The following question was recently posed by a reporter:
What kind of advice are advisors offering clients who are either retired (especially those who have recently retired) or who are preparing to retire shortly, who may have just experienced a big drop in the value of their financial portfolios, as well as possibly a drop in their home values. Beyond telling people to pare spending or continue to work, is there any good advice you can offer to people in this situation?
It's a valid question, and one of great importance to many. This topic is something that I have been addressing in a course I teach at UCLA and in presentations around the country. If I may, let me take a moment to frame the issue.
First, I would like to set an assumption that these people have a diversified portfolio, with stocks and bonds. I am less concerned with the real estate unless it was part of the retirement plan, as in sell the home and downsize. If that was a plan, it may still be viable since real estate has not lost value at all the price ranges. But let me leave the real estate alone going forward.
So back to the investments. Let me digress and suggest that there are two main strategies to deal with down markets (over simplified, but we'll start there for the sake of brevity). Investors may follow some type of active strategy (market timing, sector rotation, etc.) designed to not participate in the downturn or a buy-and-hold type of strategy designed to ride through the market downturns. (See more on this concept at my post, Navigating Volatile Markets)
Whether they realize it or not, most investors have a default buy and hold type strategy. But they don't fully understand this concept, so when they are in the midst of a downturn, they look to make a change, which is usually the worst thing to do. The time to react to a down market is before it happens!
So back to your question. The equity allocation of a decent portfolio should be able to go from loss to recovery in 3 to 5 years. If the portfolio is simply an S&P 500 type portfolio, it may take a little longer. I bring this up since taking money from a portfolio when it it down is the single biggest factor that causes a good retirement plan to fail. As an example, following a 50% loss a 100% gain is required to be break even. In more realistic terms, a 10% loss, with a 5% withdrawal rate is a 15% loss. If that 5% withdrawal rate is needed again for income, then it takes a 25% return to get back to the original investment amount. Said another away, if you have a 5% withdrawal rate, a 10% market loss requires a 25% market return to break even. However, without the 5% withdrawal rate, a 10% loss only requires a 12% return to break even.
So, were does the cash come from? Anywhere but the stocks! One strategy is to spend down the fixed income in the portfolio. With a 30% fixed income allocation in a portfolio, that portfolio can provide a 5% withdrawal rate for 7 years using cash flow from the bonds alone (using a low 4% yield on the bonds). After 6 years, the bond are gone. In order for the stocks to make up for the spent bonds, they would need to average 5% a year, after the loss and recovery is considered. Based on historic bust and boom periods, this is reasonable.
A 40% bond portfolio would have 10 years of cash flow from the bonds, and the stocks would need the same average 5% a year above the boom and bust returns.
This is not the only strategy, but it provides a good example of the way to think about the problem. The goal is to minimize pulling money from the equities when they are losing money. A home equity loan can be used as a way to normalize cash flow. Not as a regular practice, but say a major expense (medical, necessary home improvement, child's wedding) comes up when the market is down. One could tap into a home equity loan and make the minimum payments until the market recovers, then pay off the loan. I don't want to get into the numbers, but if you think about the 10%/25% (loss/gain needed) with the withdrawal verses the 10%/12% without you can see the value of not tapping the portfolio in a down market.
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