A subscriber to TheStreet's new premium publication, Retirement Daily, recently wrote to us: "What is the best thing to do with a 401(k) if the market keeps crashing or we go into another recession when I only have a few more years to go before retiring? I need to minimize losses at this point."
This question is asked frequently, especially during stock market volatility the likes of which we've seen this week. And this concern is a common one. If fact, many investors, and especially those on retirement's doorstep, are anxious about the market right now.
Consider, for instance, the results of the most recent Wells Fargo/Gallup Investor Optimism Study, conducted over the summer. That study found that:
- Most U.S. investors expect stock market volatility to continue throughout 2018 (81%) rather than settle down before year's end (19%).
- Sixty-five percent say the "worst is ahead of us" in terms of volatility, with 35% saying the "worst is behind us."
- At least six in 10 agree that volatility has caused them to pay closer attention to their investments (62%) as well as to the market as a whole (59%).
- Fifty percent surveyed say they're 'very worried' about the impact of the U.S. political climate on our financial markets.
That said, let's start with my response and then then we'll provide you with answers from several influential financial advisers. (We have ideas, analysis and suggestions from some of the best advisers and wealth managers in the country. Today, we'll bring you the first three, and the rest tomorrow.)
It's critical that you first craft (either on your own or better yet with the help of a financial adviser) a retirement-income plan. Those who have such a such a plan don't worry about market declines. And those who don't have a plan, worry.
I'll assume that you don't yet have retirement-income plan. If that's the case, let's create one. First, you have to crunch some numbers. Calculate, as best you can, your current and future expenses in retirement (housing, healthcare, transportation and the like). Next, calculate, as best you can, your sources of income in retirement (earned income, Social Security, pensions, retirement accounts, and the like).
To be fair, you might not know how much income to expect from your accounts earmarked for retirement. For sake of argument, let's assume that you can withdraw somewhere between 3% to 4% per year for at least 30 years. Advisers refer to this as the 4% rule, which -- in essence -- is a systematic withdrawal plan or a what advisers refer to as a SWP or SWIP.
If your income matches your expenses, congratulations.
But before you go patting yourself on the back, let's look at a few other strategies and items to factor into your plan.
As we've written in the recent past, advisers use several strategies and tactics to create a retirement-income plans. Besides SWPs, advisers also use something called floor-and-upside, as well as buckets.
With the floor-and-upside approach, some would have you match your guaranteed sources of income (Social Security and a traditional defined-benefit pension plan) to your essential expenses in retirement, and your non-guaranteed sources of income (your personal assets) with your discretionary expenses. And if there was a gap, you would use a portion of your personal assets to make up the difference between your guaranteed sources of income and your risky assets. Some advisers would, for instance, have you purchase a single premium immediate annuity, or SPIA, to cover the gap.
The upside portfolio would be invested in risky assets (stocks) and fund discretionary expenses.
With the bucket strategy, you would match your assets against your liabilities based on time horizons: short-, intermediate- and long-term. There are lots of variations on this approach but the essence of it is this:
- For those retirement expenses you'll incur over the next one to five years, you would invest in safe and liquid assets. Income would be your primary investment objective.
- For retirement expenses you'll incur over, say, the next six to 15 years you'll invest in a mix of stocks and bonds. Growth and income would be your investment objective.
- And for those retirement expenses that you'll incur beyond 15 years, you'd invest in stocks and some bonds. Growth would be your primary investment objective.
Besides deciding which strategy to use, you also have to review all the risks you might face in retirement and how'll manage those risks. Read more here.
Once you've addressed all those risks, you can also contemplate how you'll you allocate your assets among the various accounts you might have (tax-deferred, taxable and tax-free) and the various investment and products you could use to accomplish your goals.
Some other things to consider: Your goal is to create the most tax-efficient income in retirement, and doing that might require work and the help of an adviser who can conduct 'what-if' scenarios for you. And second, plan on making course corrections to your plan at least once per year. Tomorrow will not be the same as today even though you think that might be the case.
