How the U.S. debt downgrade will affect your retirement (and what to do about it).

As I’m sure you’ve heard by now, S&P downgraded U.S. debt one notch last Friday from AAA to AA+.  Aside from the short-term angst in the markets, how will the downgrade affect those of us planning and saving for retirement?  Here are three likely consequences from the downgrade as well as steps you can take to minimize the impact on your plans.  Note: Just a friendly reminder—nothing on this site should be considered investment advice for your specific situation.

Expect increased volatility—This is the first time in history that our country’s debt has been downgraded from AAA.  Expect continued volatility in both the stock and bond markets as traders and investors digest the news and react accordingly. 

To protect your assets and maximize your returns over time you should meet with a trusted adviser to make sure that your asset allocation is appropriate based on your risk tolerance, goals, and time frame.

Also, for those at or near retirement, increased volatility means increased sequence risk.  What is sequence risk?  Stock and bond returns aren’t linear, and sequence risk is simply the risk that you will receive lower (or negative) investment returns in the early years once you start drawing money for retirement.  Early negative returns greatly increase your odds of running out of money. 

One way to minimize sequence risk is to have a year or two of withdrawals sitting in cash.  If you retire just prior to a bull market, you can pull income from your growing investments.  If you retire on the cusp of a bear market, you can take withdrawals from your cash.  That way you won’t be forced to sell investments in a down market in order to fund retirement.

Expect higher interest rates—In an ironic twist of fate, the world responded to the downgrade of U.S. bonds by buying—you guessed it—U.S. bonds.  That’s because (ratings be damned) the U.S. bond market is still the most liquid, transparent bond market in the world and investors still flock to it in times of trial. 

All of that buying pushed prices higher which sent interest rates lower.  Don’t expect that to last, however.  Just as a person with a low FICO score can expect to pay higher interest rates to borrow money, the U.S. Government can expect to pay higher rates if bond investors perceive it to be a greater credit risk. 

That’s bad news if you’re a borrower (think higher mortgage rates), but good news if you’re a lender (think higher dividends on your bond portfolio).  Interest rates are at generational lows.  Consider the downgrade the canary in the coal mine that they’re eventually going higher.  To minimize risk and increase cash flow in retirement, set a goal to retire debt free

Expect higher taxes—If rates go up, then the U.S. will be spending more of your tax dollars on interest payments.  That’s an expense that they can little afford.  In fiscal 2010, the U.S. government spent $3.456 trillion, but only had $2.162 trillion in tax receipts.  That’s a deficit of $1.294 trillion.  Similar deficits are projected for years to come. 

To get its fiscal house in order, the government has two primary tools: cut spending and raise taxes.  We all saw what a difficult time Congress had making even modest spending cuts during the debt ceiling debate.  Even if they could agree on cuts that eliminated 100 percent of discretionary spending (i.e. non-military and non-entitlement), the budget would still be deep in the red.  What does that mean?  At some point down the road we can expect higher taxes. 

How can you prepare for that?  As you work on your retirement budget, assume that things like income and capital gains taxes will be higher than they are now and save enough to cover the added expense.  Also, different states have different tax burdens.  Some states tax Social Security and pension benefits while others do not.  Sales and property taxes also differ greatly from state-to-state.  As you consider where to retire, don’t forget to consider how your income, property, and purchases will be taxed during retirement.  Finally, if you have some time to go before retiring, consider putting as much as possible into your Roth IRA and Roth 401(k).  Distributions from those accounts during retirement are free from federal tax.

With so much uncertainty, it’s easy to get discouraged.  A quick review of history, however, shows that we have always had times of volatility and uncertainty.  The key is to manage through them by recognizing the challenges you face and doing everything you can to meet them head on.  Do that and when times get better (which they inevitably will) you will be well positioned to benefit.

Thanks for reading.  Touch base if I can ever help.

Joe

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