Mitigating Risks to Your Income in Retirement

The largest mutual fund company admitted it has been surprised by the global economy’s strength this year. That doesn’t mean, however, that it is more optimistic about the investment outlook over the next ten years. “Investors should prepare for a decade of ‘muted returns,’” says Nathan Zahm, investment advisor at the Vanguard Group.

As discussed in previous blog posts, there’s no question that the U.S. stock market is expensive today. There are different ways of calculating Price to Earnings (P/E) ratios – forward looking, backwards looking, a blend of the two – but under any measurement, stocks are expensive. If you look at the gross capitalization of U.S. stocks and compare that to the size of the U.S. economy, another effective way to look at the current value of U.S. stocks, it’s also very high.

That’s not to say the U.S. stock market can’t go higher. It can. If tax reform gets passed, it wouldn’t be surprising to see the stock market continue to inch higher (absent a world event that changes all of that). However, when we look out 8 to 10 years, it’s difficult to make a case for a robust market in the United States.

Vanguard is estimating equity returns of anywhere from 5 to 8 percent per year. In my opinion, that might be a little too optimistic. I think that if we see returns of 5 to 6 percent per year in the U.S. stock market over the next 10 years, that’s probably pretty good.

Don’t misunderstand – I could be wrong. Nobody can accurately predict what is going to happen with the markets. But when you put all of the math on the table, it paints a picture of choppy, sideways markets.

According to the American College, 80 percent of your eventual financial success or failure in retirement is determined in the first 10 years. If we do indeed have a sideways market over the next ten years and you are about to retire or are already retired, how then can you mitigate the risks to your income in retirement? In my opinion, there are two major ways you can do this.

Number One: Have an income plan that mitigates the risk of choppy markets. Your income plan should clearly define when and how you will draw income from your investments. I typically recommend that you separate your investments into two “buckets”: one “bucket” is for your safe, stable investments, while the other is for more risk-based, growth-oriented investments. Over the next 8-10 years, you should plan to draw income from your safe investments, where you can be confident that when you need to pull money out, that money will be there for you.

The other “bucket” has a long-term vantage point and can afford to take more risk. You don’t want to live off of investments that go up and down every day, every week, every month, and every year, because inevitably, they’re going to be down. And if you are dependent upon these risk investments for immediate income, you’ll likely have to sell off investments when they are down. By doing that, you’re compounding your losses. That money will never recover from the loss because you’ve spent it. It’s okay to sell investments when they are down and then re-invest the money, but you don’t ever want to sell investments when they are down and then spend that money. Therefore, having an income plan with a clear strategy for dealing with bad markets is critical to mitigating the risks of investing over the next 10 years.

Number Two: Be more diverse with your risk-based investments. Most people, frankly, are not very diverse with their investments. I see a lot of individuals come into my office with the traditional 60/40 mix of stocks and bonds in their portfolio, primarily U.S. denominated, typically in mutual funds. That investment plan is simply betting on the stock market, and will usually follow the ups and downs of the stock market. Additionally, with that type of portfolio, the one way you’re trying to hedge risk is with U.S. bonds,  an instrument doomed to not do well over the next 10 to 20 years. A traditional approach probably won’t work well if we see choppy, sideways markets over the next decade. Therefore, you should be more diverse, have more alternative investment classes, and have different types of bonds to hedge risks that aren’t dependent upon keeping interest rates low.

Having an income plan to deal with risk and having a more diverse bucket of risk investments are, in my opinion, two of the most effective ways to deal with investing in a choppy market.