Accounting for interest rate risk
Some retirees are surprised to learn that even
though a bond's interest rate may be fixed,
bond prices can go up and down (though
typically not as much as those of stocks).
When interest rates rise, bond prices typically
fall. That may not matter if you hold a bond to
maturity, but if you must sell a bond before it
matures, you could get less than you paid for
it. Also, if you hold individual bonds or
certificates of deposit, and interest rates fall
before that investment matures, you may not
be able to get the same interest rate if you try
to reinvest that money. That could, in turn,
affect your income.
Caution: It is important to note that asset allocation does not guarantee a profit or protect against loss in a declining market. Asset allocation is a method used to help manage risk. All investing involves risk, including the potential loss of principal, and there is no guarantee that any investing strategy will be successful.
Your asset allocation strategy in retirement will probably be different than the one
you used when saving for retirement. During your accumulation years, your asset
allocation decisions may have been focused primarily on long-term growth. But as
you transition into retirement, your priorities for and demands on your portfolio
are likely to be different. For example, when you were saving, as long as your overall
portfolio was earning an acceptable average annual return, you may have been happy.
However, now that you're planning to rely on your savings to produce a regular income,
the consistency of year-to-year returns and your portfolio's volatility may assume
much greater importance.
The goal of asset allocation
Balancing the need for both immediate income and long-term returns can be a challenge.
Invest too conservatively, and your portfolio may not be able to grow enough to
maintain your standard of living. Invest too aggressively, and you could find yourself
having to withdraw money or sell securities at an inopportune time, jeopardizing
future income and undercutting your long-term retirement income plan. Without proper
planning, a market loss that occurs in the early years of your retirement could
be devastating to your overall plan. Asset allocation and diversification do not guarantee a
profit or ensure against a loss, but they can help you manage the level and types
of risk you take with your investments based on your specific needs.
An effective asset allocation plan:
- Provides ongoing income needed to pay expenses
- Minimizes volatility to help provide both reliable current income and the ability
to provide income in the future
- Maximizes the likelihood that your portfolio will last as long as you need it to
- Keeps pace with inflation in order to maintain purchasing power over time
Look beyond preconceived ideas
The classic image of a retirement income portfolio is one that's invested almost
entirely in bonds, with the bond interest providing required annual income. However, retirees who put all their investments into
bonds often find that doing so doesn't adequately account for the impact of inflation
over time. Consider this: If you're earning 4% on your portfolio, but inflation
is running between 3% and 4%, your real return is only
1% at best — and that's before subtracting any account fees, taxes, or other expenses.
That means that you may not want to turn your back on growth-oriented investments.
Though past performance is no guarantee of future results, stocks historically have
had better long-term returns than bonds or cash. Keeping a portion of your portfolio
invested for growth (generally the role of stocks in a portfolio) gives you the
potential for higher returns that can help you at least keep pace with inflation.
The tradeoff: Equities also generally involve more volatility and risk of loss than
income-oriented investments. But effective diversification among various types of
investments can help you balance lower-yielding, relatively safe choices that can
provide predictable income or preserve capital with those that may be volatile but
that offer potential for higher returns.
There's no one right answer
Your financial situation is unique, which means you need an asset allocation strategy
that's tailored to you. That strategy may be a one-time allocation that gets revisited
and rebalanced periodically, or it could be an asset allocation that shifts over
time to correspond with your stage of retirement. The important thing is that the
strategy you adopt is one that you're comfortable with and understand.