Our current retirement system places all the planning responsibility on your shoulders and requires you to navigate many uncertainties, including:
1) What will your lifestyle cost in the future?
2) How many years will your savings need to support your spending?
3) What return will your investments earn?
4) Will there be unforeseen events which will impact your strategy?
Managing these four important risks can help reduce anxiety. This blog addresses the first two, and the others will be covered in two weeks.
1 – What will your lifestyle cost in the future?
Your personal inflation rate is not necessarily equal to change in the Consumer Price Index (CPI). For those planning on maintaining an affluent lifestyle, your mix of goods and services is different than the average consumer’s used to calculate the CPI. You probably spend more on services (medical, entertainment, education, eating out, travel) whose costs often increase faster than the CPI. They use more local, high-cost labor and tend not to benefit from economies of scale or sources of low cost labor. Also, if you enjoy the best – the best hotels, the best cars, the best restaurants – you are exposing yourself to higher inflation. As wealth increases, demand increases for exclusive, high quality goods and services. Supply is often limited and prices increase to maintain exclusivity.
Lifestyle inflation is a material risk because it is hard to see in the short term but has a devastating effect over time. The tendency of many is to ignore inflation and seek safety in low risk, low return assets like cash and CDs. But cash has the lowest inflation adjusted return over the long term. With an annual return of 1% on cash, after twenty years, your spending capacity will have diminished by a third. Trying to avoid risk by keeping retirement savings in cash may reduce short-term anxiety but will only lead to certain loss of relative value.
To protect against inflation, your savings needs to be exposed to an appropriate level of risk. The more luxury goods and service you buy, the more you need to protect your purchasing power over time. The more return you need, the more risk you must consider. Equity market risk is a particularly effective tool in protecting against inflation over time. Wealth levels and equity market valuations are related and increasing wealth drives the prices of certain goods and services higher.
2 – How many years will your savings need to support your spending?
Another uncertainty is not knowing how long you can work and how long you will live in retirement. If others depend on you, the uncertainty increases.
If you are planning on continuing to add to your savings for another 5, 10 or more years, how would your financial plans change if that was no longer possible? While it is hard to protect against the risk of a job loss, it is not hard to protect against premature death or disability.
If you are close to retirement or already retired, you likely face a different uncertainty – what if you have the good fortune of living a very long life? For example, a sixty-five year old woman has an even chance of living another 20 years or more. For a sixty-five year old couple, there is a 47% probability that one of them will live into their nineties. Supporting your spending needs for the next ten years is quite different than for thirty years.
While these are uncertainties every individual faces, in aggregate the distribution of life expectancies is known. Insurance products pool the risks, permitting each individual to protect against extremes, such as a very long life or sudden death or disability.
The importance of addressing all four of these risks
Of the four risks identified, lifestyle inflation and longevity have been addressed first since they are often given too little attention.
Longevity risk – sudden death or a very long life – is easily controlled. Not to do so is a mistake. Insurance is often not purchased because the cost seems high given the likelihood of needing it. If properly priced, insurance protects you from a risk you cannot control by yourself and often underestimate. The one exception is if you enjoy a level of assets sufficiently large to be able to self-insure. If not, protect planned savings while working and then shift to protecting your lifestyle if you have the great fortune of living a very long life.
Lifestyle inflation requires you to take appropriate investment risks with your savings. We have been in a low inflation period but inflation can be devastating over time.
To protect your lifestyle, you need a material allocation to risk assets – how much and what types are the topics of the next installment in two weeks.