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Posts Tagged ‘Inflation’

It’s easy to get tripped up in retirement.  I’m reminded of the expression by the octogenarian to the recent newlywed fretting about life but rejecting out of hand the advice of his experienced senior:

A long time ago I was where you are now.  And later you’ll be where I am now.  But just as you haven’t been your age before, I’ve never been old before.

So for new retirees who “not been there or done that” it’s a whole new world filled with possibility and pitfalls.

Transitioning

Most retirees have an imperfect vision of retirement at best.  And if it hasn’t been discussed or communicated, it could be vastly different from that of your spouse.

Finding meaning in a post-work world can be a real challenge.  If your identity has been wrapped up in what you do, then you might now feel lost.  Your social networks might change.  Your activities might change.

It’s important to reassess your values and envision how you want to live in this next chapter of your life.

Initially, there may be more travel to visit family, friends or places.  You may want to tackle that “bucket list.”

But to live a truly fulfilling and rewarding retirement may require you to take stock in yourself, your values and what gives you meaning.  You may benefit from working with a professional transition coach or group that can help guide you through this period of rediscovery.  One such resource can be found here at the Successful Transition Planning Institute.

Lifestyle Budget

Typically, most retirees may take the rule of thumb bandied about that you will need from 60% to 70% of your pre-retirement income to live on in a post-retirement world.  This is because it is assumed that many expenses will drop off:  business wardrobe, commuting to work, professional memberships, housing, new cars, etc.

The reality is far different.  According to research conducted by the Fidelity Research Institute 2007 Retirement Index, more than two-thirds of retirees spent the same or higher in retirement.  Only eight percent spend significantly lower and about 25% spend somewhat lower. The Employee Benefit Research Institute  reported in its 2010 Retirement Confidence Survey that while 60% of workers expected to more than half of retirees didn’t see a drop in retirement expenditures while 26% of this group reported that their spending actually rose.

It all depends on your goals, lifestyle and what curve balls life throws at you.  If you have adult children who end up in a financial crisis of their own caused by job loss, health issues or divorce, you may be spending more than you expected to help out. Maybe the home you live in will require higher outlays for maintenance or to upgrade the home so you can live there independently. In reality all of that travel and doing things on your bucket list will cost money, too.  So it’s more the rule than the exception to expect spending to increase while you’re still healthy to get up and go.

Over time, the travel bug and other activities will probably decline but even after that these may be replaced by other expenses.

Healthcare

There is an old saying that as you get older you have more doctors than friends.  This is a sad reality for many including my parents.

My father is on dialysis and has complications from diabetes.  His treatments probably cost Medicare (and ultimately the US taxpayer) more than $30,000 each quarter as I figure it.  He takes about 13 prescriptions each day and enters the dreaded “donut hole” about mid-year each year. At one time their former employers (a Fortune 500 company) provided medical insurance benefits to retirees but that became more and more cost prohibitive for their employer and for my parents as premiums, co-pays and deductibles rose.  So now they rely on a combination of Medicare and Blue Cross/Blue Shield and a state program called Prescription Advantage.

As private employers and cash-strapped state and municipal governments tackle the issue, you can expect to pay more for your health care in retirement.

Wealth Illusion

It’s not uncommon to feel really rich when you look at your retirement account statements.  (Sure, the balances are off where they may have been at the peak but it’s probably still a large pot of money). The big problem is that retirees may have no comprehension about how long that pot of money will last or how to turn it into a steady paycheck for retirement.

In reality the $500,000 in your 401k or IRA accounts may only provide $20,000 per year if you plan on withdrawing no more than 4% of the account’s balance each year. Then again if you take out more early on in retirement, you could be at risk of depleting your resources quickly.

Misplaced Risk Aversion & The Impact of Inflation

So as you get older, you’ll be tempted to follow the rule of thumb that more of your investments need to be in bonds. Although this may seem to be a conservative approach to investing, it is in fact risky.

