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The time has come, and you’re ready to live off of income from your investments. It’s important to understand the specific factors that pose a danger to your retirement.
There are three major risks that threaten your income after you’ve stopped working:
- Inflation
- Longevity
- Sequence of Returns
Which of these poses the biggest threat? And what can you do about each of them?
Inflation
Once you step away from the work force, you’ll no longer add to the amount of money you have set aside. Because of this, if inflation goes up, and your investments are not able to match it, you’ll soon find yourself with declining purchasing power.
Let’s take a look at how this might play out. Let’s imagine you receive a fixed $5,000 per month that will not increase over time. Let’s also assume that inflation remains constant, at 2%. Every year, everything you need to purchase will get more and more expensive, but you won’t have any more money to offset those prices.
In effect, each year, your income loses about 2% purchasing power. So next year, your $5,000 will be the same as about $4,900 today.
Not good.
What can you do about it?
Many retirees are already aware of this threat, and have taken steps to protect themselves. These include diversified portfolios with some assets designed to grow along with inflation. Stocks, TIPS, and even gold can provide some protection against inflation.
Longevity
Due to some great genetics, health habits, and amazing discoveries in medical technology, people are living longer than ever. That’s fantastic!
The downside is that a longer lifespan requires a longer period taking consistent withdrawals out of savings and investments.
Combined with inflation, longevity could catch some people, and their finances, unawares.
What can you do about it?
Just like with inflation, diversification is key. Having a small portion of a portfolio dedicated to stocks (though not too much!) helps not only offset the risk of longevity, but also decreases potential volatility when compared to a portfolio made up solely of bonds.
Dimensional’s Target Date Funds take this into account and always maintain a portion of their assets in equities. This makes their funds less volatile, and more likely to experience growth.
Sequence of Returns
Not many people know what this phrase even means. Sequence of returns means the threat that comes with the order of certain market events.
As an example, let’s assume you have an investment of $1,000 in a particularly volatile company. Let’s also assume that you have to make a withdrawal of $100 each year (you’re living off your income, remember?). In one year, your investments increase 50%, and in another year, they decrease 50%. What’s the difference if the losses happen first vs if they happen in the second year?
Losses first:
Losses in year one: $1,000 x 50% = $500
$500 - $100 = $400
Losses in year two: $400 x 150% = $600
$600 - $100 = $500
Losses Last:
Losses in year one: $1,000 x 150% = $1,500
$1,500 - $100 = $1,400
Losses in year two: $1,400 x 50% = $700
$700 - $100 = $600
In this simplified example, you can see that incurring losses sooner means you wind up with less money. Because of this, any loss ends up creating a huge risk to your ability to live off your fixed income in retirement. You simply don’t have the same amount of time to recover from these losses.
What can you do about it?
As you enter retirement it’s important to adjust your portfolio to reflect your new needs. Instead of growing wealth, you’re focus become income. On top of that, you’ll want to decrease the volatility of your portfolio.
Why risk 50% of your nest egg for a 1-2% greater return? Why risk going backwards when you’ve already arrived?
Incorporating bonds, TIPS, and other less-risky securities helps protect you from Sequence of Returns.
So which of these is the greatest threat?
These all pose great risks, but from a financial point of view, Sequence of Returns poses the greatest. One bad year in the stock market can wipe out decades of retirement income. Therefore, it’s important to reevaluate your portfolio as you enter retirement. Moving away from an aggressive portfolio could help you maintain income into your old age, while still protecting you from inflation.
How do you do that?
If you’re about to retire, and you’re worried that your investments might be too aggressive, click here to register for a Free Bronze Account. You’ll get access to a Free Financial Assessment that will give you a potential asset allocation that you can use to build a portfolio with an appropriate amount of risk.