How to invest during retirement
Oran Hall Personal Financial Adviser
Even with a pension, retirees need a good stream of investment income to enjoy a decent standard of living and more so because of the steadily increasing duration of retirement.
Ideally, retirees should strive to let their retirement income outlive them. For this to happen, there must be an effective investment programme.
Because retirement is generally a period during which an individual shifts from accumulating wealth to decumulating it by periodic withdrawals, investment strategies in retirement vary from investment strategies in the preretirement years.
The types of investment income generated during both periods, nonetheless, are the same although the ratios generally differ, but it is important to employ an investment strategy that will make the portfolio last longer. A balanced portfolio which includes assets that have growth potential can, in the right conditions, improve the prospects of this happening.
In building an investment portfolio in the retirement years, several risks should be considered.
First, whereas dollar-cost averaging is a process of systematically increasing investments over time, reverse dollar-cost averaging is the process of systematically reducing a portfolio over time.
Should the early period of decumulation be one of low prices, a relatively large portion of the portfolio will most likely have to be divested to meet income requirements, thus reducing the ability of the portfolio to generate the required level of income over the long term.
High asset values, interest, dividends and rent would have the opposite effect.
Second, poor market conditions prior to and during the early period of retirement can also negatively affect retirement income. The temptation to increase risk expecting to increase yields as a consequence should be shunned.
It is important to prepare for such eventualities by adopting a more conservative strategy in the last years prior to retirement, which would include investments that have a high level of principal protection.
Risk of inflation
Third, the risk of inflation is very real. Inflation may make it necessary to increase the rate of withdrawal to keep abreast of rising prices. For example, in situations where higher interest rates are used by the central bank to fight inflation, stock prices may be adversely affected and this may make it necessary to accelerate the sale of stocks to meet income requirements.
The negative effect of this increased withdrawal rate is irreversible. Inflation, then, tends to hasten the depletion of the investment portfolio.
There are situations, however, when inflation may cause nominal profit levels to increase and this may lead to stock prices increasing. Generally though, while stocks are good for a portfolio when prices are rising during the period of accumulation, the opposite is true during the period of decumulation.
During retirement, investors may earn income in the form of dividends, interest and capital appreciation. Another important source is the cash generated from the full or partial liquidation of capital assets.
With respect to bonds, when the interest rate is fixed, it provides a predictable and known stream of income but interest rates are not always fixed and, when they are, the income generated loses purchasing power due to inflation.
With respect to stock, there is no certainty that a company will pay a dividend; this is a decision in the hands of the directors. Dividend policy may provide for profits to be re-invested in the business or for a set portion of profits to be paid as dividends.
Dividends may also be reduced or omitted. These factors should be taken into consideration when looking at dividends as a source of retirement income or any kind of income generally.
Several factors bear on the level and consistency of the capital appreciation of individual securities. In most markets, a lowering of interest rates generally leads to higher bond prices. If investors base their investment decisions on yield, higher dividends may cause stock prices to increase.
Ultimately, the value of securities is of practical value to holders of securities when they are converted to cash and it should be borne in mind that what goes up generally comes down; market conditions may cause securities prices to decline, not just increase. This is one reason diversification is so important in investment management.
These considerations should be borne in mind for all securities including bonds. Should it become necessary to sell bonds prior to their maturity date, there is the risk of realising capital losses if bond yields at the time cash is required are higher than the coupon rate of the bonds in the portfolio. The opposite is true if bond yields are lower.
One strategy to counter any negative effect on the portfolio at the time bonds are converted to cash is that known in investment language as laddering whereby the maturities of bonds are spread out evenly, that is, the bonds mature at different times. This should enhance the prospects of bonds maturing closer to the need for funds even if it is unplanned.
Considering the weakness of the Jamaican currency, investment strategy should include a provision for hedging against the local currency losing value. This can be done by investing in assets which are denominated in foreign currencies or in Jamaican listed companies that are net earners of foreign exchange.
The process of investing successfully during retirement should commence prior to retirement. The success of the programme, the investor's needs, resources and risk profile, and market conditions are among the factors which will influence the extent to which changes are made to the pre-retirement investment programme and strategy during retirement.
Oran A. Hall, a member of the Caribbean Financial Planning Association and principal author of 'The Handbook of Personal Financial Planning', offers personal financial planning advice and email@example.com