Day 26: Hedge Against Threats to Your Retirement Portfolio, Part I
Degree of difficulty: Moderate
Investors are far better off focusing on the factors they can control—notably, saving enough, creating a reasonable asset-allocation scheme, and taking care in investment selection—than they are attempting to predict the direction of the economy and the market.
Yet it’s also a mistake to turn a blind eye to the threats that could erode the value of your portfolio over the long term, particularly if you’re already retired. That might seem counter to the viewpoint outlined above, but it's really not. Identifying a risk factor and putting in place a long-term plan to hedge against it is quite different from making big changes to your portfolio so it can benefit from a short-term trend that may or may not materialise. The former is risk management; the latter is market-timing.
It pays to consider these risks before you see them splashed on the front page of every newspaper, because by that time you’ll pay a premium to hedge against them. The mania for inflation-fighting instruments in 2008 provides a vivid case in point. Worries about higher prices reached a fever pitch but by then the key inflation-fighting instruments had been bid up substantially. Investors who bought commodities, for example, in the first half of 2008 suffered substantial losses in the second.
Today's task is to assess and hedge against the 'threat' of longevity. The next task, part II, will be to consider the impact that needing long-term care will have on your portfolio, and in parts III and IV, we'll look at the risks posed by inflation and rising taxes.
The Threat of Longevity
Of course we would all like to live long, happy, and healthy lives but reaching a ripe old age brings a corresponding worry: outliving your nest egg. That’s a particularly big concern for today’s retirees. Not only are they living nearly a decade longer, on average, than retirees 50 years ago, but many also saw their portfolios suffer catastrophic drops during the recent bear market.
Some of the best strategies for managing longevity risk are plain old common sense: taking care with your portfolio-withdrawal rate (and reducing withdrawals during and immediately after a down market), or working longer and/or part-time during retirement.
Holding at least some equities during retirement is another strategy for managing longevity risk. Although there’s no guarantee that stocks will go up over the next few decades—and holding a too-high stock position in retirement can subject your portfolio to undesirable volatility—equities have higher long-run return potential than bonds, whose future returns are often roughly in line with their yields.
There are also a few products designed specifically to help retirees manage longevity risk—notably, longevity insurance. The key disadvantage of longevity insurance, however, is that you may fork out a substantial sum to buy it but not live long enough to see any benefits from it. In general, longevity insurance makes sense only for those who have a good reason to expect that their life spans will run far higher than average.
Return to the article: "The 30-Day Financial Fitness Plan".
More information on hedging against threats to your retirement portfolio:
Day 27: Hedge against threats to your retirement portfolio, Part II
Day 28: Hedge against threats to your retirement portfolio, Part III
Day 29: Hedge against threats to your retirement portfolio, Part IV
