As people contemplate retirement, one of the primary goals is to identify areas of risk, with the goal of eliminating any risks that they believe could cause them harm. Experienced planners are trained to listen to these concerns, and their recommendations are usually well-intentioned efforts to achieve this goal of risk reduction. A common âprovenâ approach is to systematically change a client’s asset allocation, reducing or even eliminating any equity investment. These assets are then moved to investment vehicles deemed âsafeâ, such as cash, bonds, real estate, precious metals or even fixed annuities.
Unfortunately, none of these asset classes is completely risk free. Holding most or all of your assets in cash remains a tempting approach, and not just when the market is booming. In the 2019 environment, where the market has been relatively stable and is at an all-time high, many people turn to cash on the assumption that ‘things are too good’ and that something is right. bad will inevitably happen. Of course, assets held in cash gradually lose purchasing power as long as the inflation rate remains above the interest rate charged on cash balances. Even with relatively low inflation over the past 20 years, a 2019 dollar is only worth about 65 cents in 1999 dollars. That’s why economists call inflation a “silent thief.” Meanwhile, a majority of those retiring in their 50s and 60s expect to live much longer than 20 years and, as a result, most view inflation risks as as much of a threat as market risk. .
Bonds are certainly a respected and popular asset class, with the appeal of guaranteed capital for U.S. Treasuries and a higher yield to income relative to cash, which has historically been more successful in keeping up with inflation. . Of course, in a low interest rate environment, this yield has fallen to the point where it does not always follow the annual CPI (Consumer Price Index), which means that a portfolio that is too weighted in bonds will not completely eliminate the purchasing power risk. . Moreover, bond prices are inversely related to the direction of interest rates, which means that a change in Federal Reserve policy aimed at raising interest rates, or even the perception that the Fed might be. tightening at some point in the near future will lower bond prices. Although the principal amount of individual treasury bills is guaranteed, most investors do not buy a bond at par and hold it for the entire term. Investors typically buy bonds as an asset class, packaged through a mutual fund or ETF, and thus feel the full effect of falling bond prices. In short, bonds can carry a measure of market risk, inflation risk and interest rate risk. In addition, corporate bonds, especially in the âjunkâ category, can potentially lose capital.
Investors can also mitigate some of these risks by allocating a portion of their investments to real assets. Real estate returns have not historically been strongly correlated with stock returns, which means that there will be years when a stock market decline will be partially offset by a stable or even increasing value of one’s real estate. On the other hand, real estate values ââhave a proven history of “bubbles”, where the real value of a property becomes inflated, only to collapse and fall well below the original cost. Gold and other precious metals have their supporters, in many cases for reasons similar to real estate (their statistical correlation properties), as well as a reputation for acting as a hedge against inflation. Precious metals have many months, quarters and even years of outperforming market averages. However, they can also underperform for long periods of time and, ultimately, are vulnerable to the same kind of market risks and downside that face players in the stock market, albeit in a different category.
Fixed annuities are particularly attractive to people of retirement age, given the prospect of a lifetime income guarantee. These products are artfully marketed by insurance companies, but it is often difficult to understand the terms of their exact earnings and returns. That said, one of their biggest risks may be their liquidity risk and lack of flexibility. If a person’s circumstances require some or all of the equity in an annuity contract, the penalties can be severe and the losses incurred are unlikely to be made up.
Given the variety of risk factors most retirees face, it can be understandably daunting and confusing to know what exactly to do with your retirement nest egg. The smartest approach to asset allocation is to have a licensed financial professional with sufficient knowledge of the characteristics of all basic investment categories and the experience to understand the statistical correlation. and its role in diversification and risk reduction. As markets change and retirement situations change, it is extremely beneficial to maintain flexibility in your retirement accounts, which will allow a retiree to tactically change the allocation of their assets.