The financial services industry would have us believe that “the power of the right advisor” investing our savings will lead us to the financial promised land. In fact, investing is far from the most important factor in financial success—although the risk of investing poorly because of the powerful sway of a commissioned advisor can be an outsized risk to your financial well-being.
Last time I described the risks that affect your personal balance sheet over a lifetime and begin to converge as you approach retirement. We become more vulnerable in retirement primarily because once retired, we are no longer earning an income from employment that can, over time, offset the financial setbacks we may suffer. Depending on the strength of your personal balance sheet, the consequences of an adverse event may have more or less severe consequences for you. That is why risk management varies from household to household, and like saving and investing for your goals, is the result of a personalized lifetime financial plan.
We aren’t vulnerable only in retirement, of course. An adverse event can impact the ability to earn a living in an instant at any time, and force an issue upon us today we might have hoped not to face until much later in life. Risk management is a key part of your lifetime plan whatever your age and the state of your personal balance sheet—especially for those of us who have dependents.
Recent events once again show that the impact of risk can be sudden and life-altering. A single storm can wash away your home and with it all of your savings, unless you have the foresight to plan properly for the storm’s possibility—in this case, by buying flood insurance. Not even FEMA can prevent the life-altering impact of paying back the large emergency loans the unprepared need to get back on their feet.
Insurance is one way to manage risk. Can’t afford insurance? Then take less risk. Move further away from the beach! In this and the next post, I will outline various approaches for managing the risks I identified last time.
This is a big topic, so this is far from a definitive analysis. But there’s enough to be said even in this overview to break this into two parts, one on managing systematic risk and the second on managing specific individual risk. My intent is to make you aware of both so that you can make risk management part of your own planning—sooner rather than later!
Systematic risks affect everyone, not necessarily to the same degree or with the same consequences, but when systematic adverse events occur, they echo throughout the economy. Part of managing any risk is making a sound determination of the likelihood of an adverse event occurring, and evaluating how severe the consequence of that event would be for you, given your household circumstances. After you have made that determination, you can choose the kind of risk management approach you should take, and to what degree you should apply it.
Systematic risk comes in two flavors:
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- Systematic political risk is broad economic risk that results from policy and macro economic change beyond the control of an individual. We can’t avoid it, so we must account for it in our financial planning. Building a strong savings habit and a sizeable retirement account is key.
- Systematic business risk affects everyone who participates in the financial system when saving and investing. We need to understand this kind of risk so we don’t unknowingly over expose ourselves to it at inopportune times in our lifetime plan. An expert, trusted planner/advisor can help avoid portfolio mistakes.
Managing Systematic Political Risk
Systematic political risks directly or indirectly threaten both your social capital—the value of your pension, Social Security benefits, and Medicare benefits—and your financial capital (savings and investments).
Chief among these risks is inflation, which reduces the purchasing power of your social and financial capital over time. Generally pensions are not adjusted for inflation, while Social Security is.
Policy changes may affect the future amount of Social Security inflation adjustment and the limits of Medicare healthcare coverage. The national debt situation suggests that in the future, Social Security benefits may be lower, healthcare under Medicare more costly, and taxes higher.
I’ve included an illustration below from JP Morgan’s 2013 outlook booklet that shows the inexorable financial logic underlying these risks, a situation all too familiar to many of us—falling income and rising expenses. No one can predict if, when, and by how much inflation, taxes, and policies may change. But that doesn’t mean they won’t and that you shouldn’t take steps to manage these risks.
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Here are the most effective ways to manage systematic political risk:
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- Increase your savings rate and start saving as soon as possible, from the first day you earn income. This implies spending less and controlling the use of credit.
- Allocate a significant percentage of savings and investments to safe, inflation-adjusted securities (TIPS and high quality short/intermediate term bonds). I’ll have more to say about this in future posts on investing. Suffice for now to suggest a 5-7 year ladder strategy that adapts to rising interest rates.
