This is the second article in our series on navigating retirement risks, based on our White Paper, Creating Sustainable Retirement Income in 401(k) Plans Using Managed Risk Funds (www.milliman.com/new401k).  The first article addressed how long a 401(k) participant will need his retirement money to last.  We also discussed how market fluctuations at the wrong time – what we called timing risk – impact the participant’s account.  In this article, we discuss the importance of investing retirement savings properly. 

New mortality statistics indicate that men will live, on average, almost 22 years after age 65, and women will live nearly 24 years.  Since these are averages, the prudent course for a person retiring at age 65 would be to plan on a longer retirement period, perhaps as much as 30 years.  But such a long retirement raises other concerns and risks:  a risk associated with how money is withdrawn; inflation risk; the timing risk discussed in our last article; a risk some have labeled “cognitive risk,” which refers to the erosion of our ability to make complex decisions as we get older.  There is another risk that is not often identified as such, one that we are calling the “apprehensive investor” risk. 

One of the practical impacts of a long retirement is that the money accumulated in a 401(k) plan or rollover IRA cannot be left idle.  It needs to be invested to help offset the effects of inflation and to get a return that will help the money last longer.  Nevertheless, in the face of timing risk and general market volatility, the apprehensive investor may be tempted to invest largely, or even entirely, in fixed income products (or “bonds”).  A retiree may think that, since he will not be adding new money to his savings, he is best served by keeping it “safe.” 

But “safe” investing is not the same as a secure retirement.  A maxim of sound investing is to buy assets that outpace inflation.  In today’s markets, that means investing in equities – i.e., stocks – because stocks have the potential for growth, but they are subject to greater volatility, which creates the risk of loss due to withdrawals of money for retirement living expenses when the market is down.  Historically, we have managed that volatility risk in retirement accounts by allocating a large amount to bonds or other fixed income securities. In the past, bonds were a useful risk management and income generation tool.  

Unfortunately, today’s low interest rate environment -- the ten year treasury rate is currently below 2.0% -- has changed the investing landscape.  At current interest rates, using bonds as a risk management tool forces investors to make a trade.  Do they want to invest for growth and inflation protection, or are they suffering from apprehensive investor risk and opt for safety?  They cannot have both…but there is a way to have much of the growth benefit of stocks while reducing the exposure to volatility.

The alternative is a portfolio more heavily weighed to stocks.  Stocks have the potential of growth and higher returns, which provides inflation protection and can result in a more sustainable retirement income. 

Conclusion

This sounds like a Hobson’s choice:  you can chose bonds and protect your capital at the risk of reducing your spendable income; or you can choose stocks to seek greater returns and to offset inflation at the risk of volatility and the permanent loss of retirement withdrawals when the stock markets are down .  However, there are strategies that have been used by financial institutions for years to achieve both growth and downside protection.  These strategies are becoming available to individual investors.