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Day 26: Hedge against threats to your retirement portfolio, part I
Degree of difficulty: Moderate
Investors are far better off focusing on the factors they can control—notably, saving enough, creating a reasonable asset-allocation scheme, and taking care in investment selection—than they are attempting to predict the direction of the economy and the market.
Yet it’s also a mistake to turn a blind eye to the threats that could erode the value of your portfolio over the long term, particularly if you’re already retired. That might seem counter to the viewpoint outlined above, but it's really not. Identifying a risk factor and putting in place a long-term plan to hedge against it is quite different from making big changes to your portfolio so it can benefit from a short-term trend that may or may not materialise. The former is risk management; the latter is market-timing.
It pays to consider these risks before you see them splashed on the front page of every newspaper, because by that time you’ll pay a premium to hedge against them. The mania for inflation-fighting instruments in 2008 provides a vivid case in point. Worries about higher prices reached a fever pitch but by then the key inflation-fighting instruments had been bid up substantially. Investors who bought commodities, for example, in the first half of 2008 suffered substantial losses in the second.
Today's task is to assess and hedge against the 'threat' of longevity. The next task, part II, will be to consider the impact that needing long-term care will have on your portfolio, and in parts III and IV, we'll look at the risks posed by inflation and rising taxes.
Of course we would all like to live long, happy, and healthy lives but reaching a ripe old age brings a corresponding worry: outliving your nest egg. That’s a particularly big concern for today’s retirees. Not only are they living nearly a decade longer, on average, than retirees 50 years ago, but many also saw their portfolios suffer catastrophic drops during the recent bear market.
Some of the best strategies for managing longevity risk are plain old common sense: taking care with your portfolio-withdrawal rate (and reducing withdrawals during and immediately after a down market), or working longer and/or part-time during retirement.
Holding at least some equities during retirement is another strategy for managing longevity risk. Although there’s no guarantee that stocks will go up over the next few decades—and holding a too-high stock position in retirement can subject your portfolio to undesirable volatility—equities have higher long-run return potential than bonds, whose future returns are often roughly in line with their yields.
There are also a few products designed specifically to help retirees manage longevity risk—notably, longevity insurance. The key disadvantage of longevity insurance, however, is that you may fork out a substantial sum to buy it but not live long enough to see any benefits from it. In general, longevity insurance makes sense only for those who have a good reason to expect that their life spans will run far higher than average.
Day 27: Hedge against threats to your retirement portfolio, part II
Degree of difficulty: Moderate
Day 26 of our 30-day financial fitness regime addressed the 'threat' to your retirement portfolio presented by long-term care. Following on from that, today we're tackling another threat to hedge against.
This next threat, related to longevity insurance, is the possibility that paying for nursing-home care, assisted living, or home health care will gobble up your entire nest egg. The good hedge against this risk is long-term care insurance, which also provides valuable peace of mind if a condition like Alzheimer’s disease runs in your family. All the same, long-term care insurance is not for everyone.
Insurance professionals often push long-term care coverage at an early age; the premiums are certainly lower, and being younger reduces the likelihood that you would have already encountered a serious health problem that could jack up your premiums. Bear in mind, however, that the average age for entering a nursing home is roughly 80. So, if you buy a policy when you’re in your 50s, you could be paying premiums for 20 years or more before you actually use the coverage.
An insurance company’s financial standing is an especially important consideration for both long-term care and longevity insurance. You may not be receiving benefits for 20 years or more, so you’ll need to take steps to ensure the insurer is still around and in a position to pay its claims when you begin drawing benefits. Look for companies that earn high ratings from several of the ratings agencies.
Day 28: Hedge against threats to your retirement portfolio, part III
Degree of difficulty: Moderate
Another threat to consider hedging against is that of inflation.
Inflation is a big drag on anyone on a fixed income, like retirees. Whereas working people may receive salary increases to compensate them for cost-of-living increases, most pensioners are drawing upon their portfolios for at least a portion of their income, and rising prices erode the purchasing power of their withdrawals.
Official statistics revealed earlier this week that inflation in the UK, as measured by the government's preferred CPI, was at 3.5% in January, up from the previous month's 2.9% and high enough to cause Bank of England governor Mervyn King to write a letter to Chancellor Alistair Darling explaining why it is more than one percentage point above the target rate. Though King has described the jump in inflation as “temporary,” it is likely to be more of a long-term threat, thanks to the confluence of massive amounts of fiscal stimulus and growth in emerging markets. For that reason, it can make sense to bolster any portfolio that consists predominantly of fixed-rate investments with a dose of inflation protection.
