For most Americans, retirement is the reward from a lifetime of hard work. Some retirees choose to volunteer or take positions they enjoy while others trade in the daily 8-5 grind for a retirement full of freedom, no alarm clocks, and travel.
Between 2010 and 2030, the Baby Boomer generation (estimated at 73 million individuals) is retiring at a rate of 10,000 people per day, and while each of these individuals likely looks toward their new found freedom with excitement, they also face significant challenges. One of the most significant challenges is ensuring their money lasts throughout retirement.
When asked about the most likely reason they may run out of money in retirement, most retirees will say a significant market decline that reduces the value of their investment accounts.
Accordingly, many retirees become very “conservative” in their investment allocation in an attempt to avoid market declines by allocating a large portion of their portfolio to fixed income investments like certificates of deposit (CDs) or bonds.
While market fluctuations are a risk that retirees need to consider and address, there is a greater risk that many retirees overlook. That risk is lost purchasing power due to inflation. Retirees who are facing 25+ years of rising costs need to invest not only for the income they need today, but also for the income they will need in 25 years. Since inflation reduces purchasing power gradually, it is easy for retirees to underestimate the long-term risk it presents.
Key Takeaway:
Loss of purchasing power due to inflation is the greatest financial risk facing most retirees.
The Two Primary Risks:
There are two primary risks investors face when it comes to ensuring their money lasts throughout retirement. The first is loss of purchasing power, and the second is loss of principal.
Loss of Purchasing Power: Loss of purchasing power occurs when the economy experiences inflation. As the costs of everyday expenses increase, each dollar of income purchases less than it did in previous years. Accordingly, individuals who want to maintain their standard of living will need to spend more each year to do so.
In our analysis of historical inflation below, we utilized the Consumer Price Index for All Urban Consumers (CPI-U) going back to 1933. Readers should keep in mind that during the Great Depression era, there were 6 out of 7 years that experienced deflation (prices going down). We specifically began our analysis after those years to avoid the skewed results that occur due to the substantial drop in price levels during that difficult period of history.
Looking back at 91 years of inflation history from 1933-2023, there were three years where the United States experienced a decreasing price level. In all other years, costs rose. The following is a table that shows the changes in purchasing power over the 91-year period. The data is shown for single years as well as for rolling 5-, 10-, 15-, 20-, and 25-year periods.
As the table shows, every period of at least 5 years resulted in a loss of purchasing power, and unlike the loss of principal when investing in the market, the loss of purchasing power only gets worse with time. Individuals entering a 25-year retirement need to be prepared to see the purchasing power of each dollar permanently decline by 40%-75% of its current value by the end of their retirement.
The following table shows the value of $1 over a 25 year retirement for the best and worst case scenarios in the table above.
As the graphic shows, the loss of purchasing power is a gradual but permanent loss that can result in retirees having to spend 2-4 times as much at the end of retirement to maintain the standard of living they originally had at the beginning of retirement.
Key Takeaway:
Over a 25-year retirement, $1 will generally lose about 40%-75% of its purchasing power. Retirees must have an investment plan that can maintain purchasing power.
Loss of Principal: The other risk that retirees must consider is loss of principal. For most retirees, this is the most obvious risk; however historically loss of purchasing power is a more significant risk.
Loss of principal occurs when investments go up and down with market movements. Investments in a diversified portfolio will fluctuate causing investors to experience temporary losses until prices return to previous highs. For example, the S&P 500 index has experienced 26 negative years over the past 98 years. On average that means the index declines slightly more often than 1 out of every 4 years.
However, as the time periods increase, the frequency of experiencing a loss over the entire time period is significantly reduced. As the graph below shows, investors who invested in the S&P 500 for 10 years only saw a loss in 4 out of 89 10-year periods, and investors who invested for 15 years or longer never ended a 15-year period with a loss.
Further, when considering the overall returns during these time periods, the average annualized return hovered between 10-12% with the maximum and minimum losses becoming less extreme as the years invested increased.
While negative fluctuations of principal balances over short to medium periods frequently occur, the long-term loss of principal from a diversified portfolio of quality companies decreases substantially as time periods increase beyond 10 years.
In addition, while the potential for a diversified group of quality companies to produce a long-term loss is low, the likelihood of substantial gains is high. With the annualized long-term S&P 500 returns amounting to 10.28%, investors holding equities have been substantially rewarded over time.
The following shows that $1 invested in the S&P 500 from 1926 through the end of 2023 would have grown to over $14,547.
While this is incredible growth, it does not factor in the effects of inflation. The inflation adjusted growth of the S&P 500 over that same time period is still substantial with $1 growing to an inflation adjusted value of over $848. In other words, after accounting for inflation, the S&P 500 increased the value of $1 by more than 848 times the original value even after factoring in the loss of purchasing power due to inflation.
The key point is that a diversified portfolio of quality companies will fluctuate in value year to year, but over time as the companies generate profits, they will either pass them on to investors through dividends or reinvest them into the business for additional growth.
These distributed or reinvested earnings over time result in a steady upward trend of the market which has resulted in an average long-term return for the S&P 500 that significantly outpaces inflation, protects the purchasing power of investors, and significantly reduces the chance of loss over the long-term.
Key Takeaway:
While market fluctuations can reduce an investor’s principal over short and medium periods, long-term investors are significantly less likely to experience a long-term loss.
Why Fixed Income Alone Fails to Protect Purchasing Power:
While the principal balance of fixed income remains stable day to day, investors pay a significant price for this stability in the form of lower returns. Currently an investor can purchase a 30-year US Treasury Bond paying 4.4% interest.
