America's increasing reliance on the 401(k) plan and other defined-contribution retirement accounts is a double-edged sword. On the one hand, because investors (and not pension managers) decide how the funds are invested, they have more control over the funds they'll need during their later years.
But gone are the days when most investors can count on a predictable income stream from a defined-benefit pension once their career comes to an end. If the market takes a wrong turn at the wrong time, it could mean losing years of hard-earned savings.
When it comes to long-term investing, a degree of cautiousness can be a virtue. Those who have planned for the next bear market before it arrives are in a better position to absorb the shock of a market downturn and maintain their current lifestyle.
Here's what you can do now to protect your nest egg from the inevitable volatility of the market.
- When markets become volatile as retirement nears, it can put a damper on years of otherwise diligent retirement planning and create extra anxiety.
- As you get older, your portfolios should shift to more conservative investments that can weather bear markets, and the amount of cash on hand should also grow.
- Even if you retire right on the cusp of a recession, be diligent with your withdrawal plan and do not let emotions cloud your judgment.
- If you withdraw retirement early (before age 59½), you will be hit with a 10% penalty and may owe taxes due.
Maintain the Right Portfolio Mix
The single most important thing you can do to mitigate risk is to diversify your portfolio. Some investors believe having their savings in a mutual fund means they're in good shape. Unfortunately, it's not quite that simple.
There are two key types of diversification that every investor should employ. The first is asset allocation. That's the amount of each asset class you own, whether it be stocks, bonds or cash equivalents such as money market funds.
As a general rule, you want to lessen your exposure to riskier holdings (e.g., small-cap stocks) as you get closer to retirement. These securities tend to be more volatile than high-grade bonds or money market funds, so they can put investors in a bigger hole when the economy goes south. Older adults, unlike younger workers, simply don't have enough time to wait for a recovery when stocks take a hit.
That's why it's important to work with a financial advisor and determine the asset allocation that best fits your age and investment objectives. Because asset categories will grow or decline at different rates over time, it's a good idea to periodically rebalance your account to keep the allocation consistent.
Say you own a portfolio with 55% of the holdings in stock and 45% in bonds. Suppose that stocks had a great year and, because of these gains, they now comprise 60% of your account. Rebalancing means selling some of the stocks and buying enough bonds to maintain your overall risk profile.
Protect Retirement Money From Market Volatility
"Having a portfolio with bond funds can counterbalance market volatility. At the same time, a sufficient amount of stock funds can help preserve the principal and counterbalance inflation," says Daniel Schutte founder of Schutte Financial in Denver.
The other type of diversification happens within each asset category. If 50% of your portfolio is dedicated to stocks, look for a nice balance between large-cap and small-cap stocks and between growth and value funds. Most advisors suggest having some exposure to international funds as well, in part because it cushions the blow of a U.S. economic slump.
Keep in mind that not all bonds are created equal. For example, the debt of companies with a low credit rating, known as junk bonds, is more closely correlated to stock market performance than high-grade bonds. Therefore, the latter is a better counterweight to the stocks in your account.
"Most of us in the financial world are familiar with the asset class 'quilt,' the image with all the colored boxes that shows which asset class performed best for a particular year," says Carol Berger, CFP, of Berger Wealth Management in Peachtree City, Ga. "It is called a quilt for a reason. The different colors (asset classes) are scattered all over the place from year to year. Emerging markets, for example, was at the top in 2007, at the very bottom in 2008 and back to the top in 2009."
"Within the past 10 to 15 years, many different asset classes have been in the top spot," Berger adds. "With this lack of a 'pattern,' so to speak, why would anyone try to predict which one will outperform? This is one way I explain to my clients the importance of diversifying."
The goal is to have a proper mix of assets that historically don't rise or fall at exactly the same time.
Have Some Cash on Hand
Those who are already retired have to maintain a delicate balancing act. To protect against outliving their assets, most financial planners suggest holding onto at least some stocks.
At the same time, retirees need to be more cautious about their investments because they don't have the long time horizon that younger investors do. As a safeguard against economic slumps, some investment professionals suggest keeping up to five years' worth of expenses in cash or cash equivalents, such as short-term bonds, certificates of deposit and Treasury bills.
