It wasn’t until the baby boomer generation started to retire that we had to face the challenge of longevity risk—the risk of outliving one’s income. Compared to our parents or grandparents who might have lived ten or fifteen years in retirement, most people today can expect to live well into their eighties and early nineties. Couple that with an increasing desire by many people to retire early, and we’re seeing the retirement stage of life being stretched on both ends. That has real implications for investing for and during retirement.
You May Live Longer Than You Think
While many of us are bracing for the possibility of living 20 years or more in retirement, few understand that life expectancy is a moving target. That is, life expectancy increases as we age. Although the life expectancy table today shows that a 60-year-old male could expect to live until 81, when he turns 65, he can expect to live until 85. At age 70, his life expectancy increases some more with a 20% chance of living to age 90 and a 10% likelihood of living to 100. The bottom line is your longevity risk increases as you get older. The risk is greater for women who are twice as likely to outlive their husbands.
Inflation Compounds the Risk of Outliving Your Income
Inflation has always been an issue in retirement planning but now poses a severe threat because it will compound the challenges of longevity risk. For past generations, the threat of inflation was somewhat muted because people didn’t live as long in retirement. But people living as many as 25 or 30 years in retirement with an average of 4 percent inflation could see their purchasing power cut in half in 18 years. That means it will cost twice as much to maintain the same standard of living.
Bonds No Longer Cutting it as a Retirement Income Vehicle
For decades, the conventional wisdom has dictated that investors add bonds to diversify their portfolios and balance out more volatile equity investments. High-quality bonds have been the backbone of most portfolios due to their reliable yields and downside protection. However, bonds were never designed to beat inflation. They are designed to produce income and safety of principal.
With today’s inflation-adjusted yields on bonds going negative, they produce a drag on portfolios. Plus, when you buy a bond, its income is guaranteed not to increase, and bonds are guaranteed to lose value in a rising interest rate environment. For retirees facing the inevitable prospect of losing purchasing power, bonds are a lose-lose proposition. Where’s the safety in that?
Retirees Need to Embrace Total Returns
To position themselves for an extended period of rising prices, retirement investors should change their mindset from that of depending on high yields to that of relying on total returns. Total returns are derived from both capital appreciation and yields, specifically yields on dividend-paying stocks. Some of the best companies have a long history of paying and increasing dividends, many with yields far higher than bonds. For example, one of our long-term holdings is T. Rowe Price (NYSE: TRO), which has increased its dividend yearly for 34 consecutive years through thick and thin, including the tech bubble and financial crisis.
Investors who can hold high-quality stocks through at least a couple of market cycles have always been rewarded with positive returns. And during periods of declining market prices, the dividends have provided the ballast investors once sought from bonds.
Conservative Planning Assumptions Can Keep Retirees Safe and on Track
A well-conceived financial plan uses conservative assumptions to account for the worst economic scenarios, such as high inflation and periodic recessions. For example, rather than using historical stock market averages of 8% to 10% to project asset growth, you should apply a more modest projection such as 5%. We also assume that clients will outlive 75% of their peer group (past age 90), providing a planning cushion against living longer than expected. We would rather our clients overshoot their objectives by planning conservatively.
Many investors are naturally uncomfortable with market volatility, which is why the temptation to own less-volatile assets, such as bonds can be overpowering. However, investors need to grasp the risk-return tradeoff of owning bonds, especially in this environment. While it might help you sleep at night in the short term, it will more than likely limit your total returns, which is critical for lifetime income sufficiency. Being able to tolerate volatility in the short-term is the price of admission to higher long-term returns.