By Gary Brooks, CFP
One percent. Seemingly an inconsequential share of anything, 1 percent can actually make a tremendous difference in terms of your financial security.
Even fractions of a percent, added to investment return over time, can wholly redefine the way you live in retirement, the amount you bequest to children or give to charitable causes. An extra one percent can change your life. For instance, if you can increase your average investment return from 5 percent per year to 6 percent annually, that one percent move represents 20 percent (one-fifth) more in return on your investment and a substantial increase in options for how you live.
Assume that you’ve been a decent saver over your career. You’re 65 and in addition to Social Security you have $500,000 that may need to last 30 years. A 5 percent average annual return — reduced by 2.5 percent projected inflation — would allow you to withdraw $1,750 pre-tax dollars per month and have 81 percent probability of not running out of money.
Increase the average annual return to 6 percent (3.5 percent after inflation) and you can increase monthly withdrawals to $2,000 while maintaining significant probability (76 percent) of having your money last to age 95.
But adding 1 percent to your expected return without adding more fluctuation in investment outcomes — and potential shortfall of your goals — is difficult to do, especially in today’s low-yield environment for bonds.
For the past 30 years, many people have been able to live well in retirement supported by bond-heavy investment portfolios. As interest rates have trended down for a generation, bond returns have been somewhere between adequate and exceptional. But we are exiting the Golden Age of bonds. Now, global interest rates are near all-time lows, and investors are finding their bond returns are less than adequate to support the presumed level of income required for their financial security.
There have been multi-decade periods of weak bond returns before, but they were so long ago that most retirees had both a shorter life expectancy and a company pension instead of an investment account. There was far less reason to be concerned with squeezing a little more return out of your money.
With lower bond income than expected, many investors feel compelled to seek more investment return by moving more money into the stock market or by buying high-yield “junk” bonds that may deliver better returns and higher income but only in exchange for quite a bit more uncertainly and volatility than investment-grade bonds.
The risk of default by bond issuers, known as credit risk, is very tame right up until the point when it isn’t. A low likelihood of default risk changes dramatically right at the territory where some investors become blind to credit quality while searching for that extra 1 percent of return.
So what is an investor to do if earning another 1 percent could be so important but finding that extra 1 percent could be like navigating a very narrow cliff side trail? You could cross the tough terrain without complications if you focus on the right things, or you could cringe with each step and experience more than your share of stress.
It’s important to first focus on things you can control. We know this doesn’t include investment outcomes, but you can be much more informed about the level of risk and expected return in your investments and how that matches your goals. Having a written investment policy tied to a financial plan can add a guardrail to that cliff edge, allowing you to pass with more confidence.
If you don’t want to take a step up the risk ladder, you can commit to saving more before you need to start living off of those savings. Working an extra year before retirement can do a lot to reduce reliance on investment outcomes in determining your financial security. Not only will an extra year of savings (and one less year of retirement income withdrawals) be helpful, but you could pad your Social Security income meaningfully. Growing your Social Security payment is the best risk-free investment you can make.
Also, if you can find ways to reduce spending without reducing quality of life, that seems far preferable to taking extra investment risk to support unnecessary spending.
Another way to add risk-free return to your investments is to lower their expenses. Understand the management fees of the funds you own and their alternatives. In some cases, particularly if you have money in small-employer 401(k) or 403(b) retirement accounts, you could add a full 1 percent to your return through cost savings alone if you use less expensive funds in a rollover IRA.
Gary Brooks is a certified financial planner and the President of Brooks, Hughes & Jones, a registered investment adviser in Tacoma. Reach him at BHJadvisors.com.