The 21st Century Retirement Plan: Sustain Phase

Pre-Retirement: Balancing 'Growth' and 'Preservation'

The 21st Century Retirement Plan: Sustain Phase

  • In our view, higher interest rates will help investors in the sustain phase by providing more stable income.
  • However, portfolios will likely still need greater exposure to 'risk assets’, such as stocks and higher yielding bonds, to meet return objectives, in our opinion.
  • Understanding and managing those risks is key to finding the right balance between preservation and growth.

The ten years leading up to retirement, what we call the sustain phase, can be scary. Investors are likely to have questions such as:

  • Will I have saved enough to fund my retirement?
  • How can I mitigate the risk that my savings will see a significant decline just before I retire?
  • If I feel I have not saved enough, should I take more risk to seek higher returns?

In our view, the sustain phase is about balancing two objectives: continuing to grow the portfolio’s value while also preserving the savings thus far. This in turn likely necessitates a better understanding of your own risk tolerance - really understanding the trade-offs between these two objectives. Following the accumulation phase (see The 21st Century Retirement: Accumulate Phase), the size of your portfolio likely means that market returns will have a bigger impact than contributions, and so the consequences of your decisions increase as retirement approaches. We have observed over many years how a well-thought-out plan, combined with regular reviews and ongoing market insight, can significantly increase investors' confidence and peace of mind.

When the sustain journey ends, a potentially long distribute phase begins (see The 21st Century Retirement: Distribute Phase). The process of deciding on a spending plan for retirement and ensuring there are sufficient funds to make the plan work is the goal of the sustain phase. Investing is not a science and long-term assumptions about returns should, out of necessity, include a variety of scenarios, in our view. Equally, as life circumstances change, so should the plan. Thus, we advise flexibility and regular reviews.

Managing a Portfolio in the Lead up to Retirement is Challenging for the Following Reasons:

  1. Life expectancy is increasing: In the US, life expectancy has increased steadily from 68 years old, in 1950 to 79 years old today according to the United Nations, and they forecast it will rise to 84 by 2055. Therefore, the asset pool at retirement must be larger than has historically been the case. We cover this in greater detail in our recent Strategic View, Beware the Lure of Cash.
  2. Few guaranteed pensions: In the past, many large employers provided a guaranteed pension, meaning retirement income was your employers’ problem. Now these ‘defined benefit’ plans are rare and with the move to defined contribution plans (such as 401k plans), the burden of retirement income has been shifted to employees who must build up savings and invest it themselves. Investors with insufficient savings are tempted to have excessive exposure to risky assets, trying to achieve unrealistic spending goals. Being flexible with your retirement age (if possible) is a better solution than taking excessive risks, in our view.
  3. The stakes are higher: If successful in the accumulation phase, your 'Nest Egg' has grown larger and so the dollar swings are amplified, literally and emotionally. We think this requires a new mindset. Contributions are now much smaller in relation to the portfolio's size and so new contributions are usually too small to offset large drawdowns of the total portfolio.
  4. Managing the time horizon: In the accumulation phase, time is your friend since a longer time horizon offers the chance for the portfolio to recover from a setback; and contributions can take advantage of bear markets to buy at lower prices. However, the sustain phase is a diminishing time horizon in the journey to the distribute phase. In one sense the sustain investor still has the longer time horizon of their retirement years, but they must also manage the risk of a significant drawdown just before contributions stop and distributions begin.
Source: Refinitiv Datastream, RiverFront. Data weekly as of February 23, 2023. Shown for illustrative purposes only. Past Performance is no guarantee of future results.

The Challenges of Generating Inflation Adjusted or 'Real' Returns

With higher yields, bonds are more attractive as long as inflation continues to fall. When we last updated this piece in January of 2021, short term interest rates were close to zero and the yield on the 10-year Treasury bond was roughly 1.1%. Since then, the Federal reserve has raised interest rates to 4.5% and currently 10-year Treasury yields are just under 4%, as shown in the chart to the right. From an absolute perspective, this is great news for investors as they can finally generate a decent return on their money percentage. However - and this is critical - these interest rates are not keeping up with current inflation rates. In our view, this situation is likely to continue through the first half of 2023.

Source: Refinitiv Datastream, RiverFront. Data weekly as of February 23,2023. Shown for illustrative purposes only. Past Performance is no guarantee of future results.

The outlook for Inflation: Peaking, but likely to remain above the Fed’s 2% target throughout 2023. The Federal Reserve is now fully committed to bringing inflation down as their number one priority, something that has been repeated by Fed Chairman Powell at every opportunity for many months. We believe the Fed will ultimately succeed, and indeed leading indicators of inflation are already declining. However, it may take a recession to bring inflation down to the Fed’s target, in our opinion.

In the longer term, investors seem to be confident that long-term inflation rates will fall. However, investors concerned about inflation can now get a positive yield on the Treasury’s Inflation Protected Bonds (TIPS) of around 1.5% over inflation, as seen in the chart to the right. Investors should note that the price of these securities, like other bonds, fall when interest rates rise, and so fail to provide protection against rising rates.

