By Michael Lynch, CFP
3: Getting Risk Right
Examine the graphic above. This is Mount Everest. Imagine that you’ve been climbing mountains for years. You have trained hard and are ready for the big show. You’re confronting this map of your next challenge. What’s your goal?
When I pose this question in presentations, most people blurt out, “Get to the top.” One or two get the answer correct: return to the base.
WHICH PHASE ARE YOU IN?
It’s useful to divide your financial life into two periods: the accumulation phase and the distribution phase.
You climb the mountain during the accumulation phase. The disciplines that create success are dollar cost averaging, riding out the market declines, asset allocation, and rebalancing at both your lows and highs. You are not withdrawing money, so market swings are your ally, assisting you in buying more shares when prices are low and fewer when they are high. Stick it out, and history proves that this approach will get you the pile of money you need to retire.
Maria did fine on the climb. She probably could have done better with a diversified approach, but she nevertheless stacked up the money in what she considered a safe manner.
Descending the mountain is akin to your retirement, the distribution phase, in which care must be taken so you don’t slip, lose your traction, and careen into a crevasse, never to be seen again. It’s not that dramatic, of course. In retirement, you won’t die suddenly, you will just be forced to move, cook at home during your staycations, and find new friends since you won’t be able to keep up with your former crowd. After a lifetime of hard work and diligent savings, this will feel like a slow death.
The key to making it down safely is managing the risks of the descent. After all, gravity is working in your favor— until it isn’t.
The risks include:
• Longevity: Living a long time, which is far more expensive than dying young.
• Market and timing: A kind way of indicating the annual 10 percent declines and all-too frequent 30 percent declines in stock markets and the propensity for people to sell at the bottom.
• Inflation: The carbon monoxide of retirement—the slow, silent killer that turns a dollar into fifty cents.
• The unexpected: Disasters don’t stop happening at retirement. Divorcing kids still need lawyers, and roofs need replacing. Other problems will keep arising.
WHEN A GOOD THING GOES BAD
Longevity is perhaps the most misunderstood risk. After all, living a long life is something most of us would prefer, especially if it’s done in good health. How is this a risk? Living is expensive. Dying is cheap. Longevity means more years that need to be funded and more risk of inflation.
Poor financial markets are perhaps the easiest risk in retirement, if the scariest. History instructs on two points. First, financial markets will decline significantly at some time in most years and drastically every four years or so. It’s easy to deal with because we can expect it, much like blizzards in New England. We know they will arrive. We just don’t know the exact month, week, or day.
Market timing is even easier to understand but more difficult to address. If history proves anything, it’s that the sun will rise in the east, gravity will pull us all down over time, and timing the market’s sharp declines and ascents is impossible for humans and computers alike.
This does not stop a thriving industry from preying on the false promise that it’s possible next time. It’s not. The risk is twofold:
• Falling for the sirens, employing a market timing strategy, inevitably failing to get in and out at the right times, and slowly grinding down your assets.
• Neglecting to accept that the declines will come so that you don’t have a plan to ride them out and you are forced to sell your investments at big discounts to pay your bills.
CARBON MONOXIDE POISONING
As stated above, inflation is the carbon monoxide of finance. It’s a slow killer of both dreams and reality. Another way to put it is that termites do more damage than tornados. We worry about the tornados (i.e., the market drops). But they come and go, and we always recover. The real risk is the slow, steady, and relentless erosion from the termites. As with carbon monoxide, by the time you realize it’s a problem, the damage is likely to be too extensive to remediate.
Bad things do not stop happening just because you’re retired. You need to have a reserve for nonbudgeted expenses. Need I say more?
GET A PLAN
So what’s the plan? You need three basic elements to address your retirement income risks. First, you need safety of principal. Now that I’ve spent more than a few pages dissing it, I’ll tip my hat to it and admit that you need some US government-denominated asset that will never decline in nominal value. This gets you through the market declines and pays the unexpected bills.
The next thing you need is reliability of income. Chances are, you spent your working years earning one or more paychecks every month. You are accustomed to regular infusions of cash at predictable intervals. This helps you get through the downs of the markets and, to some degree, insures against living a long life because it’s guaranteed for a lifetime. In addition, you don’t need to ask Maria about her pain to know that income that drops 90 percent cannot be considered reliable.
Finally, you need your total income to grow at least enough over time to keep up with inflation. No one says they are on a fixed income with a smile. You need enough of your money working for you to outrun the current and get your fishing boat up the river from the sound. That requires enough power to beat inflation. If you don’t have enough of this, your retirement will succumb to the second law of thermodynamics and descend into irreparable decay.
NO SILVER BULLETS
Here’s the rub. There’s no single financial product or strategy that can address each of these needs. Assets that protect principal, such as US government bonds, bank products, high-quality corporate bonds, and deferred fixed annuities, don’t grow the income and certainly don’t provide reliable income over any reasonable long term time horizon.
Financial products that provide reliable income, such as Social Security, corporate pensions, income annuities, and income riders on deferred annuities, don’t provide for liquidity or safety of principal. Most don’t offer much hope of keeping up with inflation. They do, however, ensure that you will receive nominal income for life.
Equity-based investments offer the potential for growth of both income and asset value. Over time the income has proved reliable, although it will decline in times of market stress. These assets cannot be relied on for safety of principal. In the short term, dividends and sales from gains will not prove reliable.
The bottom line: One type of investment will provide no more than two of the three benefits you need. You must create a system once you understand the benefits and drawbacks of each approach. More on that in the next chapter.
The above article originally appeared as a chapter in It's All About The Income and is reprinted with permission from the author Michael Lynch. No parts of this article may be reproduced without correct attribution to the author of this book.