One last item -- As you think about your portfolio, think about something called your risk capacity: How much money can you afford to lose before it starts to affect how much income you can could withdraw safely from your portfolio to support your standard of living.
So, for instance, if you have a portfolio of $100,000 and you can afford to have it fall to $90,000 you have a risk capacity of $10,000. Learn not only your tolerance for risk as part of this process but calculate your risk capacity as well. Knowing that will give you some peace of mind and less worry about losing money before you retire.
Now, what to do our advisers have to say?
Dirk Cotton, Financial Planner, The Retirement Café
Reports in the news media following the "Tech Crash" and the "Great Recession" were replete with the poignant stories of households who approached retirement over-invested in stocks and found their retirement plans delayed by several years due to market losses. Some wondered aloud if they would ever be able to retire, so you're right to be concerned.
Advice to invest only about half of your savings in stocks for the years approaching and following retirement is probably a fair rule of thumb but a better allocation can be determined by when you will need to spend the money you have invested. It is very likely that a savings portfolio will recover from a bear market in seven to 10 years or less (after retiring, a portfolio from which you are already spending recovers much more slowly).
If there is a portion of your savings that you don't plan to spend during that period, you might choose to leave that money invested in stocks and assume that it will likely recover before you need to spend it. Stocks that you need to spend sooner might not have time to recover from large losses in time.
This means that the more retirement income you have protected from market losses in annuities, Social Security benefits, pensions and the like, the more savings you can leave invested for the long term.
A lower stock allocation before retirement is more important when those non-market resources are limited. My advice would be to reduce your stock holdings to about 50% of your savings this close to retirement. If you want to do a little more math, figure out how much of your savings you probably won't need to spend in the next seven to 10 years and invest that portion in stocks.
Mitch Fryling, Financial Adviser
Context and expectations are extremely important. After an extended bull market it's always a good opportunity to look back and review your asset allocation and determine if they align with your financial goals. Market risk is one of the biggest retirement risk that retirees face and it's important to understand that market volatility is normal. I often review a little market history with clients and put the recent market history into context. Being only a few years from retirement, it's a great time to sit down and review or create a retirement income plan. The planning process will help you define your goals and help you understand whether you're on track or need to make a few tweaks to get back on track.
While markets this year have acted a bit more "normal" in terms of the ups and downs that we've seen, trying to time the market is a dangerous habit. I instruct my clients to think long-term, thanks to medical advances and healthier lifestyles retirees are living into their 80s and 90s, leading to a 25- to 30-year retirement phase. This is significant, it's important to have a plan and to set good habits to avoid any big emotional mistakes that can derail your retirement. After reviewing your retirement income plan and determining the right course of action you can look for ways to reduce the risk within your investment portfolio.
While things like your goals and risk tolerance will drive the appropriate investment allocations, you will need to consider where best to place those assets and how best to diversify. While most 401(k) plans have started to provide a broader selection of funds to choose from limitation to exist. Cost is important as well as you look across your various investment accounts to determine the best way to implement your retirement strategy. Generally, being close to retirement you will want to increase your bond exposure to reduce the potential big ebbs and flows from the stock market. One way to protect the stock part of your portfolio is to look outside of the domestic markets. Investing globally over the long term has been extremely effective. Historically, a portfolio with an allocation to international stocks has experienced less volatility than a stock portfolio with a total allocation to U.S. stocks only. Other investments can make sense depending on your investment approach.
Looking beyond investments, it's important to consider the various ways to protect the longevity of the portfolio. Another risk that retirees face is what's known as sequence-of-return risk: that's the risk that a market correction could occur early in retirement forcing retirees to spend a larger percentage of their investment portfolio. While this is a major risk, there are ways to protect your investment portfolio. One popular approach is known as a bucketing approach or segmentation approach where you set-up three buckets. The first would be your basic spending needs for the next three to five years and would consist of cash and CD-type investments. The second bucket for years six to 15 and would primarily consist of bonds maturing within the six- to 15-year time frame.
