Retirement Watch

Threats to a fulfilling retirement

Inflation and loss of capital pose dangers to retirees seeking a sustainable income stream

Sep 30, 2012 @ 12:01 am

As workers retire, many will seek to convert savings into income streams to meet their desired standard of living.

An evolution toward a fixed-income-heavy asset allocation is thus a common practice in retirement planning. However, the risks and limitations of this traditional approach may not be fully appreciated.

In this era of medical technology breakthroughs and expanding life expectancy, providing a sustainable income stream, namely one that preserves purchasing power over time, may require a different approach.

From the standpoint of an income-oriented retirement portfolio, the lengthening of investment horizons poses two major risks.

First, there is the destructive impact of inflation.

It is reasonable to assume that a healthy 65-year-old will live at least another 20 years. Over a 20-year period, assuming a 2% average rate of inflation, an income stream that is fixed in nominal terms will erode by about one-third in real terms. The real value declines by more than 50% if inflation averages 3.5%.

Today's unconventional monetary policy arguably raises the risk of even more elevated inflationary periods.

Second, there is the risk of capital loss. Although “risk assets” such as stocks, commodities and lower-rated credit instruments may first come to mind in this regard, investors in long-duration government bonds and high-grade debt instruments also should be wary.

Decades of yield compression have brought long-term interest rates in the United States close to zero. If long-term rates revert to levels seen in the early 2000s, owners of 10-year Treasuries and similar instruments could witness marked-to-market value declines in excess of 25%.

Should rates rise due to inflation, these investors may discover that the income their portfolios generate is less valuable in real terms, just as their ability to recycle capital into higher-yielding investments is undermined by market price declines in their existing bond investments.

Given the dual threats of inflation and capital destruction, retirees who are interested in protecting the real value of their future income should consider capital appreciation as an investment objective in addition to income generation. This combination highlights the role of equities, alongside fixed income, in a retirement portfolio as a potential driver of capital appreciation.

As they represent fractional ownership in a business, equities provide exposure to an earnings stream that has the potential to increase in nominal terms through the pricing power of the business or through the appreciation of the real assets it may own. Dividend-paying equities, in particular, are well-suited to a portfolio managed for both capital appreciation and income.

Fixed income continues to play an important role in a sustainable approach to retirement income. The typically higher yields of fixed-income instruments and contractual nature of principal repayment underpin income generation and provide stability to the nominal principal base.

Although “risk-free” rates are held down by central-bank intervention, exposure to a careful selection of credit instruments, such as corporate bonds and loans, may be an effective way to obtain income in this environment. Shorter-duration credit instruments may in fact perform better than longer maturity bonds in a rising-rate scenario.

Equity volatility is often cited as a key reason that some retirees favor a traditional fixed-income-oriented portfolio. Enduring some volatility may be necessary in seeking to avoid the loss of purchasing power due to inflation.

One way to cope with volatility is by investing in securities that are viewed as offering a “margin of safety.”

By requiring a big discount to our assessment of intrinsic value, one can seek to avoid the permanent loss of capital and the damage that such losses can inflict on a portfolio's ability to generate income. Although all investments involve the risk of loss of principal, a consistent focus on valuation can help income investors avoid the pitfall of “reaching for yield.”

Flexibility is also critical to preserving capital. By avoiding rigid asset allocation rules or predetermined benchmarks, investors may enhance their ability to take advantage of market volatility when it creates attractive valuation opportunities and potentially to avoid pockets of the capital markets where asset prices may be stretched.

By embracing a flexible, long-term approach anchored by a disciplined focus on value, investors substantially improve their chances of success in this important endeavor.

Giorgio Caputo and Robert Hordon are portfolio managers of the First Eagle Global Income Builder Fund.

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