Accounting For How Your Longevity Compounds the Inflation Risk of Your Retirement IncomeSubmitted by Queen City Capital Management on October 10th, 2016
It has only been since the Baby Boomer generation began to cross the retirement threshold that we’ve had to seriously confront the new challenge of our longevity. Although most of us are now bracing for the probability of living 20 to 30 years in retirement (nearly double the retirement life spans of our grandparents), what isn’t quite as clear is that our actual longevity is a moving target. That is, the older we get, our life expectancy increases, and that can have serious implications for the way we plan for our retirement income.
The life expectancy chart today would show that a 60-year old male should expect to live until age 81; however, when that same male reaches age 65, he can be expected to live until age 85. When he reaches age 70, he will have a 20 percent chance of living to age 90, and a ten percent chance of living to 100.
Now, when you layer the risk of inflation onto the risk of outlasting your income (longevity risk), the risks are drastically compounded. Previous generations only had to contend with inflation for 10 to 12 years. Our grandparents weren’t expected to live much beyond retirement (which is why Social Security seemed like such a good idea back in the 1930s). Today, we need to contend with inflation for as many as 25 to 30 years. If the inflation rate were to average 4 percent, your purchasing power would be cut in half over the first 18 years of retirement.
All of this creates a perfect storm of risk that most people haven’t even considered in their retirement planning, including:
• The potential of a significant reduction in purchasing power over a 25 to 30 year retirement horizon.
• The potential need to accelerate the spend-down of capital to meet life style needs or pay for increasing medical costs.
Today’s retirees face new challenges in preparing for a life in retirement that can last another 30 years or more. They must be able to accumulate their own capital at a rate that exceeds inflation and then they must be able to sustain a rate of growth on their capital in order to close the income gap and prevent a loss of purchasing power.
Your retirement investment strategy can’t ignore the ever-present risks of inflation and longevity.
Of course, we would all enjoy the peace-of-mind that comes from investing in ultra-safe investments without the risk of losing money due to stock market declines. However, the reality is that the risk of asset value loss is only a perceived risk because you can’t actually lose money unless you sell your securities after a market decline. An intelligent investment strategy can help manage and mitigate risk and volatility.
Retirees need to focus on the “real” risks of inflation and longevity which, without a deliberate strategy to overcome them, will inevitably erode the value of their assets. Many people are relying upon their savings and investments in bonds to provide a secure source of retirement funds. As a result of the sluggish economic conditions and the monetary policies of the Federal Reserve Bank, the yields on secure investment have been driven down to near zero. A certificate of deposit may pay 1.5 percent interest in nominal terms; however, in real terms, after inflation, the real rate of return is negative, and that too compounds itself over a period of time.
For many people affected by the economy, it may be bad enough to look at their finances and plan for their future in nominal terms much less having to deal with the reality of real income and yields. But, even those who have not been terribly impacted, looking at their future through nominal lenses can lead to a financial plan that comes up well short of their objectives. An increasing number of people are having to rethink their retirement plans, and a many of them are not even thinking about retirement in the same terms as they once did. But, whether you expect to retire one day and live off of your savings, or you want to continue to work to maintain your standard of living, your planning needs to consider both the nominal income and investment returns and their “real” counterparts.
Investing for sustained long-term growth requires a well-conceived strategy based in sound investment principles and practices. Few people are equipped with the knowledge, patience and discipline needed to develop and manage a long-term investment strategy on their own, which is why you should regularly seek the guidance of your financial advisor and money manager to help ensure your investment strategy is equipped to handle both longevity and inflation risk.
Data Sources: QCCM, Advisor Websites.
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