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Recently I’ve met a number of older friends who’ve saved enough money to consider retiring. These friends have asked me, financially, what could jeopardize a comfortable retirement and how they should prepare for these potential problems. Here’s what I see as the major threats to a comfortable retirement:

1) Deflation, Stagflation and Inflation

For those in the workforce, deflation and stagflation feel like trying to walk through mud on a rainy day. Things are painful, and a recovery is slow and drawn out. For retired folk, this isn’t so bad. Prosperity led by inflation is actually the enemy of a retiree. Most retirees face a situation of managing a fixed income and fixed amount of assets. Deflation makes items more affordable and allows you to use your savings more effectively. Stagflation allows you to maintain your level of living, as you can stretch your savings out without any significant need for new income.

Inflation is the greatest threat to a comfortable retirement. Currently the government deficit is out of control. At the time of this post, national government debt stood at $12,390,129,946,402, while GDP stood at $14,285,707,057,143. Our debt to GDP ratio stood at approximately 86.7%. There are three ways to handle such enormous debt:

  1. We can write off the debt
  2. We can generate income and pay down the debt
  3. We can inflate our way out of the debt

Writing off a portion of the national debt isn’t an option, as it would guarantee a loss of our AAA rating and there would be a sudden loss of confidence in Treasuries. Generating income to pay down our debts is our best choice, but without any short-term growth driver, it would be hard to pay down such enormous debt.

Economic recovery in the US has traditionally been led by the automotive industry, the housing industry or an emerging industry like the tech boom of the previous decade. With the automotive industry in decline, the housing industry struggling and without any innovative industry around the corner, I don’t see an easy way for the US to generate enough income to pay down our debts. Without any driver of income growth, the easiest way to get out of a heavy debt burden is to slowly inflate our way out.

In order to quickly emerge from the recession and spur business growth, the Fed is printing money at an alarming rate, while keeping interest rates at basically 0. The longer the formula of growing money supply + low interest rate exists, the likelier we are to experience rapid inflation. I saved this picture from the Wall Street Journal, which illustrates the effect of an easy money policy on the stock market. With capital inexpensively available to invest, the stock market aggressively rallied following previous major crashes and gave an early warning of the inflating bubbles to come. The products of inflation and the intended effects of an easy money policy will make the value of our debts appear smaller in the long-term. If 12 trillion felt more like 120 billion, it would certainly make the debt manageable.

Stock Market Crashes and Recoveries

(Click to enlarge)

A relevant example of inflating our way out of debt would be the Savings and Loan crisis. Between 1986 and 1995, 1000 financial institutions failed and the US taxpayer was on the hook for $153 billion. The initial estimate to clean up the S&L crises was $30-$50 billion, a number that shocked many taxpayers at the time. Economists had predicted many decades to clean up the mess and get the economy back on track. What happened instead was the Greenspan policy of stoking inflation by flooding the economy with new money and dropping interest rates to as low as 1%.

By the late '90s, the tech boom was around the corner and economists quickly revised their opinions on how fast we would be able to pay down our debt. After the tech crash and 9/11, we had a return to easy money and a recovery led by housing. By the last decade, $153 billion in government debt no longer seemed like a difficult to comprehend number.

Bernanke is clearly following Greenspan’s monetary policies by simultaneously increasing the money supply, while keeping interest rates low. If we follow the pattern of previous recoveries, $12 trillion in a decade or so will no longer feel like an unacceptable number. We will be far along the path of an easy money + (insert industry) -led recovery. A new generation of dotcom’s, biotechs or green technology may be the future excuse to spend.

We can already see the early stages of recovery as financial executive pay packages have returned to record-setting levels. Many financial executives are receiving bonus compensation in the form of stock and options. Compensation heavily slanted toward stock and options will only further incentivize financial executives to create business with the easy money under management. This should add further inflationary concern for retirees.

