Article Archive

January/February 2009

Retirement Investing Strategy: Growth or Safety?
By Chuck Yanikoski
Aging Well
Vol. 2 No. 1

For generations, investment advice for retirees has remained unchanged: Invest for the safety of principal and generation of income as opposed to capital gains. But in recent years, investment professionals have increasingly touted the opposite message: Retirees should invest more aggressively, aiming for asset growth.

The logic now is that retirement age typically spans 25 or 35 years—or even longer—and needs and opportunities are different. Inflation can cause expenses to increase enormously during retirement, creating the need for income to increase as well. Additionally, today’s retirees have a longer investment horizon. Longer time frames justify greater investment risk because over long periods of time, risk pays off.

But has our world really changed that much? The fact is, it hasn’t. From a financial point of view, there are two kinds of retirees: those whose assets are substantial enough that they should never have to worry about exhausting their funds and the less well off who remain at financial risk.

Truly affluent retirees can afford to continue taking investment risks. And if their temperament and inclination enable them to do so without undue stress, then they probably should. But for everyone else—the clear majority—retirement is not the time for investment risk.

Concerning the inflation and investment horizon arguments: They’re being blown out of proportion. Over the long term, inflation is less of an issue than most people believe because for older adults who live into their 80s and beyond, living expenses tend to level off. Although a few significant costs (housing, energy, healthcare) do tend to keep rising, almost all other expenses diminish or even disappear in true old age.

Elders in the highest age brackets usually stop spending money on durable goods unless they have to. They’re unlikely to make home improvements and don’t travel or spend on entertainment or meals out because it’s too difficult for them. The very old may rarely add to their wardrobes and generally prefer to focus on life’s necessities and its simple pleasures. And considering that Social Security payments, many pensions, and some other forms of retirement income tend to keep rising, the net impact of inflation on the truly elderly is modest. Some people actually come out ahead.

The long investment horizon is also more illusion than truth. When older adults spend down an investment fund over 30 years, for example, it’s a mirror image of taking out a 30-year mortgage. Remember that with a mortgage, very little principal is paid off in the early years, while in the late years most of the payment is principal. When drawing down a retirement fund, by contrast, most of what is spent in the early years is principal, and most of what is spent in the later years is accumulated interest. So the time horizon for a majority of the investment is not 30 years but only about 10 or so. This is not an investment horizon that will support substantial risk.

The reasons for investing conservatively, meanwhile, are fundamentally the same as they’ve always been: Retirees don’t know how long their money will need to last, and if they preserve most of the principal while spending mainly the earned interest, their funds can last as long as they need to. But if retirees reach the point where assisted living or nursing care is required, they can safely begin to dip into their principal for the funds, since at that point their days (or at least their years) are basically numbered.

Risk vs. Reward
For those who like deeper financial analysis, there is a more fundamental reason why retirees should avoid investment risk—one that is rarely recognized. The market for financial risk is priced adversely for retirees, so it’s a bad buy for them. This unfavorable risk pricing for retirees occurs on both ends of the equation: There’s less to gain when risk taking pays off and more to lose when risk taking goes bad.

Retirees have less to gain when risk pays off because the higher returns realized in that situation do less good. Return on investment matters a lot for accumulating money, but it matters significantly less when withdrawing from savings. For example, over a 30-year period of saving, an interest rate of 10% vs. 7% would result in an accumulation of principal that’s 79% higher. But in amortizing (i.e., withdrawing equal amounts every year until the funds are depleted) over 30 years, earning 10% rather than 7% all the while, withdrawals can be only 32% higher.

Although this discrepancy may seem counterintuitive, it’s correct and there’s a simple reason for it. Financial people like to talk about the miracle of compound interest with respect to the astounding way money can grow over long periods of time. But when funds are no longer growing and are probably decreasing due to retirement, the interest payments don’t compound much, and the miracle doesn’t occur. So the benefit from taking investment risk is much greater for those accumulating funds than for retirees spending down their funds.

But the consequence of taking risks that turn out badly is worse for retirees than for most other investors. Rather than being a mathematical argument, this is a life issue. Young people whose investments go bad can postpone retirement, work harder to advance in their jobs, moonlight, possibly persuade a nonworking spouse to find employment, or just start over and wait for better luck in the market next time. Most retirees don’t have these options. Investment losses that are misfortunes for younger people become catastrophic for retirees.

This is important because the financial markets, which are influenced largely by wealthy investors, young savers, and institutional investors, price investment risk. Since investment risk rewards these groups better when it succeeds and hurts them less when it doesn’t, the market puts too high a price on risk for it to be a good deal for the typical retiree.

The investment company models that analyze investment risk—which are, for technical reasons, seriously flawed and should not be trusted—usually indicate that retirees can invest relatively adventurously, withdraw 4% of their money per year on which to live, and still have about a 95% chance of not running out of money. Even if these numbers were valid (which they aren’t) why take a one-in-20 chance of ending up broke when, in normal times (though perhaps not in today’s market), you can earn 5% to 6% with a very high degree of safety, still spend at least 4%, have some left over that, which in combination with Social Security and other increasing income sources, allows for inflation—and have almost no chance of running out of money?

The argument in favor of taking investment risk usually focuses on the new risks in retirement, including inflation risk, longevity risk (living too long and running out of money), and morbidity risk (incurring high medical and other care expenses). Therefore, retirees need to assume more investment risk to cope with these. But taking on more risk doesn’t reduce risk. If anything, these are reasons to reduce investment risk.

Beyond all the arguments, there’s still the simple fact that most retirees are simply not comfortable investing aggressively. Most do, in fact, prefer to conserve principal and live on the interest it generates if they can. They sleep better that way.

The “retirees should invest for growth” mantra is just another temptation to reach for a free lunch, which all economists know doesn’t exist. When individuals retire without enough money to support their lifestyles, they need to adjust their lifestyles. It’s too late to invest their way out of the problem. Arguments to the contrary from investment advisors are marketing ploys, not objective, reliable analysis.

Retirees and their advisors should resist this advice. If they do, they will all sleep better knowing that they have made the smart choice, as well as the safe one.

— Chuck Yanikoski is president of Still River Retirement Planning Software, Inc., in Harvard, MA, and principal founder of the Association for Integrative Financial and Life Planning.