Dealing with Retirement Risks

Frank Armstrong, III and Paul B. Brown

In light of the 2008 market meltdown, your first reaction (as well as your second or third) might be to swear off stocks and maybe even bonds forever, deciding to keep your money in federally guaranteed certificates of deposits and money market funds instead. This is understandable. When the Dow Jones Industrial Average falls nearly 34%, which is still substantially better than the performance turned in by the S&P 500 and NASDAQ, it is only natural to start rethinking things.

However, it’s important that you take the right amount of risk at every stage of your investing career. If you take too little risk in your portfolio, you will never accrue enough to meet your goals. On the other hand, if you take too much risk, a market downturn could deplete your accounts to the point where you might never recover.

Why Take Any Risk at All?

Given how difficult it might seem to balance risk, you can be forgiven for thinking that what we just said justifies playing it ultra-safe and keeping your money in something like CDs.

“Why shouldn’t I,” is a reasonable question.

The answer is simple: You can’t if you want to stay ahead of inflation and have any real (after inflation is taken into account) return. The dramatic drop in stock prices in 2008 certainly shows the downside of risk—you lose money. However, even factoring in the horrific year stocks had in 2008, in the long run (going back to 1925, a period that also includes the crashes of 1925 and 1987, as well as 2008’s dreadful performance), stocks have still have outperformed every other investment, and would have kept you comfortably ahead of inflation.

The same cannot be said of fixed income (bonds) or guaranteed investments such as CDs. Their long-term returns shows that guaranteed investments track inflation closely, and are actually net losers on an after-tax basis.

Let’s take that quick look. As we write this, the easiest and safest investment you can make is buying a Certificate of Deposit. Your local bank will pay you about 4% interest and there is absolutely no risk. (Not only is that 4% guaranteed, but so is your principal.) You give the bank $1,000, and a year later they will give you back $1,040.

Now, a 4% return isn’t bad these days, but you have to pay taxes on the $40 you earn. Depending on where you live, the odds are Uncle Sam and your state government (and maybe even your local government) combined are going to take at least one-third of everything you make. That reduces the $40 you received to $26.66, meaning you actually made just 2.66% on your money, not 4%.

But to really understand how much you’ve earned, you must factor in inflation. After all, a year from now $1,000 will buy less than it does today—thanks to rising prices—and you need to take that into account.

Well, inflation has been running around 3%, so we need to subtract that from our 2.66% after-tax return. When we do, it looks like this:

2.66% (after-tax) return – 3.0% inflation = –0.33% NEGATIVE actual return.

In other words, you actually lost ground by letting the bank hold your money for a year. Because it was an extremely safe investment, you ended up being further behind than when you started.

As you have just seen, the “safe” investment alternatives provide no return—and could actually cost you money—after inflation is taken into account. Meanwhile, stocks traditionally outpace inflation by somewhere in the neighborhood of 6% to 7%.

The net takeaway from this is that despite the disappointing market performance in 2008, the argument for “appropriate equity exposure,” as an investment theorist would put it (the rest of us would call it “owning stocks”), is as strong as ever.

However, owning stocks means accepting market risk, and that in turn means that in some years, the value of your stocks are going to decline, perhaps significantly, as they did in 2008.

However, over the long term, the rewards outweigh the risk. That’s why you need to be in stocks and put up with the occasional truly awful year like 2008. You know without being told that the overall trend of consumer prices is up. Inflation is a fact of life and it’s not going to go away. Most people assume that the official inflation rate, which has been running about 3% recently, grossly underestimates their real-life experience. (If medical costs and college tuition bills only climbed 3% a year, most of us would be thrilled.) Over time, if left unchecked, the loss of buying power caused by inflation is enormous.

For instance, most of the people reading this book can remember when a nickel bought a good sized candy bar, a soft drink, or a newspaper. That nickel won’t buy much today. Failing to keep up with inflation is no small thing. If you plan to live in retirement for a while, and/or if you want to pass on your hard-earned wealth to the next generation, you simply can’t afford a negative real return. You can’t even afford a zero real return. Assuming a modest 3% inflation rate, your real income will be cut by 26% in 10 years, 46% in 20 years, and 60% in 30 years. In other words, it will take $1.34 in 10 years, $1.81 in 20 years, and $2.43 in 30 years just to buy what your dollar will purchase today.

It follows that for you to meet any realistic investment goal, you must invest for a positive real rate of return. Like it or not, you must assume some risk in your investments. The trick is to manage risk to produce an optimal result. The prescription: Prepare financially, take no more risk than you can afford or than you can stand emotionally, and then stay the course.

