Retirement Investing: Knowing When To Play It Safe

As people get older, conventional wisdom suggests that they should adopt a more conservative approach to investing for retirement. This means prioritising capital preservation over growth, and reducing the risk of loss. While younger investors can afford to take more risks, those approaching retirement may want to switch to more stable, lower-earning funds like bonds and money markets. This is because older investors have less time to recover from losses and need to ensure their retirement funds last as long as possible.

As you get older, shift from growth to income

As people age and their financial situations change, it is generally advisable to adopt a more conservative investment strategy for retirement. This means shifting the focus from aggressive growth to stable income generation. This strategy aims to preserve capital and provide a consistent income stream to cover living expenses during retirement. Here are some guidelines and strategies to consider when making this transition:

Start by evaluating your risk tolerance and financial goals. As you near retirement, it's essential to assess your current financial situation and determine how much risk you're comfortable taking. Generally, older investors have a shorter time horizon for their investments to recover from potential losses, so reducing risk becomes a crucial consideration. Review your asset allocation and consider rebalancing your portfolio. Diversification is a key principle in investing, and it's especially important when transitioning to a more conservative strategy. Spread your investments across different asset classes, such as stocks, bonds, cash, and alternative investments. Gradually shift your portfolio towards income-generating assets.

Seek investments that provide a steady income stream, such as dividend-paying stocks, bonds, annuities, or rental properties. These investments typically offer lower risk and provide the necessary cash flow to cover your expenses during retirement. For example, dividend-paying stocks can provide a regular income while also offering the potential for modest capital growth. Be mindful of fees and expenses. As you transition to a more conservative investment strategy, pay attention to the fees associated with your investments. Expenses can eat into your returns and impact your overall income. Consider low-cost index funds or exchange-traded funds (ETFs) that track broad market indices, as these tend to have lower expense ratios than actively managed funds.

Finally, consider working with a financial advisor. Retirement planning and investing can be complex, and a qualified financial advisor can provide personalized guidance based on your unique circumstances. They can help you assess your risk tolerance, develop a comprehensive retirement income plan, and make informed investment decisions to ensure your retirement portfolio aligns with your goals and provides the income you need for a comfortable retirement. This transition from growth to income is a critical step in retirement planning, ensuring that your investments support your lifestyle and provide financial security during your golden years.

Reduce the risk of loss with CDs, money markets, bonds and guaranteed income funds

When it comes to retirement investing, it's generally recommended to adopt a more conservative approach as you get older. This involves reducing the proportion of high-risk stocks in your portfolio and replacing them with safer investment options. This shift in strategy is intended to preserve capital rather than focus on aggressive growth. Here's how CDs, money markets, bonds, and guaranteed income funds can play a role in reducing the risk of loss:

Certificates of Deposit (CDs)

CDs, or Certificates of Deposit, are considered one of the safest investment options. They are a type of bank account, typically offered by banks or credit unions, that provides a fixed interest rate for a set period, usually ranging from six months to ten years. The longer the holding period, the higher the interest rate offered. CDs are insured by the Federal Deposit Insurance Corporation (FDIC) in the US, guaranteeing your investment up to $250,000. While they offer low risk, one consideration with CDs is the impact of inflation. Locking in your money when interest rates are low may result in lower returns relative to inflation.

Money Market Funds

Money market funds are considered very safe investments, often chosen by those seeking to avoid the volatility associated with the stock market. These funds are highly liquid and typically pay interest. While they offer stability, the returns may be modest, and there is a chance of losing money. It's important to carefully review the prospectus of a money market fund before investing.

Bonds

Bonds are a type of debt instrument where investors essentially act as lenders to governments or corporations. They are considered safe investments, especially those issued by governments and highly-rated corporations. The risk of default is relatively low, and in the event of bankruptcy, bondholders are repaid before stock owners. Bonds offer higher interest rates than CDs but carry more risk. They are subject to interest rate risk, inflation risk, liquidity risk, call risk, and credit and default risks. Bond funds, which are managed by professionals, offer diversification and are a popular way to gain exposure to the bond market.

Guaranteed Income Funds

Guaranteed income funds, also known as fixed-income funds, provide investors with a stable income stream. These funds typically invest in a mix of stocks and bonds, aiming to provide a balance between growth and capital preservation. While they don't guarantee the initial investment amount, they do guarantee a specific rate of return or income for a set period. These funds are often used by retirees who seek a consistent income during their retirement years.

In conclusion, CDs, money market funds, bonds, and guaranteed income funds can all play a role in reducing the risk of loss in retirement investing. Each option offers varying levels of safety, liquidity, and potential returns. It's important to carefully consider your financial goals, time horizon, and risk tolerance before deciding on the right mix of investments for your portfolio. Consulting a financial advisor can help you navigate these choices and build a retirement plan suited to your needs.

