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Building and Managing a Retirement Portfolio-Part Three
For most Americans, their working years are their saving years. Their goal is simple, save aggressively and invest prudently to accumulate the retirement nest egg they’ll need to live on. Once they retire, the goal becomes converting that nest egg into a predictable “retirement paycheck” that will support their lifestyle for as long as they live. Accomplishing this requires carefully balancing between generating sufficient current income, while addressing the risks of inflation and poor investment returns that can affect the future growth and deplete the portfolio prematurely.
We’ll discuss some strategies to achieve these goals for the portfolio in the next few articles, but now let’s address two of the biggest threats to a secure retirement.
Inflation risk. Many of us can expect to spend three or four decades in retirement. During that time it is likely that rising prices will slowly but surely erode the value of our incomes. When we were working, we relied on raises and promotions to protect us against the rising costs caused by inflation. When that paycheck stops, for most of us, it will be our portfolios that will have to assume this role. No one can predict what inflation will be in the future, but even at the long-term historical (1926-2008) average of about 3% per year (which includes several years of negative inflation during the Great Depression), our purchasing power will be cut in half in twenty five years. In other words we’ll need over $100,000 to maintain the same lifestyle that $50,000 buys today. At 4% inflation we’ll need over $130,000. For most people that income will have to come from their savings and investments.
Furthermore, it is reasonable to expect a retiree will experience higher inflation rates than the population’s average as measured by the Consumer Price Index (CPI). This is because larger portions of retirees’ budgets consist of items such as health care whose costs are rising faster than the rate of inflation. For that reason alone, it makes sense to plan conservatively for the impact rising prices will have on your retirement.
Market risk. Starting off on the right foot can go a long way to helping us reach our goals. This is particularly true about the investment returns we receive in the early years of retirement.
For the most part, while we were working and regularly adding to our nest egg, the ebb and flow of the financial markets had little impact on our portfolio. In fact, we actually benefited from periodic market downturns, especially in the early years, because the resulting share price declines enabled us to acquire more shares for the dollars we invested. These shares then had the opportunity to grow over time.
Once we retire however, and begin taking systematic withdrawals from our accounts, these periodic declines in share prices become detrimental. It is the combination of poor returns and withdrawals that present the risk. We have to sell more shares at lower prices in order to raise the money to cover our spending requirements. These shares are permanently removed from the portfolio and never have the chance to recover if and when the markets rebound. The earlier in our retirement we experience bad returns and have to remove additional shares, the greater the damage to the portfolio. On the other hand, the better the investment returns we receive in the early years of retirement, the greater the likelihood our portfolio will last as long as we need it to.
While both inflation and market risk are unpredictable and uncontrollable, they can be anticipated and planned for when constructing the retirement investment and distribution plan.
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