During past bull markets, many Americans nearing retirement
fleetingly acquired a nest egg adequate for later life. Then, as quickly as
that nest egg came, it went—leaving behind regret, sleepless nights, and in the
worst case, panic selling near the bottom that eliminated any possibility of
recovery. This happened in the late 1990s, as the tech-stock bubble produced a
blizzard of paper millionaires that melted away faster than a cherry snow cone
in August. It happened in the mid-2000s, as Americans grew ever more
comfortable with stock-heavy portfolios and with treating their home equity as
an ATM, only to be savaged by the worst financial crisis since the Depression. And
it will happen again. In March, the current bull market will be six years old.
It might run an additional six years—or end in April. Regardless, the lesson
from financial history is clear:
Pascal’s Theory
Add up your basic annual expenses, and make sure to include
the taxes you’ll owe on required and voluntary withdrawals from your retirement
accounts and on the income and capital gains in your taxable assets. Then
subtract your Social Security and, if you’re lucky, pension checks. This leaves
you with your residual living expenses, or RLE.
The rub is that your retirement is reasonably assured only
if the bulk of those assets is in relatively safe holdings. On three different
occasions in the past eight decades, the S&P 500 has experienced five-year
drawdowns of 30% to 60%; if you enter retirement at the start of such a bad stretch
and stack 5% annual withdrawals on top of those equity losses, your nest egg
will evaporate so fast that you’ll have little left by the time the markets
finally recover.
If you’re of a certain age and have saved and invested well,
it’s possible you’ve just now won the race. As such, this may be a good time to
start reducing the risk in your portfolio. Those paltry coupons are the direct
result of accommodative Federal Reserve policy, which has inflated the stocks
in your portfolio. If you have substantial equity exposure, you have far more
assets than you would without Fed intervention, and the pile of fixed-income
securities you can now buy with those equities will more than make up for their
low yields. In other words, the probability of error matters less than its
consequences. Put yet another way, when faced with the imponderable, the wisest
course is the one with the most acceptable worst-case scenario.
Retirement investing fits this to a T. Let’s say you’ve
acquired an adequate retirement nest egg, as defined above, and decide to
increase your bond exposure in the belief that stock prices will fall. But the
stock market proves you wrong by powering ahead. Sure, you’ll be sorry you just
blew your chance to buy a BMW and fly business class. But if you bet on rising
prices and hold a too-high equity exposure—and straight out of the gate run
your barely adequate savings into the buzz saw of retirement withdrawals during
a bear market—the outcome will be far, far worse. This is precisely what
happened to many new retirees in 2000 and in 2008, and at some point, it will
certainly happen again to retirees who should have known better.
Just Do It
Take a hypothetical investor named George who retired on
Jan. 1, 2000, at age 65 with a $1 million all-stock portfolio, and spent
$50,000 a year on his RLE, adjusted for inflation. Considering the S&P 500
lost 41.2% in nominal dollars (or 53.4% after inflation) between the day he
retired and Feb. 28, 2009, George would have barely $100,000 left of his nest
egg by the end of September 2014. Had he held a 70/30 stock/bond portfolio,
using intermediate Treasurys as his bond component, he would have $428,000
left; and had he held a 40/60 portfolio, he’d have $703,000 left.
George got into trouble with an overly aggressive portfolio
because his nest egg was barely adequate to support his retirement—that is, the
recommended 20 years of RLE.
If you do decide to reduce your equity exposure, how quickly
should you do it? Since no one knows when, or even if, stock valuations will
decline, the “correct” answer to this question will only be clear in hindsight;
you could do it all at once, or you could do it gradually over the next few
years. The key thing, though, is to do it.
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article on The Wall Street Journal.