Without any hidden or new problems in our financial institutions, frozen credit markets are only a short-term problem as financial institutions build up reserves and capital ratios. At the moment few asset classes and business proposals currently pass the tests of risk management and the loan approval departments of banks and venture funds. Just think back to a decade ago on how little information you needed to get an investment for a dotcom or a few years ago for a loan on a property. Once a hot industry is found money will eventually be freed for investment and it’s off to a spending race once this happens.

For a retiree, this poses a danger as the effectiveness of their savings will appear to get smaller each year. The only way to combat inflation is for retirees to have strategies in place to grow their savings at a level equal to or faster than the real rate of inflation. For some, this may or may not be a challenge, as many older retirees are only interested in maintaining their standard of living and a large enough nest egg will allow them to do so.

2) Institutional Failures

By far, the largest threat to retirees is losing their savings or pension. During the S&L crises, 1000 financial institutions failed and many that failed held the savings of retirees. The enormous number of failures meant that retirees with more than $100k in a single account lost a part of their savings. If a retiree had $500k as a cash portion to retire, I would hope he or she had separated it into 8-10 deposits with different institutions. It’s a hassle to wait for the FDIC to sort out your saving deposits if an institution fails. By separating your savings between multiple institutions, you gain the safety of having available funds in the event one or more of the institutions fail.

With the rapid rate of bank and fund closures, it makes sense to go through the hassle of managing multiple accounts to gain peace of mind. To date, 182 banks have failed in the US since January of 2008, according to the FDIC website. Though I don’t have a total tally, in plain sight, a large number of pension funds, mutual funds, hedge funds and non-bank financial institutions have also failed since the beginning of 2008.

3) Asset Diversification

Everyone has his own judgment on by what percentage to divide savings into different assets, so I’ll save my opinion of what percentage to divide for a different post. Retirees should have assets in few major categories to be considered truly diversified against #1 and #2 above.

  • Self-Owned/Income Producing Property

Owning your own home free and clear to live in provides both safety for a part of your nest egg and can provide peace of mind. Income producing property can be a hassle from a management perspective and from a choice perspective, as a retiree may choose a poorly performing investment property. Chosen correctly, high yielding investment property is a great way to keep up with inflation and provide a steady stream of income for retirees to spend.

  • Paper Assets

The bulk of most retirees' savings are likely to be held in paper assets. For cash, potential retirees should consider holding one or more alternative and higher yielding currencies to the USD. I’ve recommended holding AUD as it fell as low as .65. I continue to recommend AUD, CAD, and KRW.

As potential retirees witnessed the fall of their pension funds and investment products with Fannie Mae (FNM), Freddie Mac (FRE), Lehman Brothers (OTC:LEHMQ), Merrill Lynch (MER), GM, AIG (AIG) etc. many have realized the need to diversify any paper assets into a variety of categories. Paper diversification should mean holding a mix of cash, bonds, equities, funds, notes etc., preferably in more than one currency and held at more than one financial institution.

Retirees could take a look at the Wall Street News Network website as a resource of tax-free dividend stocks to supplement any rental or interest income. A few of them that look interesting include PMX (7.8% yield), PMF (7.4% yield), NMZ (8.4% yield), VMO (7.4% yield), BFK (7% yield), BBL (7.1% yield), BKN (7.2% yield).

All of the funds above are mainly focused on investing in municipal bonds and pay dividends on a monthly basis.

  • Physical and Paper Commodities

Commodities do a great job of holding up against inflation in the long-term. A mix of precious metals, agriculture and energy commodities will help maintain the value of your retirement portfolio. Exposure for some commodities like gold, silver, platinum etc. can come in the form of physical delivery that you can store and resell. Most investors' exposure to commodities will come in the form of ETF holdings, fund holdings or shares in listed companies of the commodity sector chosen. Some of the commodity funds and listed companies offer high yield returns for investors.

All of the advice in this post can help maintain a retiree's nest egg and provide a comfortable stream of income to protect against many unforeseen economic developments.

Disclosure: No positions

Source: How to Prepare for Retirement Jeopardy