Wealth Matters – Q3 2002
Download this newsletter as a PDF.
Got Retirement?
NO ONE FEELS a bear market’s bite like retirees. The market trauma of 2001-02 has been particularly severe for them. Stocks have fallen a long way fast, leaving many people disillusioned, fearful and paralyzed.
The market will recover over time. But time is exactly the prob- lem for many retirees, as well as older workers nearing retirement. People who must harvest their as- sets for income cannot afford the volatility and uncertainty that may still lie ahead.
What retirees can do - If you are currently retired, losses to your retirement account may have increased financial pres- sure. Consider these actions:
- Buy time for asset recovery. You want to avoid having to liquidate assets for income when they are depressed. If your portfolio has experi- enced major erosion, do whatever is necessary and possible to give investments time to recover. This may require temporarily cutting lifestyle, postpon- ing purchases or taking a part-time job to meet ba- sic expenses.
- Reduce withdrawal rate. Research indicates that a well-diversified retirement portfolio can support a yearly withdrawal rate of 4% over 25- year market scenarios. Increasing payout to 5% or more reduces the odds that the portfolio will out- live its owner.(1) Although there is no assurance that future stock and bond performance will model the past, taking a more conservative payout will place less pressure on current assets.
- Review income strategy. The first step is to prioritize withdrawals from taxable and tax-de- ferred accounts. You may want to take the mini- mum required distribution from your retirement plan or IRA rollover—and give the assets more time to compound tax-deferred. Also evaluate the most efficient and least costly ways to generate income from other assets. For in- stance, you should have two or three years of income in cash or cash-equivalents so that another market downturn would not force untimely liquidation of stocks. You can employ a bond laddering method to receive a higher fixed return while reducing overall inter- est rate risk.(2) Regarding asset al- location, you might avoid liquidat- ing assets that have depreciated and draw from assets showing gains. Finally, if you desperately need cash flow and have home equity, you can generate cash while real estate values are still high by refinancing or acquiring a line of credit or reverse mortgage.(3)
Nearing retirement – If you are within five years of retirement, start preparing for a financial and lifestyle transition. The recent market slump adds strategic urgency to your plans. Consider the following:
- Accept reality. Three years ago, a booming market and supercharged economy offered hope of an early, fat retirement. But quick wealth was an illusion of the market bubble. Now stock returns are regressing to the historical average. Don’t look back and second guess your decisions. It’s time to accept the truth about markets, money and invest- ing, and use this knowledge to recover and build assets for retirement.
- Keep working. If you don’t yet feel secure enough to retire, postpone it for a few years. This can have multiple benefits. You can avoid tapping investments while they are down, fund lifestyle from current earnings, put away more new money and give assets time to recover and hopefully grow. You will have less time to spend on leisure, and by delaying your pension and Social Secu- rity claims, you can re- ceive larger payments later.
- Save and invest more. The late-1990s stock boom enabled people to save less of their income without falling behind in their re- tirement account. This is one reason why the na- tional savings rate declined sharply over the last decade.(4) But in the future, one cannot look to the market to make up for a low savings rate.
Saving more income is strong medicine that can force personal spending down and help you accli- mate to a lower-cost retirement. Put away as much as possible in tax-deferred vehicles and take ad- vantage of company-sponsored plans and match- ing contribution arrangements. The 2001 tax bill raised the allowed contribution to qualified plans, and you should invest the maximum amount to catch up.(5) - Set specific goals—and work toward them. Your financial profile is likely changing as you approach retirement. Managing it takes planning and periodic attention. Revisit your financial plan to confirm that your accumulation goals are realis- tic and reflective of your lifestyle today.
Managing portfolio risk is even more important for a middle-age worker. Unlike prior generations, who typically received guaranteed pensions for life, most workers now have self-directed retirement plans, such as 401(k)s. Employees must take responsibility for investment decisions and will reap the subsequent rewards or bear the misfortunes. - Envision your retirement. New research sug- gests that retirees who stay active (eg, part-time work and community involvement) are more pre- pared for retirement than people who pursue full- time leisure.(6) You should begin forming personal goals for your retirement years. This may involve refinancing your home, moving to a new area and making other major decisions while still working.
