The Bull Market Could Ruin Your Retirement

(Bloomberg Businessweek) -- Here’s the good news for many people in their 60s and 70s: The long bull market has fattened retirement portfolios. But after such a long rally, we’ll likely see slowing growth or even a sharp decline in the markets. That, combined with increasing life spans, puts recent retirees in “a really unique and dangerous place,” says David Blanchett, head of retirement research at Morningstar Investment Management.

For retirees who take annual withdrawals from savings, a long stretch of below-average returns early on can make it impossible for a portfolio to fully recover. Even if the market outperforms later, the gain would be on such a depleted pot of savings that it wouldn’t undo the early damage.

While trying to time the market is a fool’s game, preparing for a possible downturn as retirement approaches is a smart move; the bull market has been impressive, but it’s not immortal. Consider that since 2009, returns on the S&P 500 index have averaged about 15 percent annually, vs. 10 percent over the past 90 years. After accounting for inflation, Morningstar is forecasting virtually no gains for U.S. stocks over the next decade.

Retirees can buy annuities that guarantee income to cover fixed expenses, and some financial planners recommend what are called market-linked notes. Those investments cap gains in good years but limit losses in bad ones. So if the market were to rise, say, 20 percent, holders might see appreciation of just 15 percent, but they would be protected from losses of as much as 20 percent. “Most of our clients are either retirees or pre-retirees,” says Thomas Balcom, founder of 1650 Wealth Management LLC, who uses the investments as a hedging tool. “The last thing they want is a huge drawdown on their portfolios.” Many planners, though, eschew such instruments because they can be confusing for less sophisticated investors and can be expensive. Balcom says annual fees built into the notes are about 1 percent of the security’s value.

A relatively simple way to lessen risk is to move out of equities and into bonds and cash. But with interest rates on the rise, fixed-income securities are likely to fall in value. And with inflation creeping up, the lower returns on safer investments will fund even fewer years of retirement. “Unfortunately, that’s part of the natural trade-off to manage risk,” says Michael Kitces, a financial planner at Pinnacle Advisory Group Inc.

Another strategy is to think in what financial planners call “buckets,” separate accounts that are invested to accomplish various goals. A short-term bucket in cash would cover at least one year’s expenses, generating almost no income but having virtually no risk of loss. A second bucket aiming for long-term gains would be mostly equities. And an emergency bucket, with another year or two of income in high-yielding cash equivalents or short-term bonds, would get tapped if stocks drop and then replenished by selling shares when the market recovers. “The early years before and after retirement are when planning really matters,” says Michelle Fait of Satori Financial LLC. “The money you’ll need in the next year won’t be invested for that long, so you’re not ‘missing’ huge returns. In exchange, you won’t have to sell off investments in a falling market if it comes to that.”

Daniel Lash of VLP Financial Advisors says steering a good chunk of a portfolio into a bucket of bonds can help protect against a spell of bad stock market returns. For a client with $1 million in assets who wants $50,000 in annual income, he suggests keeping as much as $350,000 in bonds, with most of the rest held in equities that can be cashed out in good years. The bonds would typically generate sufficient returns during a down market to cover living expenses, and “when equities are performing well, they’re being sold to provide the needed income,” Lash says.

Finally, investment pros suggest that people nearing retirement consider what might happen if they end up being shunted out the office door a few years earlier than expected. By treating retirement age as a variable in planning models, they can see how a forced retirement would affect savings goals. “Someone retiring in 2009, at the bottom of the cycle, may have had a much smaller retirement balance compared to balances today, but had the ability to grow their accounts over the past nine years,” says Ryan Marshall, a planner with ELA Financial Group Inc. “Someone retiring when the market is high may not be ready if we experience another significant downturn.”

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