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Retirement Risks Are Mounting in 2021

For the most part, the financial markets in 2021 have picked up where the last couple of months of 2020 left off. Stock indices around the globe continue to grind higher, seemingly oblivious to rising interest rates and to some well-publicized blow-ups in the hedge fund industry.  Under the surface, value stocks and small-cap stocks continue to lead the charge in a welcome change from much of the past decade.  And while higher interest rates have pressured investment-grade bond prices, commodities have served their historical function as a diversifying asset class in periods of rising expectations for inflation.

Several recent surveys indicate that inflation has now overtaken the pandemic as the primary concern among investors and retirees.  Allianz's 2020 Retirement Risk Readiness Study concluded that 57% of Americans are worried that inflation will make basic retirement expenses unaffordable.  And financial markets are taking note. This year's rise in interest rates has been driven by increasing expectations for future inflation rather than by expectations that monetary policy will tighten any time soon.

If in fact inflation does re-emerge after decades of benign behavior, it will be particularly damaging for those close to, or in, retirement.  Retirees tend to rely on income generated by coupon payments from bonds and dividend payments from stocks, and if they're fortunate, from pension benefits.  To the extent that these forms of income don't adjust with inflation, retirees risk getting squeezed financially between fixed incomes and rising expenses.

To make matters worse, investors who are looking retirement in the face, or who have just taken the plunge, are increasingly susceptible to more than just purchasing power risk in this financial market environment.  As stock market valuations continue to climb, this subset of investors become more exposed to "sequence-of-returns" risk. In a nutshell, the magnitude of portfolio returns is a major determinant of financial success in retirement, but the chronological sequence in which these returns are experienced by retirees also plays a major role.  And those retirees who have just called it quits are particularly susceptible to lower-than-average stock market returns going forward and to the potential for bear markets.  

Why is that?  Over the long term, stock market returns are cyclical.  Since U.S. stocks have generated above-average returns in recent years, we should expect them to underperform in future years.  Moreover, future stock market returns have an inverse relationship to current stock market valuations, and current stock market valuations in the U.S. range from mildly to extremely expensive.

On top of that, stocks tend to perform poorly after periods of very positive investor sentiment.  As an illustration of this phenomenon, Blackrock studied stock market returns after months in which investors poured unusually large amounts of money into stock mutual funds.  Subsequent 12-month returns only averaged 6%, well below the historical norm and doubly concerning since two of the biggest months for fund inflows in the past 28 years occurred in November and then again in February.

However, there are a variety of strategies that recent retirees and soon-to-be-retirees can employ to defend against sequence-of-return risk.  All have their pros and cons, and all have their proponents and detractors in the financial planning community.  To read a recent discussion on the topic in Barron's that includes my two cent's worth, please click on How a Cash Stash Can Help Retirees Keep Peace of Mind, if Not Portfolio.


About the Author

Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.