- Monitor and buy enough health insurance to cover any increasing gaps that may open up in Medicare coverage over time
- Maximize your Social Security benefit by deferring to age 70—it’s the best deal for guaranteed income now available!
- Move to Australia (just kidding!)
Managing Systematic Business Risk
Additionally, there are systematic business risks that can impact your savings and investments, most notably market and credit risk. Market risk increases with the amount of equity (stock) exposure you have in the market. While a high exposure to stocks can lead to higher gains, perhaps appropriate earlier in your career, it also exposes your savings to higher losses, not such a good idea approaching retirement, when you need your savings as a safe, reliable source of lifetime retirement income.
What a stick in the eye to arrive at retirement, hoping to make up for lost time and increase your savings by 20% by playing the market, making big bets on stocks and chasing yield, only to find your scant savings have been further reduced by 20% in a sudden downturn! That 40% swing can be just as life-altering to your retirement as a hurricane. How to manage this risk? Don’t do it!
You’re older now, time for a different way to handle your savings and investments that also manages the risks you face in retirement. A good rule of the thumb is to hold at least your age in bonds and cash, and thus a declining percentage of your assets in stocks as time goes on. This can vary based on your personal balance sheet, something I’ll cover in future posts on investing. In general, the more you have, the higher your risk capacity, the more you can afford to risk. In other words, losing 20% in the market might sting but not change your retirement lifestyle. Those who have under-funded their retirement and feel the need to amp up market risk trying to make up for lost time probably can’t afford the risk of losing even more of their savings, and should not put the savings they have at risk.
Beyond the percentage of stocks and bonds you hold (yes, mutual funds are made up of stocks and bonds, so this applies to anyone holding mutual funds as well), your holdings should be broadly diversified to manage specific business and credit risk. This arises from holding too much stock in any one company, including one you may have worked for, and from reaching for yield and holding risky bonds and high-dividend stocks with poor credit ratings.
A mutual fund is not necessarily broadly diversified, low-cost or efficient, so be careful. In spite of their manager’s efforts, most mutual funds fail to meet benchmark average returns—the cost of that expensive management works against the investor. A low-cost, broad market index fund or ETF is the most effective way for small investors to diversify away business risk and achieve market rate returns.
In a low yield world where a safe 4% treasury coupon is no longer available, many have gone out on the duration credit curve or to lower, riskier ratings to pick up more yield—which also amps up their risk of loss in a down market when interest rates rise. Yield is only part of the total return your investments generate. When you pay your bills in retirement, it makes no difference whether the cash comes from dividends, gains, annuities, TIPs, a pension or Social Security. What matters is that you have the cash and that it lasts for the rest of your life!
Here’s how to manage your money more safely by managing market and credit risk:
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- As you age, you should reduce your market risk by reducing your allocation to stocks, unless your balance sheet is large enough that it has surplus risk capacity. On the other hand, if you’ve already won the game, why keep playing so hard?
- Later on, maybe a decade into retirement, you may be able to increase your equity allocation again, depending on your then current balance sheet and legacy goals
- Invest in broad market equity index funds balanced by a broad bond index fund or a well-constructed short/intermediate duration bond ladder
- Except for those who can fund a well-diversified top-rated bond ladder, avoid holding individual stocks and bonds
- Consider TIPS (inflation protected treasuries) and STRIPS (zero coupon treasuries) for some of your bond allocation, depending on your balance sheet
- Look for opportunities to build a risk-free guaranteed retirement income floor—maxing Social Security by deferring to age 70, creating an annuity ladder with a portion of your savings, and buying long-dated treasury STRIPs in mid-career
There’s much more to this that an impartial planner skilled in retirement income management can help you with. Be wary of the investment “advice” offered by sell-side advisors/registered reps who do not have the skills to create a sound retirement income plan based on your personal circumstance. The planning comes first, then the investment strategy follows the plan, not the other way around.
Next time, in the second part of this overview of risk management, we’ll look at ways to manage specific individual risk that varies by household and circumstance.
— By Michael Lonier , RMA℠