Setting aside that this ignores the risks that bonds themselves carry, it is ignoring the simple fact that inflation eats away at your purchasing power.  Even in a tame inflationary world with 1% annual inflation, a couple spending about $80,000 a year when they are 65 will need over $88,000 a year just to buy the same level of goods and services when they turn 75.  Given the potential for higher inflation in the future that may result from a growing economy and/or current monetary policy, investments need to be positioned to hedge against inflation with a diverse allocation into stocks and not just bonds even when in retirement.

The other risk is trying to play catch up.  As a retiree sees the balances on his accounts get drawn down, he might even be tempted to “shoot for the moon” by investing in illiquid investments like stocks in small, thinly traded markets or in sectors that are very speculative.

Ball games are one by base hits and consistency on the field and at the plate.  Home runs are dramatic but not a sure thing.

Underestimating How Long You’ll Live

We all want a long and productive life.  Many will even say that they don’t want to live to be a burden to their families.  But here again the reality is that most folks do a bad job of guessing how long they’ll live.  A report by the Society of Actuaries notes that 29% of retirees and pre-retirees estimate that they’ll outline the averages but in fact there is a 50% chance of outliving them.

So while they may have enough resources to carry them through the average life expectancy, they will not have enough when they live longer than the averages. And if a couple attains the age of 65, there is a better than 50% chance that at least one of them will live into their 90s.

Given the fact that most women become widows at the age of 53 (Journal of Financial Planning, Nov. 2010), this has a big impact on the availability of resources for retirement.  Too often, a short-sighted approach to maximize current retirement income from a pension is to choose the option that pays the highest but stops when one spouse dies. All too often this puts the widow who may live longer without a reliable source of income to provide for her.

Conclusion

Too often people underestimate how long they will live in retirement, how much they will actually need for living in retirement and how to invest for a sustainable retirement paycheck using appropriate product, asset and tax diversification.

Many people do not save enough for their own retirement.  The social safety net providing support for old age income and healthcare may not be enough to maintain a desired lifestyle.  Women need to understand the risk of living long into retirement and manage resources accordingly.  And because more than 40% of Americans are at risk of retiring earlier than expected because of job loss, family care needs or personal health, there is a real need for proper planning to address these issues.

While retirees will benefit from having a good plan and road map before the final paycheck ends, it’s never too late to start. And for the newly retired with the time to address these issues, now’s as good a time as any to speak to a qualified professional who can help.

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Whatever your retirement dreams, they can still be made a reality.  It just depends on how you plan and manage your resources. On any journey it helps to have an idea where you’re going, how you plan to travel and what you want to do when you get there.

If this sounds like a vacation, well, it should. Most people invest more time planning a vacation than something like retirement.  And if you think of retirement as the Next Act in your life and approach it properly, you won’t be so easily bored or run out of money to continue the journey or get lost and make poor money decisions along the way.

It’s How You Manage It That Counts

How much you need really depends on the lifestyle you expect to have.  And it’s not necessarily true that your expenses drop in retirement. Assuming you have an idea of what your annual expenses might be in today’s dollars, you now have a target to shoot for in your planning and investing.

Add up the income from the sources you expect in retirement.  This can include Social Security benefits (the system is solvent for at least 25 years), any pensions (if you’re lucky to have such an employer-sponsored plan) and any income from jobs or that new career.

Endowment Spending: Pretend You’re Like Harvard or Yale

Consider adopting the same approach that keeps large organizations and endowments running.  They plan on being around a long time so they target a spending rate that allows the organization to sustain itself.

1. Figure Out Your Gap:  Take your budget, subtract the expected income sources and use the result as your target for your withdrawals. Keep this number at no more than 4%-5% of your total investment portfolio.

2. Use a Blended Approach: Each year look at increasing or decreasing your withdrawals based on 90% of the prior year rate and 10% on the investment portfolio’s performance.  If it goes up, you get a raise.  If investment values go down, you have to tighten your belt.  This works well in times of inflation to help you maintain your lifestyle.

