Paul de Sousa, senior vice president at Sightline Wealth Management, who leads the firm’s private wealth team, suggests financial advisors start by doing a sensitivity analysis. This “what-if” analysis looks at what kind of shocks the portfolio can withstand without it affecting the client’s annual withdrawal rate and long-term income projections. Then, make adjustments as necessary.
Afterward, take time to explain the results so clients understand that their retirement income stream will be unaffected by an economic downturn and possible market impacts. Having the discussion now may stave off panicked reactions later.
“You can show them that their portfolios can withstand, say, a 15% shock and they can still withdraw the amount they planned to and it won’t impact their retirement,” says de Sousa. “They still have money at age 95.”
Depending on the client, these analyses can take some time. de Sousa reiterates to conduct these analyses now since it’s impossible to predict recessions. “There’s a lot of calm and peace knowing that when there’s blood in the streets and CNN is blaring about how everything is falling, you know ahead of time what will happen given a certain rate of return,” he says. “There’s no better strategy than to have done that, but you can’t do it in the midst of a crisis.”
Diversification Is Key
The first quarter is the traditional time to rebalance and diversify holdings, and given last year’s rallies in almost every market, most portfolios are likely imbalanced. But explaining why clients need to diversify and rebalance is easier said than done, says Chris Battifarano, chief investment officer of FineMark National Bank & Trust.
The past decade has not rewarded diversification, as the S&P 500 has outperformed many other sectors, including small caps and international markets, he says, and that’s twisted some people’s view of investing. People are questioning the need for diversification in other markets based on recent history, but that’s a mistake.
“If you think there will never be a recession again and the U.S. is the strongest market in the world, then don’t diversify. Be long U.S. large caps,” Battifarano says. “But we don’t believe there’s been some permanent sea-change in the world. Diversification is the key to building a more robust portfolio that can weather drawdown periods, whether they’re recessions or bear markets.”
To Battifarano, diversification means investing across the spectrum in equities, both in market capitalization and geography, but also in traditional fixed income.
In fixed income he looks both at investment grade and high-yield markets, but also what he calls “opportunistic credit,” such as mortgage-backed securities and other investments that have a slightly different risk exposure than traditional fixed income.
In a historically low interest-rate environment financial advisors have had to think creatively about how to access yield for their clients who need income. That’s caused some people who traditionally have invested in investment-grade credit to move out on the risk spectrum and buy more high yield. But in a recession, that could be a huge problem, he says.
“We don’t think high yield is worth the risk,” he explains. “It goes along with the idea that the economy is fine. When there’s a recession, high yield is going to suffer because these are the least creditworthy borrowers.”
Joseph Polakovic, owner and CEO of Castle West Financial, also thinks that the risks of fixed income are too great for income investors. He looks to stock dividends instead for his income clients, focusing on the high-quality companies that can withstand a recession.
With the markets strong now and no recession in sight, Battifarano says for his clients who need to take required minimum distributions, he is doing those much earlier in the year because of the higher valuations. He points out the average price per earnings ratio is trading at 19 times earnings, compared to the historical norm of 15. “You just don’t know what tomorrow will bring. And if you have to generate some liquidity, you might as well do it at 19 times, versus whatever it will be in the future,” he says.
Balance Short- and Long-Term Needs
The three sources say financial advisors need to think about how to balance their clients’ short-term retirement income needs in a recession, with their long-term needs for future income. The last thing clients should do is tap assets that were geared for long-term savings for short-term needs. People who tapped equity markets for income during the 2008 financial crisis locked in those losses.
Polakovic says financial advisors should keep about two years of clients’ short-term income needs in conservative investments, “to let them ride the wave” of a recession, he says.
For de Souza, that means putting two to three years of income requirements in cash while clients ride out a few bad years. “Now markets don’t usually decline for two or three years in a row. That rarely happens, but I’m being extra cautious,” he says.
Analysis by Sam Stovall, chief investment strategist at CFRA Research, shows that from 1945 to 2019, there were nine bear markets where prices fell between 20% and 40%. These markets declined 11 months on average and took 14 months to recover. There were three “mega-meltdown” bear markets with declines of 40% or more, which lasted on average 23 months and took 58 months to recover.
Battifarano says clients need to have a cash management plan for cash flow needs, especially during a recession. “Figure out what your spending requirements are, and try to stick to those. Have ample sources of liquidity in advance. You don’t want to be in a portfolio that’s 100% equities that’s had a drawdown of 30%, and now you’re forced to sell for living expenses. That’s the worst position to be in,” he says.