Donny is a good guy. Sixty years old and a retired school teacher, he is married and has a sprinkling of grandkids. He hopes to have a long and healthy retirement. But his pension from the school system does not cover his expenses, so he is taking income from his investments at a rate of 4 to 5 percent per year. His biggest concern is running out of money.
The first thing Donny said to me was, “Before you even look at my investment plan, I know what you are going to tell me.” Donny went on to explain that he does not like risk and believes that he is risk free with his current investments. He told me that he previously had a buy-and-hold strategy and got killed in 2002 and 2008. I looked at Donny’s statements and saw that he now has his $500,000 in CDs at the local bank.
Houston, we have a problem!
Donny’s income strategy comprises two components, his pension and his investments. But his pension has come under attack since the cost of living increase has been somewhere around 1.5 to 2 percent per year. I gave him a recent article from Forbes magazine explaining the real cost of inflation to a senior is two to three times that. So, what does that mean for Donny? It puts more pressure on his investment plan.
Folks, there has never been more pressure on a senior’s investment plan than there is now.
Since pensions and Social Security are not keeping up with inflation, we need to grow our investable assets so they produce an inflation-hedged income stream to supplement our shrinking fixed benefits.
Many financial advisors will have people think that to achieve that growth, they should invest in the market and they are safe with a broad stock market index fund, such as the S&P 500 index. Historically, the market has had a major correction every five to six years.
In fact, if you were to look at the S&P 500 from January 2000 to the end of December 2010, it actually lost ground by about 12 percent or so, thanks to the corrections in 2001, 2002 and 2008. Unfortunately, folks are taught that to build wealth over time, investors need to accept a significant amount of risk.
You see, no investment is without some type of risk, but it does not need to be significant. I explained to Donny the different types of risk and designed a solution to help him mitigate some of that risk.
One type of investment risk is Sequence of Returns Risk, also called Sequence Risk. Timing is everything, right?
Investopedia defines Sequence Risk as “the risk of receiving lower or negative returns early in a period when taking distributions from the underlying investments.” It is not just the long-term average returns that impact financial health, but it is the timing of returns. For example, let’s say you have a $100,000 investment and you lose 50 percent in year one but in subsequent years you gain 25, 25, 25 and then 10 percent respectively. If you are drawing income from that investment, the loss in year one is much more damaging than if the loss was sustained in year five. Managing this risk becomes critical to one’s retirement system.
Another risk is market risk. Market risk is the potential for losses due to broader economic conditions, both domestically and internationally. A market crash can crush an investment’s performance, even if the quality of that investment remains the same.
On the other hand, default risk is risk related to the quality of an investment. This risk gets magnified if we are investing in a single company, whether it be stocks or bonds. Think of General Motors in 2008 and 2009. No one ever thought that the bellwether of the car industry would go under. But that is exactly what happened. GM filed for bankruptcy on June 1, 2009, and all the existing equity owners and bond holders got crushed.
Inflation Risk is Donny’s biggest risk. Inflation Risk is the risk that inflation will erode purchasing power of an investment if the nominal return of that investment does not at least equal the inflation rate. Inflation runs somewhere between 3 to 5 percent a year over time. So leaving money in investments such as CDs or high yield savings accounts that pay virtually no interest really is not “risk-free.” In fact, this strategy practically guarantees a loss in purchasing power over the long term due to the rising cost of goods. The math works like this, if inflation is at 3 percent and you are earning 1 percent, then your loss is 2 percent per year.
But what is even more troubling than the Inflation Risk that Donny is absorbing, is the rate at which he is withdrawing. As mentioned above, he has $500,000 earning virtually no interest and he is pulling out $25,000 a year. If Donny lives more than 20 years, he is out of money. He will only be 80 years old when that happens, pretty young by today’s standards.
So, what should Donny do? Reduce his inflation risk and take on slightly more market risk with limited drawdown. I explained to Donny that drawdown, the amount by which a portfolio declines from its peak to its lowest value, before attaining a new peak, is one of the truer measures of risk related to an investment strategy.
I went on to show Donny investment strategies that focus on minimizing drawdowns, which subsequently lowers volatility. By focusing on strategies that use fund managers to lower volatility, he likely will experience higher rates of return than he would with all of his money in CDs. At the same time, he should experience less drawdown than he would with a buy-and-hold strategy.
Donny now understands risk. He also now understands how to manage it, which should allow him a much greater probability of financial success in retirement.
About the author: Scott Moore is the founder of Moore’s Wealth Management and has decades of experience in finance and investment banking.