If we assume that over the course of their retirement, that investor is in a 25% tax bracket, the 4.4% pre-tax return results in a 3.3% after-tax return. As shown previously, the average loss in purchasing power due to inflation is 3.4% annually. Accordingly, the investor is simply treading water by holding fixed income and all distributions effectively reduce the purchasing power of the individual’s original portfolio.
To demonstrate, assume the following facts. A retiree has a $1,000,000 portfolio that is fully invested in US Treasury Bonds paying 4.4%. The retiree is in an average tax bracket throughout retirement of 25% and will draw $40,000 from their portfolio initially in retirement. They will increase the amount they draw by inflation each year thereafter.
Given the after-tax return of 3.3%, this portfolio is not capable of increasing the investor’s purchasing power during retirement. Accordingly, this investor will run into significant issues if inflation is higher than expected. The following chart demonstrates this individual’s portfolio value over time assuming the average 3.4% inflation as well as the highest 25-year average inflation rate of 5.6%.
As the graphic shows, this retiree barely has enough money for a 25-year retirement assuming normal inflation. They have no margin for error if inflation is higher than expected or they outlive their planned 25-year retirement.
As a result, a portfolio fully allocated to fixed income investments is not a “conservative” portfolio at all. Rather it is one of the riskiest portfolios a retiree can have as they enter retirement.
How To Mitigate Both Risks:
A common misconception of retirees is that once they are in retirement, they are no longer long-term investors. However, rarely is the entire portfolio needed immediately. Rather a large portion of the portfolio will be invested for the purpose of providing income many years in the future.
Accordingly, it is important to consider what portion of the portfolio can be focused on long-term growth and what portion needs to be protected in the short-term.
As pointed out above, a portfolio fully allocated to fixed income isn’t the answer for long-term success, but allocating a portfolio that a retiree depends on for recurring income fully to equities is not a viable solution either.
If a retiree’s portfolio was fully allocated to equities and the market declined substantially, the retiree would be required to make their ongoing distributions from the depressed balances which would eliminate a portion of the account from participating in any future recovery.
If the market stayed down for multiple years in a row, the retiree may withdraw a large enough portion of the portfolio that no future recovery would be sufficient enough to allow the portfolio to last through retirement.
When thinking about this risk, it’s important to understand how long market downturns typically last. To understand this better, we’ll continue using the S&P 500 as the example.
Historically in cases where the S&P 500 has declined, the index generally has fully recovered to its previous high within 3 years. However, the longest periods for full recovery of the S&P 500 to its pre-decline peak was 8 years in the Great Depression era and 7 years during the recent Dot Com bubble (using total returns including dividends).
!!!Please note: In the case of the 4 periods where the market produced a negative 10-year return as shown in the tables earlier, the market fully recovered prior to declining again before the end of the full 10-year period. When only the beginning and ending values are viewed for the 10-year period, the ending balance was below the beginning balance despite having fully recovered at one point within the 10-year period!!!
Using this information, we can create a strategy that will allow retirees to invest in equities and receive the long-term benefits of higher returns while also protecting against short-term market fluctuations by blending the use of fixed income and equity in the same portfolio.
Given most fixed income provides very little inflation adjusted return over time, the goal is to hold just enough short-term fixed income or cash to allow the retiree to fund 3-7 years of annual distributions without selling any of their equity positions during a market downturn. Anything beyond this amount could be allocated to equity investments. This allows investors to receive the benefits of long-term equity growth while significantly reducing the risk that they would need to sell equity positions during a market downturn.
To continue the example above let’s now assume that instead of the retiree investing their $1,000,000 portfolio only in US Treasury Bonds, they invest 40% in US Treasury Bonds and the other 60% in equities that generate a 10% pre-tax return. We will also assume the average tax rate on the equity returns is 18% to account for a standard 15% capital gain and qualified dividend tax rate plus a 3% state tax rate.
The retiree will still draw $40,000 from their portfolio initially and then increase that for inflation going forward.
As shown, this portfolio performs much better over the long-term and provides better protection for the risks of a longer life and higher inflation.
!!! Please Note: We have not discussed “sequence of return risk” which acknowledges that the 10% equity return is not a guaranteed return each year. Rather equity returns can vary widely from year to year, and investors who experience negative returns early in retirement see a larger impact on the ability of their portfolio to last through retirement. While sequence of return risk is important, it is beyond the scope of this post which is intended to demonstrate the conceptual reason why fixed income alone is a dangerous long-term strategy for most retirees.!!!
Accordingly, it is important to create a diversified portfolio unique to each retiree’s financial situation. In the end, the retiree’s portfolio not only needs to include a strategy for managing market downturns in the short-term but also needs to provide for a lifetime of increasing income to avoid a declining standard of living in the long-term.
Key Takeaway:
An appropriately diversified portfolio can address the risk of lost purchasing power and loss of principal.
Conclusion:
As 10,000 baby boomers cross the threshold into retirement each day, ensuring they have a sound investment strategy that can stand up to the challenges of a 25+ year retirement is key.
While the natural reaction for most retirees is to focus on avoiding any loss to the principal balance of their lifelong savings, it is important to realize that their biggest risk is the loss of purchasing power over time.
While the balances of investment accounts do fluctuate on a temporary basis, the loss of purchasing power is more dangerous because it is permanent. The best way to combat the loss of purchasing power is to include a significant and diversified allocation to quality companies that distribute or reinvest their earnings over time. This has provided an average long-term return that significantly outpaces inflation and protects the purchasing power of retirees.
If you are nearing or in retirement already and are interested in learning whether your portfolio is prepared for the years ahead, we would be happy to review your portfolio and provide our perspective. If you are interested in working with a Family CFO to help coordinate your family’s entire financial picture, we would love to connect to see if what we do is right for you.
