Why It's So Important To Invest Differently In Retirement
Before you retired, chances are you focused on building the wealth you needed to support the retirement you earned. You paid down debt, invested for growth, and kept your eye on the finish line: the day you’d retire.
That finish line is actually the starting line for the next phase of your financial life. Now your goal is managing your finances so you can enjoy your retirement. You’ve worked hard for it and you deserve it.
You also need to manage risk. The risks are different in financial planning for retirement, and they aren’t all obvious. Here are some things to think about while you enjoy your post-work life.
Your Still Have a Long Time Horizon
If you retire at age 65, statistics say the chances are good you’ll have 20 years of retirement. There’s a 50% chance that you’ll live to 85 if you’re a man, and a 25% chance that you’ll reach 92. For women, there’s a 50% chance that you’ll celebrate your 88th birthday, and a 25% chance that you’ll hit 94. That means your finances will probably have to sustain you for 2-3 decades
Source: National Center for Health Statistics
While you can’t predict how your lifestyle and expenses will change over that time, you want to make sure your financial plan will help you enjoy a fulfilling retirement.
Enjoying your retirement also means having a plan that mitigates potential risks before they occur. Those risks can include market risk, longevity risk, inflation risk, and the risk of unexpected expenses. Let’s look at all three.
Market risk, such as the stock market dropping 10-20% or more, can make financial planning challenging. This is especially true if the market drops early in your retirement years. A strong financial plan accounts for market risk throughout your life, because this risk is inevitable. The key is to recognize that market drops are a part of investing, and a good portfolio can help manage that risk.
Longevity risk, which is another way of saying “outliving your money,” is something many retirees worry about. This is why, as we’ll discuss, a portfolio that balances growth and income is so important.
Inflation risk is less obvious. The average annual inflation rate in the U.S. between 1913 and 2019 was 3.1%. If inflation averages 3.1% a year, for example, $1 today will only be worth 73 cents in 10 years, or 54 cents in 20 years. If you’re spending $50,000 a year now, maintaining your same lifestyle in 20 years will require over $92,000.
That’s one of the main reasons why your portfolio should balance growth, income, and risk in retirement. Bonds and savings accounts that generate income, but not growth, may not be enough to sustain you financially years down the road.
What if you have unexpected expenses a few years into retirement? If your healthcare costs or taxes suddenly jump, can your portfolio absorb the increase? A smart financial plan accounts for both the known and the unknown.
The Role of Social Security
Social Security was designed to supplement your other income sources in retirement, not fund your entire post-work life. As of June, 2020, the average Social Security retirement benefit was about $1,514 a month, or about $18,170 a year. Unless you’re living an $18,000/year lifestyle, your portfolio will have to make up the difference. Even folks who earned six figures and are collecting the maximum Social Security benefit ($3,790/month in 2020) need more than Social Security to support them.
Besides Social Security, unless you’re one of the few Americans with a generous pension, you’ll need a well-balanced portfolio of stocks, bonds and cash to fund your retirement. Each type of investment has an important role.
The Role of Bonds
Bonds are a key part of your retirement plan, because they provide:
- Income – both from their interest payment and pulling from principal
- Stability – bonds tend to reduce risk by being less volatile than stocks
- Diversification – owning several asset classes helps stabilize your portfolio
- Non-correlation – different asset classes react to the market in different ways
That last point is very important. Bonds and stocks tend to react differently to market conditions. During a significant stock market downturn bonds may rise, or only fall slightly. Conversely, when the stock market is roaring, bonds will lag behind. That’s okay. You don’t want every asset in your portfolio to rise or fall together. You want the assets in your portfolio to help balance each other, regardless of how the overall market is moving. That means choosing the right bonds to be part of your portfolio.
Your retirement portfolio should concentrate on high-quality bonds, otherwise known as investment grade. Lower grade bonds, generally called junk bonds, may promise higher yields, but those yields come with too much risk. A couple of extra percentage points in yield may sound tempting, but if the bonds default you can suffer major losses. As a general rule, consider a mix of short-, medium-, and long-term bonds (maturities from 1-30 years), including high-quality government, municipal, and corporate bonds. Lower grade bonds tend to be speculative and act more like stocks. The role of bonds in your portfolio is to help provide stability..
The Role of Stocks
Stocks add two benefits to your portfolio that no other asset class does:
- Growth potential
- Inflation protection
As mentioned earlier, historically stocks have provided growth and outpaced inflation. Some, such as stocks with significant dividends, can also provide current income as well. Low-cost stock index funds and exchange-traded funds (ETFs) have an important place in a financial plan that balances growth with current income.
There’s another benefit to including stocks in your portfolio along with bonds. Historically, a balanced portfolio of stocks and bonds has historically recovered from market downturns faster than a portfolio of stocks alone, with less volatility.
The Role of Cash
Cash, whether in the form of a savings account, money market account or CD, provides the same benefit in retirement as it does before retirement: a highly liquid asset that can be used for current expenses.
Cash, even in a high-yield savings account, probably won’t even keep pace with inflation. But you’ll want to have enough cash to tap quickly when needed, and not be forced to sell other assets to cover expenses (unless that’s part of your plan).
Your Retirement, Your Plan
Work with your financial planner to determine what the right mix of stocks, bonds, and cash should be, based on your age, income needs, and tolerance for risk. For example, 80% of your portfolio may have been invested in stocks when you were in your 30s; in early retirement a portfolio of 40% stocks, 55% bonds, and 5% cash might be advisable. Every situation is different, so work with your planner to manage a financial plan that works best for you.
Again, the key is to balance the income you need today with the growth you’ll need to support your retirement tomorrow, while mitigating risk. Work with your financial planner to build and manage the portfolio that will help you enjoy the retirement you deserve.
Interested in learning more about how to invest while in retirement? Check out our lunch & learn here.