Before you layer on additional inflation protection, however, see if you already have any quasi-inflation hedges in your portfolio. For example, emerging markets tend to be heavy on basic-material producers, and they in turn are beneficiaries of higher demand and prices; check your portfolio’s exposure to Latin America and developing Asian markets. (Morningstar.co.uk’s Instant X-Ray tool is a good way to investigate your portfolio’s geographic exposure.) Also look at your portfolio’s stake in energy stocks. They’re not the same as owning commodities directly, but they have a fairly high correlation with energy prices, and energy is a major component of most commodities indices.
Stocks are another, indirect, way to gird your portfolio against the threat of inflation. They have the potential for higher returns than bonds, and inflation will take a smaller bite, in percentage terms, out of your future purchasing power. Owning companies with a demonstrated history of dividend growth is another way to help offset the effects of inflation on your portfolio.
Day 29: Hedge against threats to your retirement portfolio, part IV
Degree of difficulty: Difficult
Taxation, or specifically higher taxes, is yet another threat that can eat into your retirement portfolio.
Given the massive amounts of government spending over the past decade, as well as the financial bind many local governments find themselves in, it’s not at all farfetched to assume that taxes will go up in the future. Taxes may seem like one of life’s inevitabilities, but you actually exert quite a lot of control over your investment-related taxes.
“Due to the complex nature of the UK tax system and the crazy policy of pension credits, retired investors need to be careful how they structure their savings and investments to avoid losing valuable tax benefits such as age allowance or paying an effective rate of tax of 40% on low levels of income through the loss of pension credits,” warns Alan Dick, Certified Financial Planner with Forty Two Wealth Management LLP.
One method of investing without incurring taxes is to take advantage of your full annual ISA allowance, which in the current year is £7,200 for under-50s and £10,200 for over-50s. The £10,200 limit will extend to all ISA investors when the 2010-2011 tax year commences in early April. Check out Morningstar.co.uk's ISA page for more information on how to reap the benefits of this tax-free method of investing.
Day 30: Schedule regular check-ups
Degree of difficulty: Easy
It's the final day of our 30-day financial fitness regimen. If you've have been following along for the last few weeks, you're well on your way to getting in the best financial shape of your life.
And if you're just getting started, it's easy to go back and tackle additional tasks on an as-needed basis. Week 1 focused on getting organised and finding your financial baselines. Weeks 2 and 3 coached you on reaching your short- and intermediate-term goals, retirement planning was the focus of Week 4, and Weeks 5 and 6 have focused on fine-tuning your retirement plan and putting in place systems to keep your investments in peak operating condition.
The final day of our fitness programme is less about specific tasks and more about general attitude. Be realistic, do your homework, keep on top of it, allot some time to assess and reasses your situation--and then forget about it.
Be realistic: When it comes to investing for retirement, no one wants to spend the vast majority of their life working towards an unattainable goal. If you're planning on spending your retirement enjoying luxury cruises and safaris but you're pinning your hopes on a property boom then you're likely to be disappointed. Conventional wisdom has long claimed that retirees need an average income in retirement of around 80% of their working salary but as my colleague John Rekenthaler discusses here, this is not only hard for many to achieve but is actually not necessary in many cases. Assessing your financial goals and outlining realistic saving and investing habits to achieve them is half the battle when it comes to successful financial planning.
Power to the people: With a wealth of information and educational material available to individuals, including Morningstar's personal finance articles, fund analysis and equities commentary, ETF research, and ISA guides, there's no reason why you can't Do-It-Yourself when it comes to investing. If, for example, you've been happily paying into a company pension for years but you never got round to assessing whether the default funds allocation is to your liking, this is a must. Use Morningtar's Learning Centre and tools to educate yourself about asset allocation, diversification and risk assessment. And if you need a helping hand, find yourself a financial adviser who can help you assess your goals and go about achieving them.
Check up regularly but not frequently: It's important to assess and reassess your portfolio's performance but checking in on your investments too often can lead to the risk of emotion-based decisions. Set a schedule for reviewing and, if needed, rebalancing your portfolio on an annual basis. But between check-ups, try to tune out the market noise: if you're comfortable with your targets and allocation, then taking note of short-term volatility will only undermine your confidence unecessarily.
Feel free to address each day's tasks at your own pace or to omit those that either don't apply or that you feel you can't adequately address at this time. I hope you've enjoyed getting into peak financial shape.