The Role of Stocks: Capital Appreciation and a Growing Dividend Stream

We believe investors seeking to generate a 3-6% return over inflation will need to invest a significant portion of their assets in more volatile investments to get the higher returns they seek. Let’s call these “risk assets”, which can include stocks, investment grade bonds, higher yield “junk” bonds, real estate, and other investments.

US stocks, with dividends reinvested, have a return history relative to inflation going back to 1926, shown in the chart below. The trend rate of return is 6.4% over the rate of inflation (see yellow trend line rising at 6.4% per annum). This is considerably higher than the return on TIPS. Stock’s ability to outpace inflation comes, in part, due to companies’ ability to adapt to changing conditions.

Source: RiverFront Investment Group, calculated based on data from CRSP 1925 US Indices Database ©2022 Center for Research in Security Prices (CRSP®), Booth School of Business, The University of Chicago. Data from Jan 1926 through October 2022. Past performance is no guarantee of future results. It is not possible to invest directly in an index. RiverFront’s Price Matters® discipline compares inflation-adjusted current prices relative to their long-term trend to help identify extremes in valuation. Blue line represents the Large Cap Real Return Index. Yellow line represents the Annualized Real Trend Line of Large Cap Real Total Return Index according to Price Matters®. Shown for illustrative purposes only, not indicative of RiverFront portfolio performance. Information or data shown or used in this material was received from sources believed to be reliable, but accuracy is not guaranteed. The chart above uses a logarithmic scale. Line movements will be dampened/subdued based on the exponential y-axis.

More stocks mean more volatility: Although US stocks have delivered trend returns of 6.4% over inflation since 1926; returns in 3, 5 and even 10-year timeframes can be significantly different from the trend (blue line above), both better and worse. Thus, for a sustain investor there is an element, sometimes significant, of good or bad fortune. Since the last 10 years before retirement has such a big influence on the portfolio's value, someone retiring in say 2000 would have had a very different experience, both before and after, from the person retiring in 2009. One way to manage this element of randomness is to rebalance portfolios, following an exceptionally good or bad year. Another good practice is to move towards the mix you believe is appropriate for your retirement years, in the last few years of the sustain phase. We believe an investor in the sustain phase who understands their personal tolerance for drawdowns in value due to market volatility is better able to set and achieve realistic goals.

The Building Blocks of a 21st Century Retirement Plan: Sustain Phase

More Risk Assets: Although bond yields are higher now, they are not likely to deliver returns much above inflation. Thus, when constructing a plan for the sustain phase, we suggest using enough 'risk assets' such as stocks and higher yielding bonds to offer the opportunity of providing the required returns. Riskier assets require more careful selection and closer scrutiny. For example, when incorporating stocks (domestic and overseas) and high-yield bonds, we think it is important to understand the specific risks of each investment, which may not be obvious upon cursory review. We believe this is a decision that should be actively managed and monitored.

Diversification: Regarding stocks, we suggest a mix of those that pay dividends and those that don't. In the sustain phase we tend to prefer companies that we believe have the greatest potential to grow dividends, rather than those with the highest starting yield, as we believe growth of income is more important prior to the distribute phase. We also want to invest for growth from capital appreciation. Companies in faster-growing sectors often reinvest their excess cash flow in their own businesses to fund expansion. In the high growth phase of their evolution, it may not make sense to pay dividends. We want to include these stocks as we think they can play an important role in growing the value of the portfolio. Additionally, with higher interest rates there are now opportunities in higher yielding corporate bonds, but these kinds of bonds can see significant defaults in a recession. Selecting the right mix of bond types and maturities is an active decision in our view, and one that RiverFront considers carefully in our portfolios.

Risk Mitigation: Given the higher stakes in the sustain phase - namely a larger portfolio and less time until retirement -dealing with the price swings of risky assets involves risks that go beyond price volatility. In our experience, investors plan in 5 and 10-year time horizons during calm times, but often abandon the plan when volatility spikes. In our view, investors sometimes succumb to fear and greed by reacting to current headlines and making significant changes to portfolio positioning, often contrary to their stated long-term plan. Selling after a significant market correction is one of the most damaging things an investor can do, in our opinion. We call this Emotional Risk. We believe a critical part of the retirement planning process is to assess and periodically review risk tolerance to build a plan that allows the retiree to weather market volatility. Thus, in the sustain phase, we believe the optimal portfolio is not necessarily the portfolio that might produce the maximum returns, but the one that allows investors to complete the journey. This involves a realistic understanding of the potential longer-term tradeoff between returns and safety.

How RiverFront Can Help

The sustain journey is a bridge between the accumulate phase of investing for capital appreciation and the distribute phase of managing cashflow in retirement. At RiverFront, we believe investors will need to maintain a larger allocation to stocks in the sustain phase due to low interest rates and our portfolio solutions reflect this belief. This will likely involve bigger swings in quarterly portfolio values. We think our focus on portfolio construction, risk management, transparency, and consistent communication are critical elements in giving financial advisors and their clients the peace of mind to stick with the agreed plan.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.

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