3. Stay Invested:  You may feel tempted to bail from the stock market.  But despite the roller coaster we’ve had, it is still prudent to have a portion allocated to equities.  Considering that people are living longer, you may want to use this rule of thumb for your allocation to stocks: 128 minus your age.

If you think that the stock market is scary because it is prone to periods of wild swings, consider the risk that inflation will have on your buying power.  Bonds and CDs alone historically do not keep pace with inflation and only investments in equities have demonstrated this capability.

But invest smart. While asset allocation makes sense, you don’t have to be wedded to “buy-and-hold” and accept being bounced around like a yo-yo.  Your core allocation can be supplemented with more tactical or defensive investments.  And you can change up the mix of equities to dampen the roller coaster effects.  Consider including equities from large companies that pay dividends.  And add asset classes that are not tied to the ups and downs of the major market indexes.  These alternatives will change over time but the defensive ring around your core should be reevaluated from time to time to add things like commodities (oil, agriculture products), commodity producers (mining companies), distribution companies (pipelines), convertible bonds and managed futures.

4. Invest for Income: Don’t rely simply on bonds which have their own set of risks compared to stocks. (Think credit default risk or the impact of higher interest rates on your bond’s fixed income coupon).

Mix up your bond holdings to take advantage of the different characteristics that different types of bonds have. To protect against the negative impact of higher interest rates, consider corporate floating rate notes or a mutual fund that includes them.  By adding Hi-Yield bonds to the mix you’ll also provide some protection against eventual higher interest rates. While called junk bonds for a reason, they may not be as risky as one might think at first glance. Add Treasury Inflation Protected Securities (TIPS) that are backed by the full faith and credit of the US government.  Add in the bonds from emerging countries.  While there is currency risk, many of these countries do not have the same structural deficit or economic issues that the US and developed countries have.  Many learned their lessons from the debt crises of the late 1990s and did not invest in the exotic bonds created by financial engineers on Wall Street.

Include dividend-paying stocks or stock mutual funds in your mix.  Large foreign firms are great sources of dividends. Unlike the US, there are more companies in Europe that tend to pay out dividends. And they pay out monthly instead of quarterly like here in the US.  Balance this out with hybrid investments like convertible bonds that pay interest and offer upside appreciation.

5. Build a Safety Net: To sleep well at night use a bucket approach dipping into the investment bucket to refill the reserve that should have 2 years of expenses in near cash investments: savings, laddered CDs and fixed annuities.

Yes, I did say annuities.  This safety net is supported by three legs so you’re not putting all your eggs into annuities much less all into an annuity of a certain term. For many this may be a dirty word.  But the best way to sleep well at night is to know that your “must have” expenses are covered.  You can get relatively low cost fixed annuities without all the bells, whistles and complexity of other types of annuities.  (While tempting, I would tend to pass on “bonus” annuities because of the long schedule of surrender charges). You can stagger their terms (1-year, 2-year, 3-year and 5-year) just like CDs.  To minimize exposure to any one insurer, you should also consider spreading them around to more than one well-rated insurance carrier.

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It is said that when the British surrendered to the Colonial Army at Yorktown the band played a tune titled “The World Turned Upside Down.”  True or not, it is a fitting sound track to a seemingly improbable situation: The defeat of a well-trained army and navy of the most powerful empire in the world by an under-funded, out-numbered and ill-equipped army of colonials. It was as if the Sun, Earth and stars had become unhitched leaving navigators without their usual bearings.

In much the same way, the Great Recession has shattered our views on what is ‘safe’ and what it means to be ‘conservative’ or ‘aggressive.’  Looking to preserve capital and produce income?  Invest in government bonds and maybe real estate.  Young and looking to score big on the potential upside of stocks? Go for small company stocks or overseas because if there’s a bust you’ll have time to recover. At least that was the conventional thinking. Everything that was traditionally considered to be ‘safe’ and dull turned out to be dangerous and ‘risky.’

