Portfolio Shrinkage During Retirement

One of the most common financial decisions that takes place as one approaches retirement is a move toward a conservative investment portfolio. During the working and investing years, one figures risks are there for the taking. Now that retirement is approaching, the risks change and a conservative approach should be taken. Many financial planners who are not retirement planning specialists agree with this approach, and, therefore, validate the retiree's perception.

This approach may be suitable for some, usually the wealthy, but is not for the majority. There are some critical factors that may prompt a retiree to reconsider and give this a hard, second look. The first point, for example, is potential longevity. According to IRS Publication 590, life expectancy for a couple age 65 is 25.0 years. The theory of "conservation of purchasing power" comes into play. During the retirement years, taxes and inflation continue. In many cases, the cost of living will be higher than normal because of health concerns. Investments (principal and earnings) must outpace the "buying power shrinkage" caused by taxes and inflation. A conservative investment portfolio will usually not overcome shrinkage, and depending upon the size of the portfolio, it may not survive the retiree.

The second point is that a retiree may have social security and pension earnings upon retirement. These earnings may exceed income needs for many years, thus allowing other investments an opportunity to grow. If all investments are too conservative and lack growth-oriented features (i.e., stocks, bonds, mutual funds, etc.), the retiree's portfolio will not experience any additional needed growth.

The third point is that since investment portfolios are diversified, only a certain percentage will be growth-oriented. When a retiree starts receiving income from investments, the income from conservative investments should begin first, and the income from growth-oriented investments should be last. Income from growth-oriented investments should not be spent until all conservative investments have been depleted. Years may pass before this takes place, therefore, giving growth-oriented investments time to grow to overcome any portfolio shrinkage.

Some retirees may not feel comfortable depleting any of their portfolio, so they would receive income from all investment sources. If growth-oriented investments are a small percentage of the total portfolio, then the "income expectation" from this group of investments would be minimum. This minimum "income expectation" would allow this group of growth-oriented investments time to grow for the sole purpose of overcoming any portfolio shrinkage. Remember, during retirement, it is more important to "preserve purchasing power" than to "preserve capital." The former will guarantee the latter but the latter will not guarantee the former.