Retirement is a tricky proposition and sometimes downright confusing. Many assumptions have to be rendered before an individual can confidently leave the workforce.
Addressing life expectancy and forecasting your budget are two obvious areas to consider, but there are more than 23 major assumptions that have to be identified in order to provide reasonable confidence in a decision that will generate an income stream for the next 30 years of life after work.
The issue of understanding income — not to mention inflation, tax rate assumptions, etc. — can also be challenging. Many retirees associate the concept of taking “risk” with the equity markets. However, as 2013 demonstrated, there is also principal risk in the fixed income arena if an untimely liquidation requires you to sell bonds and generate income.
When fixed income matures (a bond comes due), you endure reinvestment rate risk. That is the possibility (risk) that the new bond may have a lower coupon than the one that just matured. This situation can be devastating to an income portfolio.
The year 1980 coincided with the peak of inflation. I wasn’t in the industry at that time, but if I were there is no doubt I would have heard a client state, “Joe, here is my million-dollar nest egg. Don’t lose it!” Had I put the money in certificates of deposit at the local bank in 1980, the return would have been $140,000 per year, as the annual yield on a longer- term CD at that point was 14%!
Before you begin reminiscing, “those were the days,” refer back to the annual inflation rate at that time. But that is another story.
By 1990, yields on CDs had fallen to 5.5% and your $1 million nest egg’s returns would have declined by almost two-thirds, to $55,000 a year. As the planner I could say I had done my job of protecting your nest egg, but it would have destroyed your expected income stream. By 1990 I was indeed in the industry and the fictional example became a living reality.