From the August 2007 issue of Boomer Market Advisor • Subscribe!

Equities in retirement? Not so fast

We're living longer, and financial advisors know it. They explain to newly retired clients that their nest eggs should last 30 or even 40 more years. A heavy bond allocation made sense when most retirees had only ten years of life left in them. But shouldn't a 30-year time horizon call for growth -- and lots of it?

It depends. Aside from each client's particular needs regarding required distributions, there are sound reasons to think twice before assigning a heavy stock allocation to retirees.

Distributions effectively shrink time horizons - While advisors may hope their clients don't touch their principal, many retirees rely on prudent investment management and careful budgeting to ensure they don't outlive their assets. As long as retirees spend more than they earn, the portfolio won't benefit from compounding, and avoiding an erosion of principal becomes more challenging.

To illustrate, assume a client retires with a $2 million portfolio and requires a hefty $200,000 annual distribution. A portfolio generating an 8 percent return will last just over 20 years. But with a single 15 percent loss in year 10, the portfolio will be depleted in 17 years. Because a 20-year accumulation period has widely different investment implications than a 20-year distribution phase, there's no guarantee that an asset allocation fit for the former automatically makes sense for the latter.

The timing of a loss matters greatly in the distribution phase - When clients are accumulating assets, compounding allows early losses to be recouped in later years. But a client who has closed the accumulation spigot is at greater risk of loss today than on his 80th birthday. Here's why:

Assume a couple has just retired, placed $2 million with you, and wants $130,000 each year for living expenses. You deliver an 8 percent return for the next 14 years, but lose 10 percent in years 15 and 16. At the end of year 16, your clients will have $1.96 million. If you go back to generating returns of 8 percent a year, by year 25, the couple will have $2.3 million.

However, if you lose 10 percent in years one and two, and deliver an 8 percent return in the next 14 years, by year 16, the assets will have shrunk to $884,827 with the same $130,000 annual distributions. Even if you continue delivering 8 percent annually, your clients will have depleted their nest egg early, in year 27.

Secular bear markets happen - Historically, stocks have alternated between long bull and long bear markets. Clients who happen to retire just as a bear market gets underway can suffer greatly from a heavy equity allocation.

As an example, assume the newly retired couple with $2 million and $130,000 in annual distributions earns 10 percent on stocks every year, except for years 1 and 2 when they lose 20 percent and 10 percent respectively. Also assume they always earn 5 percent on bonds. Because of the early losses and the distribution requirements, the couple is better off with a 40/60 stock/bond allocation than a 70/30 split -- even 30 years out.

If, instead, stocks provide 0 percent return in years one through five, but delivered a 10 percent return thereafter, the client is still better off with the lower equity allocation through year 14. It's only in year 15 that the 10 percent returns make up for flat performance experienced early on.

As stock indices set new highs, our examples might seem irrelevant. Yet the bear market that occurred from 1966 through 1981 produced a cumulative loss of 10 percent over the entire period. Even planners who are bullish on stocks should understand that bear markets won't necessarily accommodate their clients' retirement goals. Given the importance of avoiding losses early in retirement, the chance for sub-par stock market returns should have some bearing on asset allocation decisions for the newly retired.

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