Before the financial crisis began two years ago, certain “truths” were held as undeniable–for instance, that Modern Portfolio Theory works; asset allocation and buy-and-hold with rebalancing works; and equities outperform inflation.
Now, it appears some of those truths aren’t true, and maybe never were. So many truths were shattered and so many unthinkable things happened in the past two years that advisors and clients must look differently at every challenge.
In the retirement space, baby boomers are approaching their golden years with a set of conditions unlike any ever seen. This environment is the “new normal,” a world marked by the possibility of lower growth, increased consumer savings and more government intervention and regulation.
Experts anticipate recovery will come, but it’s unlikely to be at the same magnitude as in past recoveries.
What does this mean for retirement and retirement income? Well, for one, there will be a new retirement normal. Some people who retired “for good” in the past five years have un-retired.
Another consequence of the new normal is the need to look at the retirement income portfolio in a new light. Possibly the most significant risk a retiree faces is inflation, so let’s focus on the implications of that.
The traditional way of dealing with this risk has been to load up on equities and hope this will win the day in the end. But that won’t work. Arguably, it never did.
Let’s break it down to the level of the individual. Typically a retiree will have a baseline of expenses which he or she will need to cover. A usual approach would be to use reliable, predictable income flows to cover those needs. Such flows would include Social Security, pension income and immediate annuities. Some of these may have inflation adjustments, some not.
The next level of expense coverage usually comes with a heavy equity allocation. This approach, if intended to cover any of the “needs” aspects of retirement, could have a devastating outcome on income. At this risk tolerance level, the retiree is trying to protect and grow purchasing power. Fortunately there is a U.S. government security that is designed to protect purchasing power with inflation adjustments and grow purchasing power by crediting additional interest. This product is Treasury Inflation Protected Securities.
TIPS are inflation-indexed bonds whose principal is periodically adjusted to the Consumer Price Index. Interest payments on TIPS are based on the inflation-adjusted principal, which can be above or below the bond’s face value dependent on the inflationary environment. With TIPS, the U.S. Government guarantees repayment of the greater of the inflation-adjusted or original principal at maturity.
Many people are aware of TIPS, but unaware of how well they work for retirement income.
If comparing TIPS to equities, it’s true that equities might outperform TIPS, but at much higher risk and maybe not as well as they did in the past. Equity risk (volatility) has historically been around 15%, but TIPS volatility has been around 6%, less than half the risk of equities.
Importantly, if the retiree holds the TIPS to maturity, the retiree knows that the money will be 100% connected to inflation–in a good way–and guaranteed by Uncle Sam.
If relying on equities as the inflation proxy, on the other hand, the customer may experience returns that represent a substantial deviation from purchasing power protection. Just look at the last 10 years of annualized data: As of the end of August, equities have lost 0.8% with 16.2% volatility risk, while inflation has been at 2.6%. Over that same decade, TIPS have returned 7.3% with 6.6% risk.
One challenge in using TIPS for retirement or retirement income has been the awkwardness of the cash flows, because maturities are not evenly distributed over the coming years. But investment products exist that mitigate that issue and make TIPS more attractive and accessible, both inside and outside variable annuities. TIPS also offer a great complement to longevity protection.
Retirees have a difficult choice to make in a new normal world where sacred “truths” about asset allocation and asset classes have been debunked. A retiree who is looking to protect purchasing power must consider a new approach. Then the question becomes: Why not use a product that is designed to protect purchasing power (TIPS) instead of one that has substantial risk of not doing so?
Thomas F. Streiff is executive vice president and retirement product manager at PIMCO, Newport Beach, Calif. His e-mail address is email@example.com.