Written by Liz Ernst for Lake Point Advisory Group
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Behavioral Finance—a Powerful Tool for Providing Retirees
with Financial Peace of Mind
Investing during your working years is aimed at wealth-building and utilizes a growth strategy in which you invest aggressively in stocks that will gain in value over the years (and decades), allowing those significant gains to build a nest egg for retirement. Younger investors can generally afford to take on market risk during their working years, since they have time to make up for losses caused by volatility.
Once retirement is looming—by one’s mid-to-late 50s, the strategy generally changes to less risky investments that significantly reduce one’s risk of volatility, since investors close to or in retirement don’t have the cushion of future job earnings to make up for market losses. Lake Point Advisory Group (LPAG) recognizes the significance of this transition, and we help pre-retired and retired individuals find new strategies to minimize risk and better ensure their retirement savings will last for the next 20, 30 or 40 years.
Minimizing risk and establishing a financial plan that meets one’s unique retirement lifestyle goals without draining their savings prematurely requires planning and flexibility, as this is not always an easy transition for retirees. After years (or decades) of aggressive investing and spending, many retirees often over-estimate how far into retirement their savings will last, and don’t plan for the unexpected expenses such as taxes and medical expenses that accompany retirement. At LPAG, we apply principles of behavioral finance in helping our clients establish a retirement plan that can provide a stream of income throughout retirement to best meet their retirement goals.
Behavioral finance is a relatively new field that combines behavioral and cognitive psychological theory with conventional economics to help advisors and retirees identify why individuals make certain financial decisions, and recognize past financial mistakes in order to avoid making them in the future.
When applied to retirement planning, behavioral finance principles can help advisors make recommendations to investors that can help minimize the impact of volatile markets on retirement savings, and adopt new strategies to protect their nest egg’s longevity.
If you’re nearing retirement or have already retired, you may already understand the concept of behavioral finance. Not surprisingly, many people aren’t aware of this field, so I’ll explain it further here, and specify some scenarios to point out why it’s important.
If you’re like most retirees today, you experience heightened anxiety over your financial security, and you have plenty of company. A recent American College survey of retirement income certified professionals showed that more than 60 percent of their clients are concerned with market volatility significantly impacting their retirement income stream.
Market volatility is the main stimulant behind many bad financial behaviors such as buying high and selling low. For example, many retirees often react emotionally when the market drops and, in a knee-jerk reaction, divest some of their equities to invest in stocks. Jumping back into risky market investments that could put their nest egg in peril is another impulse common among retirees. But volatility isn’t the only culprit when it comes to making poor financial decisions.
Uneasiness sets in when investments earn low or no gains in a flat economy, which can pull some emotional triggers that may lead to bad financial behaviors. By resisting these triggers, investors can most likely minimize damage to achieving their long term financial goals by merely resisting the compulsion to take on risk and instead, stay the course. A qualified fiduciary retirement advisor can be extremely valuable in helping retirees establish a low-risk, diversified portfolio that causes them to be less likely to make emotional decisions during stressful times.
There are many strategies for creating a plan that addresses risk to your retirement security from the start. Our advisors are adept at finding ways to minimize the impact of volatile and flat markets in a retirement income plan, and a behavioral finance perspective can be extremely helpful here.
Many retirees’ first reaction to market volatility is to do something that could be destructive in the long term when they don’t need to. A trusted fiduciary advisor can help you get through unnerving market changes sensibly, and it’s amazing how often merely waiting it out can work to your benefit. What’s not amazing is how often a spontaneous decision can do real harm to your savings.
Selling investments and taking portfolio distributions in order to generate income to meet retirement expenses—like taking portfolio distributions during a volatile market—puts retirees at risk for something known as sequence of returns risk, making you vulnerable to collecting lower or negative returns early in a period when withdrawals are made from your underlying investments.
Sequence of returns risk is unique because until the investor begins withdrawing money from their investments, there is no impact on their portfolio. However, selling stocks right after a significant market downturn can lock in lower returns, which can negatively impact the longevity of one’s retirement portfolio.
When markets are volatile, retired investors need to be flexible and avoid selling stocks. By doing so, you can greatly improve the endurance of your nest egg, even though reducing market withdrawals may also mean reducing expenses, if just for a short period of time. Such a strategy can be well worth the long-term benefits.
If flexibility with retirement income is not possible, you can consider securing enough guaranteed income sources to cover your basic retirement needs—a strategy often referred to as flooring, which is usually accomplished through a combination of investments and insurance products such as bonds and annuities that can help provide a predictable amount of income each month in retirement to meet expenses.
Coordinating annuity or bond purchases with other consistent income sources, such as pensions, Social Security payments or rental income can help provide reassurance during volatile markets, and allow you to focus on enjoying your retirement instead of worrying about meeting expenses.
Other potential strategies may include tapping into non-market correlated income sources, such as a home equity, or more specifically, a reverse mortgage that offers a non-taxable income. Reverse mortgages in the form of a home equity conversion mortgage (HECM) can provide a hedge against market risk and offer a permanent potential source of retirement income that can be tapped into whenever the markets drop.
Other potential sources of non-market correlated income could include withdrawals from the cash value of an annuity or life insurance policy.
It’s important to understand the impact that market volatility can have on your retirement income sources. While pension payments are not subject to market risk, retirement assets like 401(k)s or IRAs are likely to hold stock investments that are subject volatility risk, and this is what feeds anxiety.
Behavioral finance strategies can help your advisor guide you to stay the course during stressful times, look for ways to minimize the temptation to sell equities while they are down, and look for ways to tap into non-market correlated income sources. Investors who enter into retirement with a comprehensive retirement income plan with guaranteed income sources that protect against market risk will fare best throughout their golden years.
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