There isn’t an investor out there who hasn’t felt the dramatic swings in the markets over these past few years, prompting them to reconsider the makeup of their portfolio.
For the young investor holding more growth stocks, for example, the long-time horizon until retirement provides better chances for portfolios to come back and, hopefully, produce higher returns… in the long run.
But investors nearing retirement, and who have saved judiciously over the years are more likely to take on less risky investments.
In either scenario, the one element that neither demographic can escape is the fact that…
‘Inflation’ will always be with us!
Over time, whether investing ‘solo’ or using professional guidance, every investor must face the impact that inflation will have on their portfolio. Certainly a loaf of bread today will be more expensive in the future. Consequently, as inflation goes up, every buck buys less in goods and services: bread costing $1 today will cost $1.02 with a 2% inflation rate.
As such, that dollar simply won’t be able to buy those same goods and services for what they cost previously. In fact, factoring in a 3% inflation rate one’s purchasing power is dramatically reduced by half throughout a 24-year time-frame—a dramatic reason for savvy investing for retirement that begins
One way to beat inflation…
In theory, the ideal portfolio to beat inflation would be made up of 100% stocks. Then, the companies you invest in would stand a good chance—over time—of creating the revenue and earnings to keep up with inflation.
But a portfolio made up of 100% stocks is not a prudent investment choice. Instead, a well-balanced portfolio of stocks, stock mutual funds and a selection of fixed income securities makes more sense.
On the flip side, a portfolio created with just fixed income bonds and bond mutual funds can be just as risky. Why? Surprisingly, there is a risk in owning these types of securities and it’s called interest rate risk.
That means when interest rates rise the fixed investments you hold may lose in face value. Who wants to buy your bondthat is throwing off 2% when the interest rates just went up and you can buy one that will earn 3%, for example. The result? Generally, and in the case of a bond mutual fund the price will drop, but then you’ll be receiving 3% interest payments.
Reaching retirement with a robust portfolio is certainly the goal, but choosing the right withdrawal rate affects outcomes during retirement.
What is a safe withdrawal rate?
Two decades ago, a financial planner (William P. Bengen) gave us the “4% rule” to follow when withdrawing from the portfolio during retirement. Basically, by following that percentage religiously, starting with a 4% during the first year, retirees can adjust that percentage by the inflation rate. The nest egg, according to Bengen, stands a good chance of lasting at least 30 years.
But now with low yields on fixed investments (2-3% or less?!), compared to 6.6% back when the rule was created in 1994 puts into question the viability of the “4% rule.”
In contrast, another variation of this rule points to a 4 to 6% withdrawal in the first year of retirement:
The initial withdrawal rate is between 4.8% and 6%, based on the stock/bond mix. At the end of each year, the retiree takes the preceding year’s withdrawal amount [in dollars] and adjusts it for inflation. But there are guardrails against big market swings: If that amount divided by the current portfolio balance equals a withdrawal rate of 20% more or less than the initial rate, the retiree adjusts the amount they withdraw that year. Wade Pfau, Professor of Retirement Income/American College of Financial Services.
What’s an investor to do?
To keep it simple, investors are often encouraged to follow the 4% rule but allow for adjustments annually that reflect changing markets.
In one example, given by the investment research firm, Morningstar:
“…a retiree with a 40% stock nest egg could withdraw only 2.8% initially and still have a 90% chance of success over a 30-year retirement.”
A big factor in any withdrawal rate is the annual cost of living increases. During years of market declines, retirees could technically draw out 5.1%.
But some pundits maintain that if an investor sticks with a well-diversified portfolio and spends only the money that hasappreciated in one’s stocks and bonds holdings, then there’s a decent chance of keeping the principal intact.
To discuss the effects that inflation can have on your savings, contact us to schedule a chat.