Peter Lynch famously said that spending 13 minutes thinking about the economy is a waste of 10 minutes. We tend to agree with that sentiment. 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 that 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 last summer, 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.
“It is essential to accurately assess an one’s risk attitude,” says Alan Dick, Certified Financial Planner with Forty Two Wealth Management LLP, “which is a combination of your tolerance to risk (how much risk you are prepared to take) and your perception of risk.”
“It is also essential,” Dick continues “to assess your risk capacity, i.e. how much risk you can take without jeopardising your financial goals if it all goes pear shaped.” Though one’s tolerance to risk may remain unchanged, over time one’s capacity to take investment risk diminishes with age due to the shorter time scale to recover from negative market conditions and the inability to earn additional income to buy time while markets recover. Thus, diversification is still important whatever your age or stage in life. “Even investing everything in cash, which may seem low risk, will actually create a significant risk due to the dangers of inflation and inflation is currently very low there is no guarantee that it will stay that way in future,” Dick comments.
Here, we highlight some of the key retirement-portfolio risks to stay attuned to, and also provide you with some specific long-term strategies and investment ideas for hedging against them.
The threat: Longevity
Yes, it seems odd to refer to longevity as a “threat”; it goes without
saying that we’d all prefer 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. With the most basic types of longevity insurance products, you give the insurance company a lump sum at the outset of your retirement. If it turns out you live well beyond your expected life span (based on actuarial figures), you’ll receive a monthly payout at that time. The key disadvantage of longevity insurance is that you may fork over a substantial sum to buy it but not live long enough to see any benefits from it. If your longevity policy is set to pay out at age 85 but you only make it to age 83, you won’t have any recourse. 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.
Many people mistakenly see annuities as offering extremely poor value and believe that if they die young the nasty greed insurance company will simply pocket their money, comments Alan Dick. “All annuity funds effectively go into a big pool and the unused funds of those who die early help to subsidise the income of those who live longer than expected,” he explains. “Life expectancy still appears to be rising so there is a real danger that individuals will live well beyond their funds unless they annuitise. The recent trend towards smaller, more accurately defined mortality pools such as post code based annuity rates and smokers’ annuity rates may have a long term negative effect on the income available to healthy pensioners who live for a long time as there will be fewer early deaths in the pool to provide cross subsidy.”
The threat: Long-term care
Another 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.
The threat: 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.
While inflation appears to be under control at present, 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.
The threat: Higher taxes
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.
Christine Benz is Morningstar's Director of Personal Finance; Holly Cook is Online Editor of Morningstar.co.uk.
