When you invest, you take risks. For most people, risk is managed by building a diversified portfolio that holds different types of investments whose performance is loosely correlated. When changes are made, it should be done with an eye to how the changes help you achieve greater balance.
Typically, portfolios consist of a collection of accounts, some of which are university-sponsored and some that have no university affiliation. Other accounts may be owned by a spouse or partner, which are considered to be part of a household portfolio. There are four defined contribution retirement plans available to UNC system employees. Each plan has its advantages as well as its limitations. Investors can utilize some attributes to mitigate risk while others may leave investors vulnerable to other risks.
The first hurdle is to recognize that investment management requires a focused and engaged approach that treats each portfolio account as a piece of a larger puzzle. Each piece of the puzzle comes with its own complementary strengths and weaknesses. Some accounts may have a wider selection of investment options that may allow you to better diversify. Other accounts may offer options that better suit your specific retirement goals or convey more favorable tax treatment of contributions, withdrawals or earnings.
A relevant question might be “Why would I want to risk losing money?” The answer is that by not doing so, you may expose yourself to the risk of outliving your money. Based on the Social Security Administration’s latest Period of Life Table, a 65 year old couple have an 18% chance of at least one of them being alive at the age of 95. Retirement planning must account for this possibility.
If you have investments in US or foreign stocks, you have exposure to market risk. This is a systematic risk that affects all companies, regardless of the company’s financial condition, management, or capital structure. For most of us, exposing ourselves to market risk is a necessity in order to meet our retirement goals. Although the market surrender of 2007-2009 is still fresh in our minds, history tells us that over the long haul, stocks tend to grow more rapidly than safer and less volatile investments.
Inflation risk and interest-rate risk
Generally, an increase in inflation will result in a commensurate rise in interest rates. The latest rate of inflation in the US is 2.1% for the 12 months ending May 2014. An increase from 1.6% for the 12 month period ending January 2014. In general, an investor’s rate of return must exceed inflation in order not to lose buying power.
As inflation rises, and with it interest rates, the value of bonds will decrease in value. For this reason, this may be a particularly good time to consider investment in stable value options within your university retirement plans as opposed to bond-based mutual funds. The 403(b), 401(k), and 457(b) accounts offered by the UNC System and the State of North Carolina each offer a stable value option with no withdrawal restrictions that pays interest (that may fluctuate). This stable value option, while not FDIC insured, has not (to date) resulted in investor losses.
Liquidity risk is the risk that cash may not be available for the purposes you desire. This may be for withdrawals for retirement income or for the purchase of new investments that you may perceive to be undervalued. We cannot emphasize enough the importance of maintaining sufficient liquidity during retirement. We believe that a forward-looking, rolling five-year approach that maintains sufficient liquidity to satisfy the cumulative withdrawals needed during those periods is a necessity. However, maintaining assets in stable value options that have withdrawal restrictions may not address your liquidity needs.
Addressing management risk is also a critical component of risk management. For the individual investor in the UNC System retirement plans, this involves selection and periodic evaluation of mutual fund holdings. Relative performance compared to funds with a similar investment objective can change over time. Investors must be attuned to these changes in performance so that other options can be selected as alternatives. Gaining access to the self-directed brokerage component offered by the Optional Retirement Plan and 403(b) plans is critical to addressing management risk. The limited number of core investment options made available in these two plans is inadequate to address the risk that any single mutual fund’s performance could degrade over time with respect to its peers.