Most baby boomers focused on retirement have one eye on the financial headlines and the other on mutual fund and ETF performance tables in search of suitable investment strategies. But to be successful in retirement today requires a much more holistic view of what you are facing and what the investment realities are. There are four crucial financial issues I think all retirees must address, and I have outlined them below.
#1: You’re Living Longer Than You Expect
How long do you need to support yourself in retirement? If you’re the average couple retiring in your mid-60s, you probably think about your parent’s lifespan and add a few years. “Till my mid-80s” is what I hear most often. Unfortunately, you cannot plan for your average life expectancy; you have to prepare for the chance that you will live longer.
According to Moneyguide Pro, a non-smoking, married couple in just good health with an average family history of longevity faces a 50% chance that one person is still living at age 93. There is a 20% chance than one person is still alive at 99, or 33 years after retirement. There’s a 20% chance that both will be alive at age 90, which means supporting two people for almost three decades. You will probably live longer than you expect, so you need to have the resources to cover your expenses.
#2: You’ll Need More Money Than You Think
When we think about retirement income, we typically take the amount we need today and project it forward for 15 or 20 years. For example, a 65-year old married couple planning to live to age 85 on $50,000 above social security might assume they need $1,000,000 in total lifetime income.
This amount ignores that at least one of you will probably need the majority of that income for a decade longer than you planned. You also forget that we live in a world of ever-rising inflation—the things we spend money on get more expensive every single year. Since 1928, trend-line inflation (CPI) has been 3% a year. Assuming your income needs to grow at 3% annually to keep pace with inflation, you wouldn’t need $1,000,000 for 20 years; you would require over $2,500,000. If we assume you need that amount for 30 years, the total is over $4,500,000—4.5x your original estimate! Things get scary if we assume higher-than-average inflation. Between 1941 and 1981, CPI averaged 4.7% per year. $50,000 annually compounded at that rate of inflation for 30 years requires over $6,000,000 in lifetime income!
Many treat retirement as the investing “finish line.” They pack it in and put most of their assets in relatively “safe” bonds and Target Date Retirement Funds trying to avoid losing money. But if you are spending from your portfolio at double the rate you are growing your wealth, you will run out of money sooner rather than later. That’s not safe; it’s going broke slowly but surely.
#3: Bonds Are No Longer “Safe”
The long-term return on bonds (Five-Year T-Notes) since 1928 has been 5.1% per year. This result isn’t as high as the +9.8% per year gain from the S&P 500, but bonds had much lower volatility than stocks and are therefore a favored investment for people nearing or already retired.
Historically, yields were sufficient to support the expectation that bonds would keep earning +5% returns. In 1990, bond yields were well above average, at 8.1%. In 2000, they were lower but still above their long-term levels at 6.6%. By the start of this year, however, bond rates had fallen to 2.5%. As of June, bonds yielded just 1.8%. Currently, bonds are paying almost 50% below the long-term level of inflation (3%), and are priced to return 65% less than their long-term average. Investors who own bonds have to accept negative real returns to avoid the short-term volatility (but much higher expected returns) of stocks. You cannot afford to do this with very much of your portfolio and still be successful unless you have very meager goals.
The most common solution to the low-interest rate problem is to “reach for yield” by buying longer-term bonds, lower-quality bonds, or both. But neither of these moves is worth the risk for retirees. Lower-quality corporate bonds could tank right along with stocks during economic downturns, and longer-term bonds can get pummeled when interest rates and inflation go up. During the 1941 to 1981 period where inflation averaged 4.7%, long-term corporate bonds averaged only 2.6% per year and long-term government bonds just 2.3% per year. Losing over 2% a year to inflation during your lifetime on the majority of your investment portfolio would have catastrophic consequences for your retirement prospects.
Instead of buying riskier bonds, retirees today should accept that they need to hold a higher percentage in stocks to reach their goals. Higher stock allocations tend to be more volatile, but as I’ll discuss in a future article, we overstate their long-term risks in retirement.
#4: Some Stocks Are Overextended
Yields on bonds are at historically low levels, but garden variety US large-cap stocks aren’t a panacea either. The last ten years have been exceptional for the S&P 500, with a +14.7% annual return through June. Compared to its long-term average from 1970 to June 2009 of +9.4% per year (similar to its performance going back to 1928), returns on large-cap US stocks have been 54% higher!
But not all stocks have run ahead of their long-term averages. I’ve mentioned many times in recent months that US and international small cap and value stock asset classes have been much more subdued. An “All-Value Asset Class Index” that holds only large and small value stocks in the US and international markets has gained +12.2% in the last decade. This return is 16% lower than its +14.5% per year gain over the period from 1970 to June 2009. If returns in the future revert to their long-term averages, we could be in for a stretch of below-average returns for US large-cap stocks and above-average returns for US and international value and small-cap stocks. Avoiding below-average returns could be the difference between achieving your financial goals or falling short.
One of the most significant obstacles that investors face is ignoring the short-term noise associated with financial headlines and current events. The focus instead should be on long-term issues that will impact you for years and decades to come. It’s difficult to remember a time in recent history where we faced more challenging problems than we do today. Investors who are thinking about retirement or recently retired are particularly affected.
The issues aren’t impossible to overcome if you have a plan. First, acknowledge and accept the challenges, don’t ignore them. Next, have a strategy to address them. Maintain the courage to stick with your decisions even when they don’t appear to be working as planned. If you can do all these things, you give yourself the highest chance to fully achieve all of your lifetime financial goals and aspirations. Having someone you trust to help you create the appropriate solutions and guide you through these difficult times could make all of this easier and prove to be one of your best long-term investments.