Identify Income Risk When Investing for Retirement Income

After going over main advantages and some disadvantages of investing for retirement income in my previous articles, I will focus on risk in this piece.

Risk is one of the terms that we encounter in the initial stages of our effort to invest our savings for retirement. We heard the term and we knew that we had to be on the lookout for potential investing pitfalls. But most of did not know much about what risk meant beyond its basic cautionary signal.

As we progressed up the investing learning curve, we discovered that investment risk relates to the chances that investment we hold will lose market value. One way we could have learned this definition of risk would have been by reading and studying investment books, articles and financial forums, by carefully listening to more experienced investment professionals, or even coworkers and close relatives. Unfortunately, it is most likely that we have learned the definition of investment risk by watching that “sure” investment not only fail to make us a lot of money, but actually go in the opposite direction.

Like most of the personal finance topics, we acquired the bulk of our working knowledge from the costly financial mistakes. So, as we subsequently learned to pay attention to the scholarly articles or knowledgeable authors who are not trying to sell us some financial product on personal investing, we began to realize that investment risk has several parts. Investment risk comes in many shapes and forms, such as market risk, interest rate risk, unsystematic risk of company managers making wrong decisions, regulatory risk, credit risk and many more types of risk

Income investor risk

However, all these apparently distinct types of risk have one thing in common – the price of the security. Therefore, when the share price of Apple Inc. (NASDAQ:APPL) drops one day by 5%, the investment media promptly line up market denizens to explain to us all the reasons for this sudden price drop that nobody predicted. What these market “insiders” and investment experts are in effect explaining is some form of market or security risk. Unfortunately, this is always after the fact and is of little or no value, but we love to listen to the explanations.

However, because a pure income investor is not concerned with broad market movements and how this may be affecting income portfolio values, how does the pure income investor define and measure risk? This brings us to the definition of risk specific to the pure income investor.

To the pure income investor, Income Risk is the probability the expected dividend from an income security will:

• Not increase at the rate expected
• Will be unexpectedly cut
• Will be unexpectedly eliminated

 As you can see, there is a distinct difference between the marketplace definition of ‘risk’ and the definition of ‘risk’ to a pure income investor. All further reference to ‘risk’ in this article and all upcoming articles in this series will refer to ‘income risk’.

Learning how to ignore the siren’s call of the markets and its criers

I want to spend a little bit more time talking about this definition of risk. I am not trying to convince anyone that this is what they should be doing. What I am trying to do is aid those who think they would like to adopt this investment approach in retirement, but are still mentally struggling with the idea of ignoring the movements of the stock and bond markets.

For me, this has been the hardest part of converting my mind to that of a pure income investor. In my early days, I found myself sneaking peeks at my account summary statements and feeling great when the numbers were good. However, when the valuation numbers were down, I felt the deep sense of despair. It took me years to teach myself to keep the market fluctuations in perspective mentally. While it is difficult to completely ignore the movements of the market, I had to train myself not to be bothered by it one way or another.

To teach myself to ignore changes in the share price of income securities that I hold, had to convince myself to consider my holdings to be something different. I have found that it is much easier to shrug my shoulders at broad market declines or even recessions if I if a look at my income portfolio as a life annuity or a pension from a former job. A life annuity from an insurance company – called a Single Premium Immediate Annuity (SPIA) – and a pension from a previous employer will both provide a steady stream of income to the retiree’s household.

Different point to view

Virtually no retiree receiving monthly income from a life annuity or a pension will panic and call the insurance company or the pension administrator if the broad markets suddenly and unexpectedly sell-off. While I doubt that any retiree even thinks about it, perhaps they should.

Sometimes, insurance company SPIAs or employer provided pensions reduce their payments to their retired beneficiaries. Even though the word ‘guarantee’ is often used to describe their monthly payments, insurance companies do default on their contracts and employers sponsoring pensions, including public employers, can default on their obligations that results in a reduction in the benefit being paid to the retiree.

This type of default is highly uncommon and there are a myriad of rules regulating pensions and insurance company reserves as well as back up insurance for most such products. While uncommon and rare, unexpected benefits reductions do occur occasionally.

Income risk is prevalent across all types of investments and income investing is no exception. In an upcoming article, I will provide two simple dictums that all retirement income investors must understand to be able to manage income risk.

Bruce Miller is a certified financial planner (CFP) who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.