General Principles – Consider a few guidelines that both retired and nearly retired investors should follow:
- Question return assumptions. Academics and financial managers are claiming that long-term re- turns for stocks will fallover the next decade. Most estimates place fu- ture returns in the 7% to 8% range—down from the 10.7% total return generated by the S&P 500 index from 1926 to 2001.(7) A diversified portfolio may return even less due to its re- duced exposure to stocks.
Research suggests that investors have ad-justed their expectations downward, but not to a level that reflects current valuations.(8) Your return expectation is important. It influences your finan- cial decisions regarding savings rate, spending, in- vestment goals, risk tolerance, market sentiment and willingness to stick with your basic strategy through a downturn. - Concentrate on risk reduction and asset mix. Retirees cannot afford taking large financial hits to their wealth. But the longer your time horizon and larger your retirement account, the more risk you can afford to assume. Rely on portfolio design to reduce risk and stabilize returns. Moreover, a dis- ciplined rebalancing strategy will help keep your portfolio mix in line with the original investment plan. When returns are volatile, asset adjustments can add precious percentage points to return.
- Watch taxes and expenses. Taxes and inci- dental portfolio costs can drag down investment performance. Investment and withdrawal strate- gies should factor in the tax impact and cost of management and administration.
- Don’t panic. The current financial environ- ment is hard to navigate due to the combination of low stock returns and low interest rates. Some investors are tempted to dump stocks and flee to stable-income securities, such as bonds and fixed annuity contracts. These investments can have a stabilizing role in your asset allocation. But they also carry risk. Bonds will decline in value when in- terest rates start rising, and various bond types, such as corporates and municipals, carry specific risks as well.(9) A diversi- fied portfolio may offer a satisfactory to- tal return with more downside protection, upside potential and asset control than a pure fixed income strategy.
- Examine your past strategy. The market has delivered disaster to aggres- sive traders and investors who overcon- centrated in individual stocks.(10) Learn from these misfortunes and avoid the thinking that produced them. Conversely, the last two years have proven the value of diversification and periodic rebalanc- ing. A diversified portfolio has not felt the extreme effect of the market decline. By holding a mix of stocks and bonds, large and small cap stocks, and both do- mestic and overseas investments, diversi- fied investors have limited their overall losses because asset groups have not per- formed the same.(11) Having a well-defined investment strategy and structured portfolio can help you endure the uncertainty of market cycles, however extreme the volatility may prove to be.
(1) The study evaluated how various stock/bond mixes and payout rates would have en- dured for every 25-year invest- ment period from 1926 to 1995, based on historical returns. They concluded that an asset mix of 75% stocks and 25% bonds, with a 4% maximum pay- out rate, would produce the highest odds of the portfolio surviving over 25 years. (Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz. “Retirement Savings: Choosing a Withdraw- al Rate That Is Sustainable”, AAII Journal, Feb. 1998, pp 16- 21.)
(2) Laddering involves purchas- ing fixed income securities of varying maturities to guard against interest rate risk.
For example, you acquire Trea- suries that mature every six months over a two-to-five year period. This produces a steady stream of income while reduc- ing the impact of rising interest rates on the market value of the bonds.
(3) A reverse mortgage enables a homeowner age 62 or over to extract equity from his house in the form of a lump sum, credit line or monthly annuity. Pay- ment of the new debt is de- ferred until the homeowner dies. The amount of the loan will depend on age, home value, current interest rates, terms and location. In general, the older you are, the higher your home value, and the larger your equity stake, the more you can borrow. Acquisition costs are similar to those for regular mortgages. The money provided to you from a reverse mortgage is tax-free. However, the funds may affect your eligibility for certain kinds of government as- sistance.
(4) The national savings rate fell from 8.7% of disposable income in 1992 to 1.6% in 2001. (“Don’t Think the Market Will Pump Up Your Nest Egg”, Wall Street Journal, 12 June 2002, D1)
(5) The 2001 tax law increases contribution amounts in tax-de- ferred plans. An IRA allows a $3,000 per year contribution and climbs to $4,000 in 2005 and $5,000 in 2008. This additional amount increases to $1,000 by 2006. Anyone over age 50 can invest an extra $500 per year. Participants in 401(k)s, 403(b)s and 457 plans can contribute an $11,000 yearly maximum, which increases gradually over the next five years to $15,000 in 2006. Workers over 50 can use the catch up provision to invest an additional $1,000 annually, which rises to $5,000 by 2006.
