Retirement is suppose to be the time when you check out of the rat race, throttle your stress level down and pursue all of the things that you deferred during your working years. You’ve educated the kids, paid the mortgage off and saved enough to fund your golden years. Now, it’s time to collect your gold watch, stop worrying and start enjoying life.
Does your retirement reality look anything like that description? If it does, I’ll wager that you retired more than 15 to 20 years ago. If you retired in the last decade or you plan on retiring in the next decade your retirement years will be dramatically different. Do you know why? Our more senior generation of retirees likely enjoyed long careers at their company and they retired in an era that provided them with a company funded pension. Recent and future retires face the daunting task of replacing these disappearing company-sponsored pensions with a home-grown retirement income plan of their own design. Our government has tried to help us along the way by creating the IRA, 401K, SEPP IRA, and ROTH IRA savings plans. The problem with these plans is that you are responsible for saving your money. Investing your money endures market turmoil and eventually figuring out how and when to take your money out so that it lasts your entire lifetime.
For this reason, recent retirees are facing more financial stress than ever. Regardless of how successful you were in accumulating assets during your working years, retirement now is the transition from one career to another – the retirement income specialist. You need a plan to cash out of the retirement and investment accounts that you saved all those years. Your plan (and hence your retirement lifestyle) needs to be flexible enough to adjust as inflation and economic realities change.
The Tools of the Trade
To build your retirement income plan you may want to consider some bonds, because they can potentially generate steady income-cash that you can withdraw and spend. At times, bonds can be as risky as stocks, so you have to educate yourself on the risks. The main thing you must understand is the relationship between the bond’s price, its maturity and the rate of interest it pays. If you are good with numbers or a spreadsheet you can use the set of price/yield functions to run these calculations. As interest rates change in the future it will have a direct effect on the value of the bonds you bought to seek income. Since interest rates are very near zero right now, you need to know what will happen to the value of your bonds when (not if) interest rates rise.
It would be helpful if you could calculate how sensitive your bonds will be to future interest rate changes. This calculation would help you assemble a portfolio of bonds together that would react differently as rates fluctuate and help to reduce the risk that they all decline in value at the same time. By calculating the second derivative of the price/yield function we can solve for the duration of a bond. Duration measures the sensitivity of a bond’s price to changes in interest rates which is just what we will need. For example, if you have a bond with a maturity of 19 years and you calculated its duration at 9, then you know that if interest rates rise 1 percent, the value of the bond will decline about 9 percent. If you find these calculations intimidating, then you might want to cancel that fishing trip to free up more time to spend on your retirement income plan.
Compared to stocks, bonds can potentially provide stability to your income and your assets. Unfortunately, the bond portion of your retirement portfolio will be exposed to inflation risk. Should inflation rise and push the cost of living higher, your bonds will decline in value. As inflation pressures build, investors demand higher rates from fixed rate bond investments to help offset the risk. When the Federal Reserve actually starts to raise rates, the bond math that we discussed earlier becomes applicable. There is only one way for a bond with a fixed annual interest rate (its coupon) to generate a higher rate of return to an investor. They have to be able to buy it at a lower price. This presents a dilemma for you as you manage your retirement income. Do you cash out of your long term bonds and forgo the higher yields in order to protect the principal value? Do you keep collecting the income from the bonds and hope that inflation doesn’t get out of hand, decreasing the value of your bonds? There is a third option ..
Owning Stocks after Retirement.
While bonds can potentially provide steady income and less volatility than stocks, stocks can provide protection from inflation. Another branch of investment mathematics called Modern Portfolio Theory (MPT) can help you understand how to incorporate different asset classes together. Different asset classes have varying degrees of risk and return. Some asset classes move in opposite directions entirely. The math behind MPT seeks to take the emotion out of these differences by measuring the effects of these different investments on a portfolio containing them all.
Is there some optimal mix of stocks, bonds cash, gold and real estate that would generate a better risk adjusted return than any single asset class? The key phrase in the last sentence is “risk-adjusted return.” Without going into grizzly mathematical details, the answer according to MPT is YES. Investors can help to better manage risk and return by properly blending asset classes together under the calculus of MPT. Divorce yourself from any previous notion of stock investing as a “get-rich” exercise or as “too risky.” You are adding stocks to your allocation to manage and hopefully mitigate other risks in your portfolio, not to make enough to buy a bigger house or expand your retirement lifestyle.
Putting it All Together
When it comes to developing a reasonable retirement income plan, Modern Portfolio Theory, the efficient frontier, negative correlation, duration, convexity and risk-adjusted returns are more than jargon. They are the essential tools of the trade. They can help you build what we call a “Purpose Built Portfolio” designed around your unique needs instead of the whims of the moment. A lesser approach is just a collection of securities that likely won’t last as long as you will need it. To be successful in retirement income investing you will need to use these concepts to deflect the greed and fear that inevitably interfere with the risk management process.
Your retirement will be different than those who went before you. You will have to accept more responsibility for your retirement income needs than any prior generation. Are you prepared for your second career in asset management? You will likely spend a couple of decades at it. That is iIf your money lasts long enough.
Does your current approach incorporate professional portfolio analytics to address risk? Do you have experienced, independent advisers who help you? With decades of experience building purpose built retirement income portfolios, LeConte Wealth Management can help you. Through our planning services, we can review your current efforts at building your own portfolio. We will highlight the risks that you are exposed to and develop a sensible retirement plan that addresses these risks. Through our expertise in asset management, we can help you execute your plan.