There’s nothing scarier than conventional thinking in a changing market.  And what has evolved after the near melt down of the US financial system – indeed the global financial system – in the Fall of 2008 is certainly a changed market.

Household names including the bluest of the Blue Chips have entered and come out of bankruptcy.  The foundation for wealth for most people – real estate – has crumbled and is a long way from recovery to previous levels. Government debt of developed countries considered at one time to be nearly risk-less have been to the precipice as Greece neared default and threatened the entire Euro zone. Now, it’s not even beyond the pale to consider a future downgrade of the credit rating of the US Government.

Having an understanding of risk is important not just for investors but for the advisers trying to guide them.  In the past, an adviser (or your company’s 401k web site) would have you fill out a questionnaire.  Those eight to 12 questions would identify the type of investor you were and lead to an asset allocation reasonably appropriate for an investor’s Risk Profile, Time Horizon and Goals. This was sometimes considered a “set and forget” type of thing.

But commonsense and our experience tell us that things change.  Take the weather:  Some days it’s sunny and other times it’s rainy or cold.  What you wear on one day or even part of a day may not be right when the weather changes.  That’s just like investing.  A risk profile and asset allocation determined at one point might not be right for another.

So risk profiles are not static things either.  Invariably, they change based on how we feel. Hey, we’re only human. You need to reconsider your risk appetite regularly and now is a good time.  And it should be more than a few multiple choice questions.

After the run-ups in the markets in the late 90’s, people would tend to see things going up perpetually and say they would be more comfortable with risk.  On the other hand, after the two major meltdowns this past decade, the pendulum has swung the other way. Too far, in fact.

Faced with our own emotions and the vagaries of a global economic system, one might consider it to be less risky to sit on the sidelines.  Or maybe it’s safe to put all your chips on what you know – like your company stock.  Or just cash it all out and leave it parked in a money market or bank.

At first glance these strategies may be considered low risk but in reality – even the reality of today’s changed world – they are not.  Your company stock?  Consider Enron or Lucent and ask their employees how their retirement accounts held up.  Cash?  At the minuscule rates banks are offering, you’re already behind the eight ball with taxes and inflation.

There’s more to risk than the volatile nature of an asset’s price. And what should matter most is not which assets are owned but how well they perform on the upside and downside.

If you’re hungry, your goal is to not be hungry.  You say you like to eat steak and always eat steak.  Well, that’s great but the risk of heart disease may catch up to you.  So what you ate before may not be right for you now. Maybe it’s time to substitute more fish and add more vegetables.

That’s the essence of remodeling your portfolio now.  Government bonds still have a place in your portfolio – just like that steak – but it’s time to scale back on the developed nations of Europe with their risks of default and the US where another bubble is brewing and add those from emerging markets. If you own gold or want to buy it because it’s a “safe haven” for inflationary times and you don’t want to miss the boat, consider other more usable commodities like potash.  (As the world adds nearly 75 million people a year, there’s a growing demand for cultivating food for them and potash is a staple needed for fertilizers).  After seeing a huge multi-national like BP get hammered for its lackadaisical approach to employee and environmental safety, it may be time to add more small companies to the mix which have less bureaucracy and may be faster to respond to opportunities and troubles.

The risky stuff may actually be more safe than the traditional stuff.

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Just when you thought it was safe to get back into the investing waters, talk of deflation has creeped back into conversation.

Why does it matter? Well, how you position your portfolio to deal with these two scenarios will make a big difference to your personal bottom line.

With inflation, your money is worth less the longer you hold onto it. So you’re more likely to spend in the now because prices may be moving up.

With deflation, your money may buy more later the longer you hold onto it as prices continue to drop. (Not good for a seller but a better deal for a buyer – just ask someone trying to sell a house in Florida these days).

Since consumers respond differently to these two opposing forces, the ultimate direction of them can have a decidedly different impact on how the recovery progresses because of the way consumers react and business respond to their actions. Ultimately, this will impact how to position an investment portfolio accordingly.

