Risk is always an issue in retirement planning

As the long-awaited day of retirement approaches, most people will need an investment strategy to generate income to cover their living expenses. Peace of mind comes from knowing you have a plan in place that will keep you financially secure throughout your retirement years.

Although Social Security is a fundamental pillar of retirement income, for most, it falls far short of covering all expected expenses. This means that most retirees will need to build additional savings to invest for their retirement income.

This planning requires careful consideration of the risks facing future retirees, particularly longevity risk and inflation risk.

Longevity risk is the fact that you could outlive your retirement savings; Inflation risk is the fact that rising costs of living may mean that your savings cannot maintain your standard of living. Not surprisingly, there are a number of investment alternatives well suited to overcoming these challenges.

Here are the pros and cons of two of the most popular options.

Immediate fixed annuities

An immediate fixed annuity is a contract between you and an insurance company in which you agree to hand over a lump sum in exchange for a guaranteed income. The income is fixed, paid monthly until your death and is not affected by stock market volatility or interest rate fluctuations. These features make this option ideal for those concerned about longevity risk.

The sharp rise in interest rates over the past 18 months has significantly increased the yield on immediate fixed annuities. If a 65-year-old had invested $100,000 in an immediate fixed annuity in 2020, he would have received $495 per month until his death, according to Kelli Hueler, CEO of Hueler Cos. Today, that same $100,000 invested in an immediate fixed annuity will pay a 65-year-old man $671 per month until his death. This represents a 35% increase in retirement income.

The guaranteed income provided by immediate fixed annuities carries its own risks, as they lock in current interest rates for your entire life. A surge in inflation could lead to a liquidity crisis if too much of your retirement income is fixed.

Balanced funds

Although higher interest rates make immediate fixed annuities more attractive, an alternative approach is to invest in a well-managed, low-cost balanced fund. Balanced funds invest in a mix of stocks and bonds and can allow retirees to meet their income needs while maintaining a high probability of protection against inflation.

If you’re willing to accept the unpredictability of market swings from year to year, you’ll face what industry experts call “sequence of returns” risk. This is the risk of suffering a significant loss early in your retirement journey, which will impact your portfolio’s long-term income production. Despite this risk, this approach offers significant long-term benefits.

To put into perspective the appeal of balanced funds and the risk-return tradeoff they represent, it is reasonable to consider a scenario in which a balanced fund generates an average annual return over the long term (i.e. over several decades) by around 8%, which is a conservative estimate for some of the best funds of this type.

In this scenario, a 65-year-old investor who places $100,000 in a balanced fund, earns 8% per year and withdraws 4% per year for income, could expect average monthly payments of $638 over a hypothetical period. retirement of 30 years. It is important to note that for the same investor who lives to age 95, it is possible that there may be more than $300,000 left over to offset any future inflation or pass it on to heirs.

Francis is president of Francis LLC and a registered investment advisor. He can be contacted at michael.francis@francisway.com.