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
5.........................................................15%
10.......................................................28%
15.......................................................39%
20.......................................................49%
25.......................................................57%   
30.......................................................63%

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.