The Right Hook
During a fight a boxer may expect to be hit from both the right and left. It’s just not known when and with how much force. But a good boxer, like a Boy Scout, knows to be prepared.

First the economy has been peppered with jabs from the right that could result in higher inflation: expanding money supply, ballooning government deficits, higher commodity prices, weak currency value.

Given the huge inherited, current and projected government deficits here and abroad, the conventional thought has been that all of this government stimulus will ultimately result in “crowding out” private investment and raise the ugly head of higher inflation down the road. The prospect of higher taxes to pay for these past deficits also lends support to these thoughts.

Recent run-ups in certain commodity prices like oil and energy products have resulted in a rise in consumer prices in January bolstering fears of inflation.

The Left Hook

Now comes the left hook – the deflationary threat: asset prices continuing to fall, increasing slack in industrial capacity, and continuing pressure keeping a lid on labor expenses because of high unemployment.

Credit is still tight with bank lending down. While dollars have been pumped into the economy through the TARP program, it’s mostly sitting in bank vaults. Money that isn’t circulating isn’t a cause of inflation.

Recent economic reports have indicated that core consumer prices actually are flat, well below the 10-year average of 2.2%.

Despite some recent reports, housing prices and rents are down and still expected to fall in key markets, dampening the immediate threat of inflation.

Defensive Portfolios: Lessons from Spencer

The best and strongest home depends on your environment and the threats faced.

Each evening before putting our infant son, Spencer, to bed, we read a story. The favorite for now is


    The Three Little Pigs
(undoubtedly because of Spencer’s dad’s animation).

We all know the story: Three pigs, three houses built from different materials, one pig survives because of his well-built brick house.

The same can be said for portfolios. Heck, a house of sticks can provide some shelter in some circumstances but what happens if a big bad wolf shows up?

Since we don’t know which type of bad wolf will be showing up at the door (inflation or deflation), it makes sense to be positioned to survive either threat.

The elements of a portfolio will likely be the same regardless of an investor’s mind-set. The differences will be in the proportion of the components used.

Inflation Protection Portfolio
To protect this type of portfolio consider elements more likely to retain value even as inflation increases. Example: Commodity funds or ETFs; inflation-linked fixed income funds that include TIPS and/or floating rate notes; Real Estate Investment Trusts or REIT funds (10%); Cash to take advantage of higher short-term interest rates.

Deflation Protection Portfolio
The majority of this type of portfolio is positioned in long-term Treasurys followed by cash and municipal bonds. As consumer prices and interest rates fall, the fixed income stream from the bonds would be worth more.

To protect against surprise inflation, a smaller proportion would be set aside into TIPS, commodities and higher-quality/large cap US stocks.

Little Pig, Little Pig, Let Me In
Not sure where the market will go? Not sure which threat to expect? Learn from the third little pig: Build the strongest house possible.

If there is inflation, the economy will be expanding. As such equities will be the place to be. So consider an allocation of 20% to 25% in the US and a like amount in foreign equities. A portion of these equities should include high-quality firms that are dividend-paying. Commodities and cash will likely benefit from inflation so a 10% allocation to each is prudent. The fixed income component can include some exposure to TIPS (5%) as well as intermediate high-quality bonds (20% – 30%).

To hedge against the risk of deflation, a portfolio with exposure to municipal bonds (5%) and long-term Treasurys (5% – 10%). And some of the equity portfolio should include exposure to consumer staples that tend to do well in such an environment.

To provide some added diversification consider adding positions in companies that focus on infrastructure and firms that can maintain pricing power like utilities, pipeline operators and the like.

Taking these steps should allow an investor to sleep better at night. At least it works for Spencer.

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For individuals in retirement living on a fixed income, it can devastate one’s savings and lifestyle.

