For each year in which a bull market persists, workers become likelier to retire. But those who leave the workforce now — the ninth year of the longest U.S. bull market — are potentially setting themselves up for a tough stretch that could test their portfolio’s long-term resilience.
Why? When the stock market becomes historically expensive, as some metrics suggest it is today, research shows it’s often a harbinger of below-average future returns. This can be especially painful for retirees with long life expectancies because withdrawals combined with poor returns will leave less in an account to compound over decades.
Take, for instance, a 65-year-old who retires when his or her portfolio is worth $1 million. If the retiree withdraws 4%, or $40,000 in the first year, and the portfolio loses 40% of its value soon after, he or she will have just $576,000 left to fund a retirement that could last 30 or more years. Any subsequent withdrawals will make it even harder for the portfolio to recover.
Returns in “the first five to 10 years of retirement matter most,” says Wade Pfau, a professor of retirement income at the American College of Financial Services in Bryn Mawr, Pa. Early declines can “lock a portfolio into a downward spiral.”
That doesn’t mean that people on the cusp of retiring should cancel their plans. For one thing, it’s notoriously difficult to predict the arrival, duration and severity of bear markets. And if you are ready to leave your job, sticking around may undermine your health and happiness.
The good news: There are steps you can take to limit withdrawals from stocks when they are down and partly protect your portfolio. Just be sure to understand the trade-offs.
1. Build a cash cushion
This strategy typically involves setting aside one to five years of living expenses in cash so you won’t have to sell stocks at depressed prices.
Retirees with cash buffers often react more calmly to market declines, reducing the odds that they will panic and bail out of the market completely, says Ross Levin, a financial adviser in Edina, Minn.
The problem, Mr. Levin says, is that the low returns on cash often reduce a portfolio’s long-term returns. “If you have 80% in stocks and 20% in bonds with a three-year cash position, that’s a worse strategy from a returns standpoint than having 70% in stocks and 30% in bonds,” and nothing in cash, he says. A cash buffer “allows you to manage a client’s psychology during bad times, but it’s not an optimal strategy.”
To solve that problem, some advisers instead use bonds as a buffer. A $1 million portfolio with 60% in stocks and 40% in bonds effectively holds eight years of living expenses in bonds, Mr. Pfau says.
But if stocks sink and a retiree needs to liquidate bonds to cover living expenses, the buffer is likely to shrink.
To prevent clients from selling stocks at depressed prices to replenish their bonds, many advisers recommend waiting until the stocks recover their losses to do so. But an investor who used such a strategy in 2008—when the financial crisis slammed U.S. stocks—would have had to draw down his or her bond buffer for about five years before starting to build it back up, a nerve-racking experience for all but the least risk-averse, Mr. Pfau says.
A better strategy, many say, is to invest in a diversified portfolio — such as 60% in stocks and 40% in bonds — and rebalance it after major market moves.
Retirees who do so will use their winners to cover at least some of their expenses. For example, in 2008, when the S&P 500 (.SPX) lost about 37%, investment-grade bonds gained about 5.25%. As a result, someone who had 60%, or $600,000, in stocks and 40%, or $400,000, in bonds before the crash had 47%, or $378,000, in stocks and 53%, or $421,000, in bonds afterward.
If a retiree with such a portfolio needed $40,000, he would start by withdrawing the $21,000 of bond profits. Because bonds comprise significantly more than 40% of the post-crash portfolio, the investor would whittle them further, by withdrawing the additional $19,000 in spending money he needs. To re-establish the desired 60% stock-40% bond allocation, he would then transfer $77,400 more to stocks from bonds.
In contrast to holding a “cash buffer,” this approach “systematically ensures” that an investor sells holdings that have appreciated most while also buying things that have declined and are relatively cheap, says Michael Kitces, director of wealth management at Pinnacle Advisory Group Inc. in Columbia, Md. By shifting money into assets that are beaten down, rebalancing helps a portfolio recover faster when a turnaround finally arrives, he adds.
According to recent research, which looked at 140 combinations of investment strategies, withdrawal rates, and buffer-zone sizes over successive 30-year periods from 1926 to 2009, investors came out ahead with cash-buffer strategies in only three instances. In contrast, with rebalanced portfolios, they came out ahead in 70 simulations, said co-author David Nanigian, associate professor of finance in the Mihaylo College of Business and Economics at California State University, Fullerton. In the remaining 67 combinations, the strategies performed the same, he said.
How often should you rebalance? Some investors do so quarterly or annually. Cameron Brady, an adviser in Westlake, Ohio, says he acts when his clients’ portfolios drift by five percentage points from target allocations.
3. Use another type of buffer
What if you like the idea of a cash buffer, but don’t want to tie up a portion of your portfolio in an asset that’s sure to earn low returns?
To provide clients with a source of cash in the event of a market meltdown, some advisers recommend using home-equity lines of credit or reverse mortgages, which allow people ages 62 and older to convert their home equity into cash.
Both charge upfront fees. For example, the upfront “mortgage insurance premium” many borrowers pay on reverse mortgages is now 2% of the home’s value, capped at $13,593.
With a home-equity line of credit, Mr. Pfau says, borrowers must make monthly repayments. (Reverse mortgages must be repaid when the borrower dies, moves, or fails to pay property taxes or homeowner’s insurance.) Both charge interest.
Mr. Pfau recommends that people with permanent life insurance, including whole life and universal life policies, consider tapping the cash value in these policies during market crises. You can withdraw premiums tax-free and also borrow from the cash value to get additional tax-free income, he says.
“You will reduce the death benefit,” he adds, “but by helping to preserve the portfolio, you are probably better off.”