Saturday, October 18, 2014

Why You Need Equity Funds In Your Retirement Portfolio.

The most important question when one is nearing retirement is "will my income be sufficient to last thirty or more years"?  The answer to that question is complicated since most retirees what a risk-adverse retirement portfolio and don't know how long they will live.  However, in our present low inflation environment risk-adverse instruments like bank CDs, money market funds, and bonds pay little or no interest (>2%) and therefore does not generate the sufficient income necessary to live comfortably in retirement.  Sure, as educators we get a pension and social security benefits and they are partly but not fully adjusted for inflation and consequently, the spending power will be eroded over time. Most educators have been intelligent enough to put money in the TDA but as one approaches their retirement date, the majority puts it into the fixed income plan that gives 7% interest, a nice perk in our low inflation period.  However, like all risk-adverse instruments, the fixed income portion of the TDA will erode over time as well as inflation will slowly eat away at the spending power  Let's look at the three risk-adverse retirement funds and why the total income will erode over time due to inflation.

Pension:  Our pension is partly adjusted for inflation.  However, the inflation adjustment does not occur until 5 years after you retire and ten years if you retire at 55 years of age.  Using the average inflation rate, the pension will erode by 15% by the time the pension is eligible for an inflation adjustment and 28% if you retire at 55 years of age.  Moreover, the inflation adjustment is only one half of the Consumer Price Index (CPT) and is limited to 3% no matter how high the CPI gets. Finally, the inflation adjustment is confined to the first $18,000 while the average teacher pension is $42,000, that means that the majority of the pension is not adjusted for inflation. Therefore the pension spending power will be eroded over time.

Social Security: Unlike pensions, social security is adjusted for inflation.  However, the modified CPI used for the inflation adjustment ignores energy and food spikes which adversely affects retirees.  Further, social security only accounts for 25% or less of an educator's retirement income.

TDA: Quite a few educators take an annuity from the TDA since it provides the largest payout.  Since the average educator TDA is $316,000 then the payout is approximately $30,000.  However, just like all other risk-adverse instruments the $30,000 will erode over time since there is no inflation adjustment when you annuitize the TDA.

How much will the retirement income erode over time due to inflation assuming a historical inflation rate of 3.4%?

Years                                    Erosion Due To Inflation

That means that the $30,000 annuity in 2044 will have the same buying power as $11,100 would have today.  Not a pleasant thought. 

How does one account for the eroding effects of inflation?  The answer is to include in your retirement portfolio assets that appreciate over time and the only asset that has stood the test of time are equity funds. Historically, going back to the Great Depression, stock equity funds have appreciated by 7.7% over the period.  Yes, there are some bad years, the latest being 2008 but in the long run stocks and equity funds appreciate above the inflation rate and will protect your retirement portfolio from the ravages of inflation.  There are other assets that appreciate like commodities, .real estate, collectables, and precious metals but they are rife with speculators and experience wide swings and are not appropriate for a retirement portfolio.

Many professionals recommend an asset allocation that will give you the best chance of success is a 60% stock/40% fixed retirement portfolio but in any case, one should have at least a 40% equity fund allocation in their retirement portfolio. Regardless how you structure your retirement income, make sure that equity funds are part of the portfolio to protect you from the ravages of inflation.


Anonymous said...

Great post Chaz. My friends are envious that I will live quite comfortably when I retire at age 55 with 31 years in the system. I'm about half way there. 62%
of my FAS is pretty darn sweet if you ask me! Right?

As teachers, we are quite lucky to have a guaranteed income for life on top of Social Security. Even with inflation, we are STILL so much better off than many others.

And let's not forget the quarter million dollars many of us easily accumulate through TDA.

Not a bad life after retirement!!!

Anonymous said...

I agree. I will have 27 years in when I retire at 55. Been putting into my TDA as well. Plan on working part time when I retire. Got 12 more years to go. To all my fellow teachers: Stick with it because there is a light at the end of the tunnel.

Anonymous said...

Can you retire with 30 years if you are under 55 and get full pension? Or is 55 the magic age?

Anonymous said...

I have a few years to go, and I agree we have it good. At least until 2018, then who knows! I will have six figures in my TDA, but... Here is where I respectfully disagree with you Chaz. Stocks are a gamble. 7% can't be matched. Every month I earn almost 1K in interest! Guaranteed! Can't beat that! Also, I would never annuitize my TDA. If I (G_d forbid) die before the money runs out, my heirs get none of it! The city gets it! NO WAY! I personally will let collect interest until I am 71.5 years old, then put it in a savings account. No investing for me! Too much of a gamble. Boy, 3 Years and 9 months left!!!

Chaz said...

Anon 11:05

How do you handle inflation? If you look at my chart, the 7% draw will erode over time. That's why you need equity funds.

I agree that taking the 7% draw is preferable to the 10% annuity and I also agree with you on the safety of taking the 7% but you will need to have some appreciation.

Finally, you and I have the same retirement date.

Anon 8:23

No, you need to be 55 years of age to retire, no matter how many years you have.

Anonymous said...

Chaz, you financial genius, I believe you mean RISK-AVERSE not ADVERSE. Really, stick to whining about your ATR martyrdom and forget about big-boy topics like retirement.

Your fan,
Ed Opper

Anonymous said...

to 11:05. You have been working for almost 27 years and you don't even have 100K in your tda. I would be embarrassed to say that. What were you thinking ( or not ). You better play catchup real quick. Put in 23%, with interest you could double your tda in 3 years. good luck and by the way McDonalds is always hiring for when you retire.

Anonymous said...

Anon 8:08

I never said I had 30 years in! I am going out at age 62. I deserve an apology for your condescending tone.

Anonymous said...

to 8:26. I am so sorry. I will take fries with that cheeseburger.

Anonymous said...

Anon 9:20 PM
You are very annoying.

Anonymous said...

Horror stories...

Don't forget the Queens HS for Teaching. In the 21st century America, these fascist pigs think it's ok to put dozens of unknowing teacher into numerous rooms with TWO WAY MIRRORS!

Anonymous said...

The Queens HS for that the place where kids graduate with A+ averages and 90% of the graduating class go to a university system where 50% to 85% of the freshman class need to take remedial math and English?

Sounds fishy to me....

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