There is one day among all others that it is the riskiest day of your financial life. The day that you retire. Let me explain. There are two main risks when it comes to investing. First, the most obvious risk is volatility. The chance of loss that can occur, especially when you invest in risky assets like stocks. The second risk is inflation, or the potential for outliving your money. If the costs of goods and services go up faster than your investment portfolio this becomes a real risk. These two risks are elevated the day your retire. If you experience a major loss in your portfolio in the first year of retirement, you are going to have to maintain your lifestyle on a much lower asset base for the next 25+ years. Similarly, if inflation explodes higher right after you retire, you will need to generate more income for your entire retirement just to maintain your current standard of living.
To look at it another way, if you are 90 years old, both volatility and inflation aren't as large of a threat. You just aren't going to live that long for those risks to do significant damage. If I am 92 years old, have $1 million, and am pulling $50,000 per year from the portfolio, it really doesn't matter that much if I lose 30% of the portfolio value, I still have 14 years of income ($700,000 portfolio divided by $50,000 per year) left if the portfolio has no growth from that point on. These risks subside every day as your life expectancy gets shorter.
At retirement, there are some ways to mitigate those risks:
- Volatility- there are two ways to counteract volatility. The first, and easiest. Invest in safe assets. If you just buy CDs with your money you won't experience any volatility (unfortunately you won't earn much either). Another way to reduce volatility is to extend your holding period. Over rolling one year periods, stocks lose value about 30% of the time. Over rolling ten year periods, they only lose value about 5% of the time (S&P 500). That is why volatility is not a major risk to younger investors. If they don't sell, those losses tend to recover, because they have lots of time before they need their money.
- Inflation- while we haven't seen any significant inflation in our country since the 1970s and early 1980s, it would be wise not to disregard this risk. One of the best ways to fight inflation are with assets that benefit from rising prices. Mainly, stocks have been able to incorporate rising inflation into the prices of the products they sell and real estate increases rent and sees values go up. More recently, the US government has created inflation protected securities which increase in value directly with the consumer price index. In short, there are specific securities that can help combat an inflationary environment.
Thinking about these risks and how to mitigate them in retirement is key to a successful retirement income strategy. Now that pensions have become less common, and interest on CDs and bonds are meager, it is more important than ever to have a solid strategy in place.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.