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What can retirement savers do in bleak markets?

Financial market conditions appear bleak. Inflation has driven interest rates higher, leading to falling prices in the equity and bond markets. The contrast with a prolonged period of rising prices in both markets is huge.

It’s natural for retirement savers to feel depressed, not just about the present but also about future prospects. And it’s particularly gloomy because the ballast traditionally provided by bonds when equities fall can no longer be taken for granted.

So the big question is: what can you do? I’ll focus on three aspects.

  • What can savers do?
  • What can retirees do?
  • And what can you do to prepare for the inevitable next episode of adverse conditions?

Falling markets can be good for savers

The first question is the most comforting to answer. Savers should recognise that their assets no longer conform to their planned allocation (whatever it might be). So the first thing is to rebalance back to it. This has the fortunate effect of buying into whatever has fallen furthest, taking advantage of the new lower prices.

In fact falling markets are, perhaps paradoxically, good for savers. Think of the falling prices as a sale. The amounts you had planned to invest regularly will now buy more units of each asset class than they would at the previous higher prices.

Of course that advantage only holds if falls are temporary. But they usually are. That’s the good news. There’s always the possibility that markets never recover. That’s what author William Bernstein calls ‘deep risk’ – and frankly there’s no satisfactory way to deal with that. It’s little comfort that the whole world will be seriously affected, not just you – but that’s the reality of it.

So let’s assume that the falls are not so much long-term as short-term or medium-term. And short-term falls are not a problem if you don’t panic and sell. The only defence against panic is to think rationally rather than emotionally.

The savers most affected by a medium-term fall are those who are relatively close to having to start cashing out gradually as they approach retirement. And the same problem is even worse for those who are already in retirement and see their pension pot fall in value. So let’s focus on them, and get to the second question I mentioned earlier.

Retirees need to have a 'safety pot'

Retirees are particularly vulnerable to what is termed, in the jargon, ‘sequence of returns risk’. They don’t have the luxury of waiting to allow future high returns make up for current negative returns, because their assets are declining as they make withdrawals to sustain their spending needs, and those future high returns act on a smaller asset base. So a sequence of returns that starts low or negative can’t be balanced by later high returns.

That means it’s essential to have a part of your pension pot that’s relatively immune to falling asset prices. And the only such assets are cash-like assets, or at any rate short-term assets, which decline little as interest rates rise.

I think of this as a ‘safety pot’, in contrast to the rest of the pot, which is your ‘growth-seeking pot’. Of course there’s a further problem right now, in that stable-value assets are no protection against high inflation.

The only protection lies in assets with returns that are themselves linked to inflation. Americans are lucky in that the US government issues what are called I-Class Savings Bonds (I-bonds for short) with returns that are constantly adjusted to match inflation.

It’s these types of safety-oriented assets – or, if you don’t hold any, the shortest-term bonds in your portfolio – that offer you the least costly defence against sequence of returns risk.

Lessons for the next market fall

This leads to the final question. What lessons can you learn for next time?

The answer for those of you who are more than, say, five years from having to withdraw money from your pot is nothing, other than that it’s wise to have a long-term investment plan which you can stick to, such as the now traditional ‘glide path’ that underlies many accumulation plans for retirement.

Why five years? There’s no magic to the number. It’s the period of time when historically markets tend to recover to their inflation-adjusted levels after a fall. And yes, history is not a prediction of the future, but it’s at least a guide.

The answer for retirees and those closest to retirement? Build up that safety pot to allow you to gradually withdraw up to five years of spending without touching your growth-oriented pot if the market takes time to recover from a fall. (I wrote about this strategy a year ago.) And the ultimate defence: be willing to adjust your spending too. Life constantly changes. If we can adjust without too much pain, that’s a big defence against panicky reactions.

 

Don Ezra, now retired, is the former Co-Chairman of global consulting for Russell Investments worldwide, and the author of “Life Two: how to get to and enjoy what used to be called retirement”. This article is general information and does not consider the circumstances of any investor.

 

11 Comments
Brian
November 05, 2022

Floating rate bank hybrids provide a hedge, sure they are not gauranteed but if the big 5 banks fail (include macquarie) we will be in much more trouble than is suggested in the article

A K Mani
November 02, 2022

What about the Australian Govt Bonds? How are they faring?
Any opinions for investments for retirees?

Steve
November 02, 2022

LaTrobe 12 Month Term Account paying 5.3% pa (and increasing) is a no-brainer.

K
November 05, 2022

Mortgage fund. "Withdrawal rights are subject to liquidity and may be delayed / suspended.” No government guarantee.

Neil
November 02, 2022

"Americans are lucky in that the US government issues what are called I-Class Savings Bonds (I-bonds for short) with returns that are constantly adjusted to match inflation."

Australians can get into govt inflation linked bonds very easily on the ASX through the iShares Government Inflation ETF (ASX:ILB). Price has gone up about 5% in the last month, presumably as inflation-for-longer expectations start to take hold.

Paul Rider
November 02, 2022

Hi Neil, correct me if I wrong but ILB and I-Bonds are somewhat different. With ILB, principal values are adjusted to incorporate the current inflation rates. Whereas I-Bonds get an adjustment to their interest rate to reflect inflation.

SMSF Trustee
November 02, 2022

Paul, maths are much the same. Adjust the principal for inflation and the fixed interest rate pays an increased dollar amount in line with the inflation rate.
Some inflation linked securities do it one way, some the other. But the inflation hedging works out the same.

Paul Rider
November 03, 2022

Hi Warren, then why is ILB down 11% Ytd? If it acted as hedge against rising inflation, the price should have increased with skyrocketing inflation. It hasn't acted as a hedge at all.

James
November 03, 2022

"If it acted as hedge against rising inflation, the price should have increased with skyrocketing inflation."

Because perversely, inflation and interest rates have gone up simultaneously!

Warren Bird
November 05, 2022

Paul, I assume you are asking your question about my comment about the maths generating a bounce back, which isn't part of this particular thread.

In any case let me answer your question. Inflation linked bonds hedge income and cash flows for rising inflation in the short term, but capital only over the long term. Capital values fluctuate as real yields fluctuate, the same as the way nominal bonds fluctuate with nominal yields.
So the reason that capital values of ILB have fallen is that the real yields at which they're trading have risen.
If you owned ILB before this market move then you will over the life of the security earn the real yield that it was paying then. The capital value when it matures will have been increased with inflation, thus lifting your quarterly nominal income in line with the CPI too.
To use your language, the cash flows you are being paid have "skyrocketed" with inflation. So has the inflation-adjustment factor that applies to the face value of these securities. But their traded value has been reduced by the rise in real yields.
Of course, ILB have never promised to be a short term total return inflation hedge. If they've been marketed to you by someone saying something different then it's that marketers mistake, not the fault of the governments who've issued them.

Warren Bird
November 02, 2022

Of course, with bonds the bounce back is guaranteed by the way the asset class works. Those bonds that have risen in yield from 1% to 4%, causing a negative return in the process, will now return 4% per year to maturity as they amortise to par value at maturity. Shares have historically bounced back, but don't have the same mathematical certainty to do so.

 

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