As a bond or CD-holder, the purchasing power of regular interest income gets hit.  As a stock investor, stock prices can suffer as profit margins and earnings of your equity holdings are hurt by the higher costs for inputs like energy, precious metals and labor.

Right now, Wall Street is in a good mood.  For the quarter just ended, the Dow has gained about 14%, the S&P increased 14.5% and the NASDAQ was up 15%.  In fact the last time the Dow saw such a large quarterly surge was back in the fourth quarter of 1998 when it rose more than 17% as the dot-com bubble was forming.

This quarter’s rally continued a trajectory that began in mid-March 2009.  It has been primarily propelled by glimmers of light at the end of the tunnel.  A variety of positive statements from Federal Reserve Chairman Ben Bernanke contributed to a more optimistic view.  Residential real estate sales continued to come back mostly prompted by a first-time homebuyer tax credit.  Corporate earnings have been up.  The popular “cash for clunkers” program spurred auto sales and by some measures consumer spending increased marginally even without the impact from auto sales.

Despite the Wall Street rally, Main Street is still hurting: unemployment continues to rise, business and personal bankruptcies have increased, bank failures are at their highest level and the dollar continues to weaken fueling fears of inflation down the road.

Signs of future higher inflation are on the radar screen:  All the government economic stimulus here and abroad coupled with mounting public debt; the Fed’s projected end of a program in March 2010 that will likely lead to higher mortgage rates; a Fed interest rate policy which has no place to go but up and rumblings that foreign governments and investors may not want to continue at their current pace of supporting our debt habit. 

So how do you position yourself to profit whichever way the tide turns?

Now, more than ever, it is important to have a risk-controlled approach to investing.  This is centered on an age-based allocation that includes exposure to multiple assets.

This is why we will continue to manage portfolios with an allocation to bonds and fixed income but there are ways to protect from the impact of inflation and still allow for growth.

1.)    Include dividend-paying equities:  Using either mutual funds or ETFs that have a focus on dividend-paying stocks will help boost income as well as return.   Stocks that pay dividends have averaged near a 10% annual return compared to a total return less than half of that for stocks that rely solely on capital appreciation.  Better yet, consider stock mutual funds or ETFs that focus on stocks that have a record of rising dividends.

2.)    Stay short:  By owning bonds, ETFs or bond mutual funds that have a shorter average maturity, you reduce the risk of being locked into less valuable bonds when higher inflation pushes future interest rates up.

3.)    Hedge your bets with inflation-linked bonds: Fixed-rate bonds offer no protection against inflation. A bond that has changes linked to an inflation index (like the Consumer Price Index) like TIPS issued by the US-government or ETFs that own TIPS (like iShares TIPS Bond ETF – symbol TIP) offer an opportunity for a bond investor to get periodically compensated for higher inflation.

4.)    Float your boat with Floating-Rate Notes: These medium-term notes are issued by corporations and reset their interest rates every three or six months.  So if inflation heats up, the interest rate offered will likely increase.  Yields in general are higher than those offered by government bonds typically because of the higher credit risk of the issuer.

5.)    Add Junk to the Trunk: Hi-yield bonds are issued by companies that have suffered down-grades – sort of like homeowners with dinged credit getting a mortgage.  Yields are set higher than most other bonds because of the higher risk.  Yet, as inflation heats up with a growing economy, the prospects of firms that issue junk improve and the perceived risk of default may drop. So as the yield difference narrows between these “junk” bonds and Treasuries, these bonds offer a “pop” to investors.

6.)    Own Gold and Other Commodities:  Whether as a store of value or hedge against inflation, precious metals have a long history with investors seeking protection from inflation.  It’s usually best to focus on owning the physical gold or an ETF that is tied directly to the physical gold. Tax treatment of precious metals is higher because of its status as a “collectible” but this is a minor price to pay for some inflation protection.  And because the demand for commodities in general increases with an expanding economy or a weakening dollar (in the specific case with oil), owning funds which hold these commodities will help hedge against the inflationary impact of an expanding economy.

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