The question that most retirees face is how much investment risk should they take in retirement. To answer this question, you first need to understand their budget. The goal of any retirement plan is to customize an investment strategy that will help pay the bills throughout retirement. It is critical that proper assumptions are made that will account for both inflation and market risk. Making a retirement budget will help you avoid one of the biggest retirement mistakes, which is running out of money too soon. The second biggest mistake that retirees make, is not accounting for inflation and market risk. These risks have more to do with the timing of their retirement than anything else.
For instance, retirees that entered retirement before the Great Recession in 2007-2008, took on significant market risk. Some would say that recession never ended. In 2006, it was common to find longer-term CD rates over 4%. Now, 8 years later, interest rates are still hovering slightly above zero. Overseas, central banks, including the European Central Bank and the Bank of Japan, have implemented negative interest rates. The GDP growth rates for both Europe and the US are hovering between 1%-2.5%.
I believe that the new risk retirees face today is inflation. Inflation risk is a new threat because the Federal Reserve has kept interest rates too low for too long. The Federal Reserve chose not to raise interest rates this week because of slower growth in China and Europe. However, the US economy has added enough jobs that the unemployment rate is now below 5%. Employers are now having trouble finding qualified workers, which is triggering a pick-up in wage growth. Historically, inflationary pressures are usually led by higher wage growth. Since February 2015, the 1-year core CPI measure, which excludes volatile food and fuel costs, rose 2.3 percent. Health care inflation continues to remain in the high single digits.
In the past, retirees would ladder a portfolio of bonds or CDs. This strategy worked well. Over the past 10-years, the Vanguard Total Bond Market Fund (VBTLX) averaged 4.72%. Now with the 10-year Treasury Rate at 1.87%, those entering retirement today will have a difficult time matching the past results of the Vanguard Total Bond Market Fund over the next 10-years.
I believe that these markets are entering a new phase where inflation may become the greatest risk. If growth continues to fall overseas while US job growth sparks wage inflation, bonds may be setting up for big losses down the line. These risks will only increase if interest rates continue to fall because of the negative interest rate policy overseas.
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Underlying data source from Morningstar.
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