(6) “Retirement Guide”, Busi- ness Week, 29 July 2002, p89.
(7) The S&P 500 and other stock market indexes are not actively managed. You cannot invest di- rectly in an index or average. Past performance is no guaran- tee of future results.
(8) A mid-2002 Business Week / Harris Poll survey reported that workers now expect equities to produce about a 10% long-term yearly return, compared to an expected return of 16% in 1998. They expect a balanced portfo- lio to return about 10%, com- pared to 13.8% in 1998. (“Retire- ment Guide”, Business Week, 29 July 2002, p88.)
(9) Fixed income vehicles are increasing in risk. For in- stance, the default rate among municipalities has risen as many aggressive projects planned in the boom years are now showing distress. In the corporate bond arena, the same negative forces affecting company profitability, credibility and stock performance are also influencing their debt ratings.
(10) Despite decimated retirement accounts at Enron and other failed companies, many workers are still holding too much employer stock. According to the Employee Benefit Research Institute, retirees 60 and older have more than half of their 401(k) assets in stocks—and al- most one-third of these people are concentrated in their company’s stock. (“For Investors Near Retirement, Stock Market Poses Stark Choices”, Wall Street Journal, 23 July 2002, A1.)
(11) Small-cap stocks tend to experience greater volatility than large-cap stocks. International investments involve special risks, including economic and political uncertain- ty and currency fluctuation. There is no guarantee that any diversification strategy will outperform other invest- ment approaches.
Stock Volatility
DRAMATIC market swings have many people saying that the U.S. stock market has grown more volatile. They are only half correct. Overall market volatility is not trending upward. The higher volatility they perceive is among individual stock returns.
A study featured in the Journal of Finance explored the roots of volatility in stocks. The conclusions offer a number of compelling lessons about the value of diversification in managing risk within a portfolio.(1) The study found that:
> Company-specific risk accounts for most of the return volatility experienced by a common stock,
> Individual stock returns have grown more volatile over the last 20 years, while volatility at the industry and market levels has no established historical pattern or recent upward trend, and
> Individual stock returns are show- ing lower correlation today than in ear- lier times—that is, returns are more dis- similar for a given time period.
The authors could only speculate why individual stock volatility is in- creasing. Their reasons included rising specialization among companies, higher risk taking from management and herd mentality behavior of institutional in- vestors. Regardless of the reasons, the study offers compelling lessons in port- folio management, which include:
- Diversification is even more impor- tant today. Investors who hold only a few stocks bear the full load of firm- specific risk. The market doesn’t offer a return premium to investors who as- sume this “unsystematic” risk because it can be virtually eliminated through broad diversification. Conversely, a well-diversified portfolio mostly as- sumes “systematic” risk—the risk of being in the market or in an asset group having unique performance dimensions.
- • Low correlation (combined with higher diversification) helps reduce re- turn volatility. How can individual stock volatility rise without affecting the total market? Because declining correlation among stocks has offset the effects of their higher volatility. Modern Portfolio Theory proposes that holding stocks with low correlations can reduce portfo- lio risk and improve total return.
- The methods of diversification have evolved. Three decades ago, convention- al wisdom said that 15-20 well-chosen stocks could effectively diversify a port- folio. Today, if individual stocks are in- deed producing more volatile returns and are less correlated, it follows that a larger group of stocks is needed to di- versify. Since the mid-1980s, reducing volatility (standard deviation) has re- quired a larger number of stocks in the portfolio.
- A nondiversified strategy is riskier than ever. As individual stock perfor- mance becomes more extreme relative to the market, the risk of not diversifying has intensified. Investors who hold con- centrated positions in stocks should take note—and especially people who own a large position in company stock, con- centrate in a particular industry or sec- tor, or implement aggressive trading strategies, such as day trading.
Of course, effective diversification depends on both the quantity and quality of stocks and other asset groups chosen. But the message of this research is clear. Diversification is the primary tool for managing risk. If individual stock re- turns grow even more unstable in the fu- ture, diversification’ s strategic role will increase as well.
(1) Campbell, John Y., Martin Lettau, Burton G. Malk- iel, and Yexiao Xu. “Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyn- cratic Risk”, 25 May 2000
View Post