Finally, the third bucket would be your longevity portfolio and would hold your stocks and possibly some bonds. This approach provides some piece of mind that if you experience a market correction early in your retirement that you have cash on hand to meet your basic spending needs while providing the long-term growth that you need to meet your retirement goals. It's important to incorporate other income into your plan such a social security or pension income that you may have coming in to meet your spending needs.
Kerry Uffman, Owner, TWRU Private Wealth Management
Your subscriber's intuition is correct, you don't sit back and expose your wealth to damaging losses before your retirement years begin. But my question for them is this: Is the intuition just to be tactical to avoid damaging losses or more should a pre-retiree be more strategical?
Pre-retirees will be moving from their wealth accumulation years (whereby strategically stressing making decisions to maximize wealth) to the need to strategically re-organize for the next longtime period called the de-cumulating years.
During our working years, strategically we make decisions to maximize our wealth... essentially balancing financial capital wealth according to our return objectives in concert with our personal risk tolerance. So, for many years we focused mainly on the choice of how much to have in "risky assets" vs." safe assets" to drive our wealth towards the goal so to be able to retire as desired.
For pre-retirees, this old choice of "risk-on vs. risk-off," requires re-engineering. The new evolving choice needs to be: Do you want a retirement that is based on hope and probability or choose more a retirement engineered for the much stronger value of expectation?
The pre-retiree's change in strategic choice: The "hope" pursuit is replaced by "expectation engineering." Having engineered expected outcomes has to evolve as the pursued essential strategic value and the new mantra of a pre-retiree.
So, to resolve the question about risk avoidance that the subscriber initially posed, you must re-frame the question by first doing some essential engineering steps.
First, the subscriber should determine how much annual retirement income for spending is required to harvest just from financial capital wealth. I like the idea of a rolling floor of expected income from all source of retirement income at least the first 10 years of retirement.
This claim for a rolling 10 years on financial capital is relieved by the next group of engineered formulations: Isolate income sources from part-time work and solidify plans to harvest annually social capital such as pensions and Social Security.
Muted by part-time work and social capital sources, then you can acknowledge how much financial capital will be expected to be drained annually.
Second, now your first expectation level is revealed. You will know the required annual dedication of financial capital to draw down to meet your expected lifestyle on a year by year basis for a rolling 10 years.
Having the revelation of this annual dedication claim upon financial assets is called "expectational flooring." If the subscriber can re-engineer retirement wealth to meet expectational flooring goals, then the need for a new investment tool chest is brought into play. A tool chest that involves putting assets in the financial capital mix that will fund the expectational flooring requirements. This tool chest is actually the "safe investment" tool chest to construct retirement income that is always stable, sustainable and secure. These three values point to a dedication of the financial capital part of wealth that must be "safe" and "not-risky."
So the tactical choice to avoid market losses, is solved by first the strategic asset dedication of building expectational flooring, not "risk-on and risk-off" tactics. Wealth that is not dedicated to this expectational flooring is by design available to become part of "risky" asset portfolio. The "risky" asset portfolio can follow the subscriber's investment policy used to grow wealth for long-term needs and keep the rolling floor rolling.
I have found by first building an expectational floor via dedicating assets to actually have the 10-year flooring in place, is much better than the hope or probability proposition of the way wealth is invested in the wealth accumulation period of our lives. Don't be surprised that both the traditional investment portfolio based on risk tolerance doesn't remind you of the engineered portfolio based on the build a floor, then expose the upside approach. The risky asset profiles likely could be the same even if arrived in different ways. Nevertheless, I like the idea that expectational engineering can emotionally guide you through market and downs because you will know the asset dedication methods used will secure retirement income at least 10 years out... so you can ride the volatility waves you are now concerned with always a 10-year horizon of expected income.
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