Avoid losing purchasing power by earning more than the inflation rate

Inflation is a serious concern for retirees, as it erodes purchasing power and can affect their standard of living. Therefore, it is crucial to invest in assets that keep up with or surpass the inflation rate to maintain purchasing power. Here are some strategies to avoid losing purchasing power by earning more than the inflation rate:

Diversify Your Portfolio

Diversifying your portfolio across various asset classes, such as stocks, bonds, and real estate, can help fight inflation. Historically, stocks have provided inflation-beating returns over time. While they come with risk and volatility, investing in stocks can help grow your retirement savings and ensure they last throughout your retirement. Additionally, real estate investing can serve as a hedge against inflation due to the intrinsic value of real estate and the ability to generate rental income.

Invest in Inflation-Protected Securities

Consider investing in Treasury Inflation-Protected Securities (TIPS) or Series I Savings Bonds. TIPS are government-issued securities that adjust their payouts based on the Consumer Price Index (CPI). Series I Savings Bonds are issued by the U.S. Treasury Department and offer a completely risk-free investment with protection against inflation.

Annuities

Annuities are insurance products that provide a stream of income payments. Some annuities are inflation-adjusted, meaning their payment amounts will increase along with the CPI. Annuity laddering involves buying multiple annuities at different times to take advantage of different market conditions and create multiple streams of income to stay ahead of rising costs.

Calculate and Plan for Inflation

Use tools like the Bureau of Labor Statistics' inflation calculator to understand how inflation will impact your purchasing power over time. When saving for retirement, factor in inflation to determine how much you need to save to maintain or improve your standard of living.

Consult a Financial Advisor

Consider seeking advice from a fee-only fiduciary advisor or a financial advisor who can help you create a financial plan tailored to your needs and goals. They can assist you in constructing a portfolio with an appropriate level of risk and a strategic asset allocation to combat inflation effectively.

Rebalance your asset allocation, lower high-risk stocks

As you get older, it's generally recommended that you rebalance your asset allocation to lower the proportion of high-risk stocks and replace them with safer investments, such as bonds. This way, your portfolio can accommodate safer investments and focus on capital preservation rather than growth.

Rebalancing is the process of returning a portfolio's asset allocations to the levels defined by an investment plan. It involves periodically buying or selling the assets in a portfolio to regain and maintain the original, desired level of asset allocation. This desired level of asset allocation should match an investor's tolerance for risk and desire for reward.

Over time, the values of the assets in your portfolio will change as market performance alters them. This will result in a changed risk profile for your portfolio. For example, if the value of equities in your portfolio increases, the allocation in stocks will rise above their preset percentage. You may then decide to sell some stocks and buy bonds to realign the percentages back to the original target allocation.

There is no required schedule for rebalancing a portfolio, but it is recommended that investors examine their allocations at least once a year. Calendar rebalancing is the least costly strategy and involves analysing and adjusting investment holdings within the portfolio at predetermined times, usually annually. Constant-mix rebalancing is a more responsive approach that focuses on the allowable percentage composition of an asset in a portfolio.

To rebalance a portfolio, you can buy or sell assets to reach your desired portfolio composition. This can be done by selling off investments from overweighted asset categories and using the proceeds to purchase investments for underweighted asset categories. Alternatively, you can simply purchase new investments for underweighted asset categories or alter your contributions so that more investments go to underweighted asset categories over time.

Benefits of Rebalancing

Rebalancing can help keep investors' portfolios aligned with their risk tolerance and need for a certain amount of return. It is a disciplined, unemotional investment approach that can reduce exposure to risk. It can also be changed as investors' financial needs and investment goals change.

Focus on capital preservation, not growth

As people get older, their investment portfolios should become more conservative to accommodate safer investments and focus on capital preservation rather than growth. This is because older people have a lower risk tolerance and less time to recoup losses.

Capital Preservation Strategies

Capital preservation strategies involve investing in the safest short-term instruments, such as Treasury bills and certificates of deposit. These types of investments have little to no risk and smaller returns compared to current income and growth strategies. They are a priority for retirees and those approaching retirement, as they may rely on these investments to cover their living expenses.

Drawbacks of Capital Preservation Strategies

One of the main drawbacks of capital preservation strategies is the effect of inflation on the rate of return from "safe" investments over time. While inflation may not significantly impact returns in the short term, it can substantially erode the real value of an investment over time. For example, a modest 3% annual inflation rate can slash the real value of an investment by 50% in 24 years. Therefore, investors utilising a capital preservation strategy may be better off investing in inflation-adjusted investments, such as Treasury Inflation-Protected Securities (TIPS).

How to Invest for Capital Preservation

• Capital preservation funds
• Real estate investments
• Annuities
• Target-date funds
• Mutual funds, preferably index funds, that invest in the stock and bond markets
• Low-cost ETFs (exchange-traded funds) that mimic the S&P 500

Frequently asked questions