"When you retire, most of your expenses should be relatively stable," says Kirk Chisholm, a wealth manager at Innovative Advisory Group in Lexington, Mass. "However, on occasion, a big expense can come along unexpectedly. When this happens, you cannot compensate for it by working more hours. You will need to address these expenses by dipping into your savings. The last thing you want to do is to take money out of your investments when they have temporarily dropped due to market conditions."
If you're worried that the rate of inflation will grow and eat away at your purchasing power, consider having some of your "cash equivalents" in the form of Treasury Inflation-Protected Securities, or TIPS. While the interest rate on these securities is fixed, the par value increases with the Consumer Price Index. So if the rate of inflation hits 4% annually, your investment grows right along with it.
"If you can get a decent level of current income from a TIPS, the inflation adjustment component keeps the buying power of the principal intact," says Stephen J. Taddie, CBE, CFM and managing partner at Stellar Capital Management in Phoenix, Ariz. Remember, though, if you buy a TIPS at a premium and we enter a period of deflation, future inflation adjustments could be negative.
Be Disciplined About Withdrawals
Simply put, the more money you have squirreled away, the better position you'll be in should a bear market arise. This may sound simple, but too many retirees overspend in retirement, which leads to poor investment decisions that are made out of desperation.
The antidote is simple: use discipline in your spending habits. Most experts suggest withdrawing no more than 3% to 5% of your funds in year one of retirement to maintain a sustainable lifestyle. From there, you can adjust your annual withdrawal to keep pace with inflation. So if you determine that you can take out $2,000 a month in the first year and consumer prices rise 3% annually, your allotment would grow to $2,060 by year two.
By planning your withdrawal allowance, you eliminate the need to liquidate a large sum of assets at fire-sale prices simply to pay the bills. "Retirees' mistakes most often come from taking out too much of their retirement assets early on and panicking when the markets are struggling," says Patrick Traverse, founder of MoneyCoach in Mt. Pleasant, S.C. "Make sure you have a solid plan and stick with it."
If you are still saving for retirement, making an early withdrawal can be costly. If you are under age 59½, qualified IRA and 401(k) accounts withdrawals will usually come with a 10% penalty, and you will probably need to pay taxes on all the contributions and gains that you have deferred. So, if you were to withdraw $100,000 early, you'd be hit with a $10,000 penalty as well as $25,000~$35,000 in taxes, depending on your income tax bracket—meaning you may only get 60%~70% of what you thought you were taking out.
However, in March 2020, Congress passed the Coronavirus Aid, Relief and Economic Security (CARES) Act, which allows retirement savers to withdraw up to $100,000 from accounts penalty free if they have been impacted by the COVID-19 pandemic. Distributions must be taken by the end of 2020. What's more, to minimize the tax hit, reporting these distributions as income can be divided over three years.
Don't Let Emotions Take Over
If there's one tendency to avoid when saving for retirement, it's impulsiveness. When stocks take a plunge, it's tempting to try to cut your losses by selling shares. But most of the time, investors choose to act after the downturn is well underway.
You're better off staying the course when things are rough. If you're rebalancing your nest egg on a regular basis, you may actually buy more stock when the market's down to keep your allocation in check. By purchasing at a low—or near the low—you're poised to maximize profits when the market eventually rebounds.
It's equally important to have a steady hand when the economy is humming along. If you're still saving for retirement, resist the urge to cut back when your 401(k) is exceeding expectations. The market will always have ups as well as downs. Those who are ahead of expectations prior to a bear market will invariably have an easier time handling the fallout.
"Most people think of risk as 'the size of the probability that something bad could happen,'" says John R. Frye, CFA, chief investment officer at Crane Asset Management in Beverly Hills, Calif. "I do not agree. Risk is the size of the probability that something unexpected might happen, and unexpected events are equally likely to be good. It’s a bell curve."
"If you can survive the short-term effects of a downturn," Frye adds, "you can afford to take risks and should not fall for the notion that you should pay a high price to hedge it away. I've got dozens of retired clients who stayed fully invested (in equities) through the delightful market of 2008-2009. They are all grateful they did."
The Bottom Line
By its nature, the economy will always experience boom and bust cycles. Investors who take a disciplined approach and diversify their portfolio are almost always in a better position when the next bear market arises.