Friday, October 31, 2008

Balancing risk vs. reward in retirement years

Employee Benefit News

By Philip J Fogli

September 15, 2008

Although market losses are a big concern, employees shouldn't forget that being too conservative may result in interest rate and inflationary risks that can erode the value of their retirement savings....

... While retirement plan participants should move toward fixed-income investments in retirement, if they take on too little risk in their portfolios, their investment returns likely will not keep up with the pace of inflation, resulting in a loss of real purchasing power.

The 10-year Treasury bond has a yield of 4.01%, slightly higher than the 3.64% average for one-year bank CDs. ...

[Inflation] rose 7.9% in the second quarter of 2008 to bring annualized inflation to 5.5%. If this rate becomes stable, employees will need a 5.5% return just to retain current purchasing power in real dollars. Any money invested at current CD rates or treasury yields will result in a real loss. ...

It is important to remember that bond returns have been bolstered by decreasing interest rates for many years. If increasing interest rates start to eat away at yields, and inflation continues its upward trend, large bond allocations in employees' retirement portfolios ... can jeopardize their financial solvency in retirement. While bonds still belong in portfolios and might continue to make up the bulk of participants' investments, it is important to mitigate the inflationary and interest-rate risks that their portfolios might need to weather.

TIPS to follow

The well-known methods to mitigate pension risk are to buy inflation-linked assets or put in place inflation-linked swaps. ... [Inflation]-linked investments can be purchased in the form of Treasury Inflation-Protected Securities (TIPS). ...

TIPS principals increase with inflation, as measured by the consumer price index. When TIPS mature, the investor is paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal, resulting in interest payments that rise with inflation.

For most investors, it makes the most sense to purchase TIPS in the form of a mutual fund or exchange-traded fund. ... [The] annual inflation rate has run at 3.42% since 1913, about 7% under the average annual return for the S&P 500. Investing some assets in large-cap stocks will help investors stay ahead of inflation over time.

... [Investing] in commodities is a relatively direct strategy with which to keep pace with inflation. ... While commodities are a hedge against inflation risk, they are also prone to long periods of flat returns. Still, their low correlation with the stock market makes commodities another attractive allocation strategy to manage inflation risk. While analyzing portfolios for the risk of direct investment losses is still a primary concern in retirement years, there are other risks that can compromise financial security in retirement. ... Inflation can erode purchasing power. It is important to assess your portfolio for all of the risks you face and invest accordingly.

Philip J. Fogli is a Princor registered representative and financial adviser at PACS Consulting in Philadelphia.