In former times, an article on retirement investment would have been short and simple: “Shift everything to cash and conservative, fixed-income securities.” Advances in medicine, nutrition and fitness have lengthened life expectancy and changed the perspective of investing. Today, a 65-year old in reasonably good health has an actuarial life expectancy extending into his or her 80s. Nonagenarians are much more common today than in the past. A retiree must contemplate the possibility of living off investment income for two decades or more.
Living longer implies the necessity of providing income for that longer life. Finance is the study of distributing resources over time. Like it or not, retirees must apply basic financial principles in order to avoid running out of money before they run out of life.
Risk/Return Tradeoffs in Retirement Investment
Consider two alternative scenarios involving a 65-year-old individual who has just retired. The individual’s gender and family status mean little in this specific context, but suppose she’s a single woman. Her actuarial life expectancy is age 73. What will her attitude toward investment risk be? What types of retirement investments should she undertake?
She will almost certainly be very conservative in her approach to risk, avoiding all high-risk and even most medium-risk investments. Investment in individual stocks or even a diversified portfolio of stocks will earn a higher rate of return than conservative investments like government bonds or high-grade corporate debt, but that generality is only reliable over a fairly long period – say, at least a decade. A serious setback – the kind of bad patch experienced by the stock market during 2007-2008, for example – is more likely to strike a portfolio dominated by stocks. This might devastate her personal wealth. On average, she would have less than a decade to recover any losses. If she went back to work – and this might not even be possible – her productivity would probably not equal that at her highest-earning years. She would be unlikely to recover her losses through employment income.
Consequently, her investing strategy will be to convert nearly all her investible assets into fixed-income securities – virtually riskless assets such as U.S. government bonds or notes or the highest-grade corporate securities. Of course, it is true that inflation can be injurious to somebody on a fixed income, but her average life expectancy makes it unlikely that inflation will have time to ruin her. (The great peacetime U.S. inflation of the 1970s, for example, took over a decade to reach crisis proportions.) Meanwhile, she will be careful to hold sufficient liquid assets to cope with emergencies, medical and otherwise, and to indulge the occasional luxury. Those liquid assets can be held in interest-bearing demand-deposit or money-market-fund accounts.
Now consider an alternative scenario. Once again, take our recently retired 65-year-old woman, but now assume that her actuarial life expectancy at retirement is age 84 (instead of 73). Previously, her investment choices were a no-brainer. Now she has a lot to think about. The first thing she has to worry about is making her money last for her remaining lifetime. To do that may well require continued growth even during retirement. Over a retirement expected to last an average of twenty years, an unanticipated inflation can badly undermine her standard of living. Therefore, she cannot afford to complacently hold all her wealth in fixed-income or liquid form. Neither can she afford to adopt the same growth strategy that built her retirement nest egg, however, because the same downside considerations that applied in the first scenario also exist here – she will find it difficult to recover from losses and cannot regain her former productivity if she returns to work. True, she has more time to recover from an investment misstep, but this is counterbalanced by the fact that some of those years will be spent in a condition of physical debility.
The upshot of this new scenario is that her investment strategy will be one of conservative growth, gradually becoming more “conservative” and less “growth” as the years pass. This strategy will produce a much different portfolio than did the first scenario. A cushion of liquid assets to meet expenses and provide for emergencies is still advisable, but the remaining assets will probably focus on a mix of security and growth. One excellent way to meet the challenge posed by increased longevity is with an annuity. This has several advantages. First, it solves the longevity problem at a stroke, barring default by the insurance company. Second, it is an attractive choice because the rate of return on an annuity or pension depends on how long the recipient lives to enjoy the asset. Longer life means a higher rate of return. Thus, annuities become more attractive as life expectancy increases. Third, annuities delegate asset management to professionals, which rates to improve productivity. Note that each of these considerations is either absent or inapplicable in our first scenario.
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In principle, the absence of earned income in retirement makes an immediate annuity the obvious choice. While other strategies are possible, the immediate annuity is the one most-clearly suited to retirement investment. The retirement nest egg is already hatched and ready to be cooked and eaten. The time for saving is over; income is supposed to be used for consumption. In contrast, a pre-retirement strategy might well prefer a deferred annuity, using earned income to save for retirement and accumulate the necessary capital sum to fund the annuity.
The third component – the growth part of the equation – might well be mutual funds, diversified across investing philosophy (growth, small cap, international, balanced, etc.) and perhaps by investment company as well. One way of combining the second and third parts of this strategy is by choosing an indexed annuity. The indexation feature allows for a fair amount of growth. The various insurance features (guaranteed minimum return, death benefit) provide more protection of principal than would an equity investment. The annuity feature provides lifetime income. Indexed annuities are often structured as immediate annuities but frequently allow additional contributions at the annuityholder’s discretion.
The outlook and results of the second scenario are markedly quite different than for the first one. Notice that the second scenario still falls short of the wide-ranging choices available to investors in their twenties and thirties. Bank CDs are excluded because of their illiquidity – their rate of return does not compensate for the lockdown they impose in investors’ capital for the term of the investment. Individual stocks are usually liquid enough, but too risky even for a retired investor seeking higher returns; protection of principal is still highly desirable.
These two scenarios were not randomly chosen; they reflect actual conditions in two different historical time periods.
What a Different a Decade Makes – to Retirement Investment
U.S. life expectancy at birth during the 20th century rose from around 50 at century’s dawn to the upper 70s at its close. The U.S. also saw dramatic increases in life expectancy at age 65 during the second half of the 20th century. The first scenario above reflected conditions over 40 years ago, when retirement investment followed a well-worn path that had been trod since the nineteenth century. The second scenario represents today, with life expectancy at age 65 over a decade greater. Clearly, the simplicity of the past has been displaced by today’s complexity. This is simply one tradeoff resulting from the amazing advance of science and technology and its effects on human longevity.
Each scenario represents an average or central tendency. Then and now, some people lived into their nineties and beyond while others died prior to retirement. But the steady increase in average life expectancy has had a profound effect on the nature of retirement investment over the last few decades. In turn, this has affected the suitability of various investments for today’s retirees.
Decades ago, when life expectancy was shorter than now by a decade or more, retirement investment consisted of little more than shifting assets to fixed-income instruments. Today, the menu of choices is much richer and the investment process more complex. A good rule of thumb is to provide for liquidity, security and growth. Growth is required to meet the demands of a longer life and resist the ravages of inflation. Security reflects the fact that longer life means more uncertainty about the future and greater need to provide for it. Liquidity ensures that immediate and future funds retain flexibility when most in need.
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