The Number 1 Risk to Your Retirement? Inflation
The Number 1 Risk to Your Retirement? Inflation
There are a number of risks to having a secure, comfortable, happy retirement. A stock market crash, prolonged and expensive healthcare/long-term care issues and costs, and overspending can all work to damage your retirement years. These are all significant retirement risks, but perhaps the largest and most overlooked risk is inflation. Inflation has the power to dramatically reduce your standard of living over the course of a 15-30 year retirement. Inflation erodes your portfolio and spending power so gradually that you hardly notice it or worry about it. If you invest too aggressively and there is the risk/possibility that a market crash can reduce the value of your portfolio in the short-term. Invest too conservatively and you risk the certainty of having a much smaller portfolio (in real terms) in the future due to inflation.
How Much Can Inflation Reduce My Standard of Living?
Inflation has averaged about 3% per year over the long term in the United States. With inflation of just 3% per year the buying power of today’s dollars loses more than half its value over 25 years. If you invest too conservatively (too many bonds?) you are sure to fall behind inflation and your portfolio will likely shrink considerably from today’s value over long periods of time. If you are spending $80,000 per year in the beginning of your retirement at age 62, do you want to try to get by with the equivalent (in today’s dollars) of less than $40,000 per year when you are 87 years old (25 years later)?
How Do I Protect My Retirement Portfolio From Inflation?
Some investments are much better at keeping up with inflation than others. Part of a good balanced and diversified portfolio is having a mix of assets that “protect” your portfolio from a sudden market crash, as well as assets that “protect” your portfolio from inflation eroding the value of your portfolio over time.
The worst investments in terms of inflation tend to be fixed-income type of investments such as bonds (especially long-term bonds), pension payments, fixed annuities, etc. The payments you receive from these investments stays the same each year, but inflation (rising prices) in the market causes those payments to have the ability to buy less and less each year.
Many people think they are being conservative and safe by having the majority (over 70%) of their portfolio invested in bonds and other fixed income securities. Keep in mind that 1) a sudden increase in inflation/interest rates can cause significant losses to your long-term bond portfolio, 2) bonds have had substantially lower returns (about half) than equities over the long-run, 3) bond interest income is taxed as a substantially higher tax rate than stock dividend income and capital gains and 4) bonds have the substantial risk of value erosion from inflation over time.
Equities (stocks) are a good inflation hedge on a long-term basis (but usually a poor inflation hedge in the short run). In the short-run if inflation (prices) in the economy suddenly increase that usually causes interest rates to increase and causes the stock market to go down. Over time companies are able to raise their own product/service prices, which increases their profits and increases their stock prices over time. Since we are thinking long-term in retirement, I consider equities a good long-term inflation hedge.
Real Estate and REIT stocks are another good inflation-hedge investment for your portfolio. Real estate values/prices have shown a good ability to keep up with inflation. Commodities are another investment that is considered a good inflation hedge.
Inflation-Protected Bonds are another excellent hedge against rising inflation. These are typically safe government issued bonds where the interest payments and the bonds underlying value are adjusted upwards each year in line with the Consumer Price Index (CPI). There are mutual funds and an exchange-traded funds (ETF’s) dedicated to investing in these inflation-protected bonds. The ETF that I favor in this regard invests in US Treasury inflation-protected bonds with the ticker symbol (TIP). These inflation-protected bonds have the additional positive feature of having a fairly low correlation with equities and regular bonds, providing good diversification value to your overall portfolio.
Keith Tufte
President
Longview Wealth Management, LLC.
http://www.longviewwealth.com