Retirement Investing: The End Game

In times like these, it's tempting to squirrel away your hard-earned fortune in the safest place you can find: a federally insured bank, government debt, or maybe, if you're especially scared, convert it to cash and lock it in a big, strong safe.

The temptation is greater if you're lucky enough to already have all the money you need for retirement. You don't need to earn more in the market, so why not just protect what you already have?

If only it were that simple.

Unfortunately for skittish investors—especially those within hailing distance of retirement age—there is no obvious path to perfect safety.

Inflation, the Portfolio Killer

Of course, there are conservative investments. U.S. bank accounts and certificates of deposit are insured by the federal government (up to certain limits). You can be assured that most conservative money market funds won't lose money. Investors have no reason to worry that bonds issued by the federal government or financially secure state governments won't be paid back.

As a short-term protection strategy, these work beautifully. But over the long term, such conservative approaches can undermine even a massive fortune. The reason is inflation.

"Inflation is the big threat," says Milo Benningfield of Benningfield Financial Advisors in San Francisco. "It's the silent killer of portfolios."

And most investors should be thinking long term. A 65-year-old investor might need to cover 30 years of retirement expenses—something financial advisors call "longevity risk." (And a long, healthy life is one risk many of us wouldn't mind taking—even if it's a lot more expensive.)

Your portfolio may be safe from losses, but that's no help if it doesn't keep up with the rising cost of living. Economists and investors differ on the outlook for inflation in the near term, but even slow steady price increases can take a toll.

According to U.S. government data, in the 30 years from 1978 to 2008, the cost of energy for U.S. homes rose by 3.8 times. Increasing by 3.5 times were the average rent on a primary residence and the price of breakfast cereal.

Health-care costs are a special worry for retirees. The cost of inpatient hospital care is up 88% in the past 11 years.

Deflation, the Bigger Concern Now?

As investors have learned recently, however, the stock market is no easy fix for the inflation problem. The past 15 months have wiped out half the value of U.S. stocks, eating up more than a decade of gains for major indexes.

And there's the possibility—though not the likelihood—that conditions could get worse. Aaron Gurwitz, head of global investment strategy at Barclays Wealth, says investors should be more worried now about deflation—the threat of falling prices and asset values—than inflation.

Deflation is so destructive that it's the top enemy of the world's policymakers.

"Most likely all the things that all the governments in the world are doing will work," Gurwitz says. But, "a downside scenario is a lost decade," with no gains for investors. Long-term, high-quality government bonds protect against this scenario.

"We're not making this investment recommendation because we think it will make money," he says. "We're making it because we're worried it might."

TIPS, for Peace of Mind?

For conservative, risk-averse investors who are also worried about the long-term inflation threat, there is one relatively simple solution: Treasury Inflation-Protected Securities, or TIPS, are bonds issued by the federal government that are guaranteed to keep pace with increases in the government-calculated consumer price index.

There are disadvantages to TIPS, however. In the unlikely event of deflation, the value of your TIPS will decline. And in a low-inflation environment, your post-inflation earnings on TIPS will be low. One advantage is that, even after persistent deflation, you're guaranteed to get back at least your principal investment in the security.

Another concern about TIPS? The inflation rate calculated by the government won't necessarily keep up with what Benningfield calls your "personal rate of inflation." Depending on your age, lifestyle, and location, your own costs—for transportation, energy, housing, or health care, for example—could soar much faster than costs for the average American.

You Still Need to Diversify

For Ronald Florance, director of asset allocation and strategy at Wells Fargo Private Bank, "the first and best inflation hedge is always diversification." He advocates a broad portfolio that includes bonds, stocks, and other investments.

He's not alone. Many investment professionals and financial advisers also say diversification is best even for conservative investors who might rather play it safe with a narrower strategy.

"This idea of 'going safe' in retirement doesn't really hold water," says Barry Korb, of Lighthouse Financial Planning in Potomac, Md. Conservative investing—and the resulting low returns year after year—"increases the chances of [retirees] running out of money," he says.

The key, experts say, is some balance. Unless you're hoping to profit from a rebound in stocks, equities need not be a large portion of your portfolio. Most advisors focus retirees' portfolios on Treasuries and high-quality municipal and corporate debt.

In the stock market, investors can concentrate on shares of energy or basic material companies, which should be a better hedge against inflation than other stocks, says Joe Terranova, chief alternatives strategist for Virtus Investment Partners (VRTS).

Cash, Insurance, and Other Considerations

To ease anxious nerves, investors can make sure they have plenty of cash to cover expenses in the next few years. "Look out five years to see what their cash-flow plan is going to be," says Jay Hutchins of Comprehensive Planning Associates in Lebanon, N.H. Make sure cash will be available—without dipping into long-term investments like stocks—for major home or auto purchases, for example.

In constructing this balanced portfolio, it's important to keep an eye on all your risks—not just the risks in your investments. Do you have enough insurance, especially health insurance and long-term care insurance? If you're especially wealthy, make sure your fortune is protected from litigation, Hutchins adds.

Another way to lower the risk of running out of money in retirement involves Social Security. Korb advises clients, whenever possible, to delay taking Social Security payments, which can result in a higher monthly payout. A part-time job or consulting work can also lower risk by delaying when you start dipping into retirement funds, Korb says.

The problem with all this is that it doesn't offer a simple answer to beleaguered investors. No strategy is a guaranteed success, especially when the world's financial future is so unpredictable. But, experts say, a thoughtful, diversified strategy should allow investors to keep up with inflation while also protecting against worst-case scenarios.

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