Thursday, 10 May 2018 00:00

Risk Management: Part 2 Interest Rate Risk, Inflation and Longevity Risk

By Stephen Kyne, Partner, Sterling Manor Financial | Business

LAST MONTH, in this column, we began to explore some of the types of risk that people often encounter in their financial lives. The first installment covered Market Risk, which is the primary category of risk that many people think of when investing. This month we’re going to look as some less obvious, yet equally pervasive, risk types. 

Interest rate risk affects most investors, especially those whose portfolios are heavily weighted in bonds or other debt instruments. Put simply, this is the risk to you that prevailing interest rates will increase, which could then drive down the value of debt instruments you hold. We are in a rising interest rate environment right now, so you may currently be experiencing the effects of interest rate risk.

Let’s assume that I am your bank, and I own your mortgage which is locked in at 3.5 percent. Now, let’s assume that I don’t want to take on the risk that you will default on your payments, so I take your mortgage and bundle it with several others also paying 3.5 percent, and I try to sell them (as banks often do). If the prevailing interest rate in the market has increased to 5 percent for mortgages of similar credit quality, then I will need to discount the price so that someone will want to buy my 3.5 percent mortgages instead of another bank’s 5 percent mortgages.

You may not be a bank, but if you are an investor who depends on bonds as a part of your portfolio, then you may as well be. As interest rates increase, the value of your bonds, which were issued at a lower rate, decrease on the secondary market. If you are investing in bonds through a mutual fund, then this can be especially true. Suddenly those “safe” bonds start losing value, and because of the way mutual funds are structured, you could lose value and still receive a 1099 for gains within the fund!

Inflation and Longevity risk often go hand-in-hand. They are both risks associated with the possibility of living too long, and suffering the erosion of your purchasing power over your lifetime.

My grandmother was born in 1921. When she was born, her life expectancy was 54 years. She worked until she was 65 (11 years after she was supposed to have died). She passed away at the age of 93 – nearly 40 years longer than her initial life expectancy!

Planning to die young is a terrible retirement strategy.

Since we need to plan for a relatively long retirement, we need to accept that, in order to maintain the same lifestyle for the duration of our retirement, our last years will be significantly more expensive than our first years. 

The average rate of inflation for the staples seniors consume (food, energy, healthcare) are higher than for many of the discretionary items that non-retirees purchase. If we assume a 3.5 percent rate of inflation, then we find that our purchasing power is halved every 20 years. In other words, if you retire at 60 with annual expenses of $75,000, then by age 80 it will cost you $150,000 to maintain the same lifestyle, and nearly $300,000 by your late 90s!

Longer life expectancies mean longer retirements. Longer retirements mean more exposure to the effects of inflation. 

Think of someone you know who may be struggling financially in their later years. It’s very likely they were quite comfortable when they set out in their retirement, but they’ve lived longer than expected, and their purchasing power has been slowly eroded.

When working with your independent financial advisor, we recommend planning for a life expectancy of 100 years, unless you have personal health conditions which make that unlikely. Preparing your finances to support you over the course of a long life will help ensure that you will not have to drastically alter your standard of living in retirement because you’ll be ready for the effects of inflation over the long-term. 

A conservative investor who has all of their money in CDs at 1.5 percent might feel secure in being free of the volatility found in the investment markets, but they are really just losing money safely when inflation is factored in. Your independent financial advisor will help you to understand how hard your investments need to be working to keep you safe from inflation and the risk of outliving your assets. 

Stephen Kyne is a Partner at Sterling Manor Financial in Saratoga Springs and Rhinebeck.

Securities offered through Cadaret, Grant and Co., Inc. Member FINRA/SIPC. Advisory services offered through Sterling Manor Financial, LLC, an SEC registered investment advisor or Cadaret Grant and Co., Inc. Sterling Manor Financial and Cadaret, Grant are separate entities.

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