is simply a personal preference to assume added risk in hopes of greater wealth over time.
Conclusion
To conclude, there are many opinions as to the right way to invest in retirement. We believe that the right investment approach is the one that makes you feel comfortable and confident in your future. After all, your savings and investments are intended to facilitate your life’s journey and shouldn’t dictate how your journey looks and feels along the way. Good Luck!