Preparing financially means that money you are going to need over the next several years is set aside in rock-solid fixed income instruments such as money market funds, CDs, and short-term high-quality bond funds. These will provide the liquidity to ride out the inevitable financial storms.

Preparing emotionally means determining your risk tolerance before the inevitable market downturns. One of the surest ways to destroy wealth is to sell after the market is down. Therefore, determine your asset allocation based on as reasonable a worst-case scenario that you can tolerate, and then consider yourself committed to endure the ups and downs of the markets.

It’s not a sexy approach, and sometimes, like during the meltdown we experienced in 2008, it calls for discipline, but it’s the only time-tested way to harvest what the market offers.

What All This Really Means

We must accept certain amounts of market risk, not because we like it, but because it’s the only way to achieve our financial objectives. Accepting market risk is painless when stock markets are climbing ever higher, but it requires intestinal fortitude (our editor didn’t like the word guts) during the inevitable market declines. Managing the risks, taking the right amount of risk, providing for liquidity needs, and maintaining a long-term outlook are the essential components of a successful investment experience.

You need to think of your investment portfolio as having two parts:

• A risk-free part. These are your investments in things such as CDs, money market funds, treasury bills, bank deposits, and short-term, high-quality bond funds.

• A risky part. This consists of stocks and other equity investments.

Your first step toward managing risk is to properly divide your portfolio into the two parts, but how much in each?

If you have read this far, you already know our answer. The further you are away from retirement, the more risk you can take. That’s why we have suggested having more of your money in stocks, when retirement is relatively far off, and less as your retirement date draws near.

You must always maintain enough highly liquid, risk-free assets to cover all the expected withdrawals from the portfolio for the near- to mid-term. Depending on how aggressive you are, this could be a period of the next 7 to 10 years.

Said another way, money that you will need in the next few years should not be in the world’s stock markets; it should be in fixed income investments such as bonds and CDs.

All the rest could be in equities if you are comfortable with the risk. Remember, stock markets go up and down in unpredictable ways, and although they have always recovered and gone on to new highs, the downturns might cause you acute stress. So, if you can’t live with the market fluctuations, add more risk-free assets to the mix until you can ride out any short-term declines and sleep soundly at night.

The perfect mix is the one that makes you feel the most comfortable. We might believe that someone who is at R–5 (five years away from retirement) should have a portfolio made up of 60% stocks and 40% in bonds and cash equivalents such as CDs and money market funds. You might believe that is too aggressive, and might want to flip those percentages and only have 40% in stocks. That’s fine with us, as long as you understand the potential gains you are giving up, because over time stocks outperform any other investment.

What would the typical retirement portfolio look like over time? Early in your career, you won’t be anticipating any withdrawals for a long time, and you can comfortably load up on risky assets, such as stocks. This gives you the best chance to accumulate a tidy sum to provide a safe and secure retirement. As you get closer to retirement, you will need to shift to risk-free assets to cover the withdrawals you know you are going to make after you stop working.

Let’s use some real numbers to show how this could play out. Suppose you plan to take out 4% of your account each year to provide your retirement income. Somewhere around R–5, you will want to have a minimum of 28% to 40% of your retirement portfolio in risk-free assets to cover the needs for the next 7 to 10 years. If you are a more conservative type, you could add another 10% to those figures—boosting the percentages to 38% to 50%, respectively—just so you sleep well.

Notice that we said you want to have your retirement portfolio in place about five years before you retire. You don’t want to have your retirement decisions for tomorrow determined by what the market does today.

The more widely you diversify your risky portfolio, the better the probable outcome. We would suggest a mix of domestic, foreign, and emerging markets along with foreign and domestic real estate purchased through Real Estate Investment Trust (REIT) mutual funds and a commodities futures position (which again is possible to achieve through mutual funds).

The further you move from a fully globally diversified portfolio, the higher the risk, and the greater chance your retirement accounts will “blow up” on you. Don’t let your company’s stock, or any other stock, make up more than 5% of your retirement portfolio. You will never get compensated for risk that could have been diversified away.

One Final Thought About Risk

There is a limit to what you can expect from the world’s markets. Most economists guess, based on past experience and years of data, that the expected returns from equities might vary between 8% and 11% over the long term. You must resist the temptation to take on more risk than the diversified global portfolio offers in the hopes of increasing your returns.

You can easily increase your risk—and thereby potential returns—by using leverage, concentrated stock positions, or market timing. Although a few people will win using such extremely aggressive strategies, most of them will have substandard returns, and a few will blow up their retire accounts completely.

Although it might seem like the only way to recover from a late start or another financial disaster, you try to outperform the worldwide market averages at your peril.