With middling forecasts for many investment vehicle returns in the next decade, it might be time for advisors to review the implications for clients at or near retirement.
Christine Benz, Morningstar’s director of personal finance, outlines four factors advisors should keep in mind for retirement plans during this rocky investment period.
In What High(ish) Equity Valuations Mean for Your Retirement Plan, Benz focuses on equity valuations, which in mid-October were at around 32 on the cyclically adjusted Shiller P/E ratio. She writes this level was “exactly double its historic median and even higher than it was in the late 1990s.”
Poor fixed-income returns and a rocky equity market may have these implications for soon-to-be and new retirees, she says:
1. Asset Allocation and Glide Path
The typical investment glide path of an in-retirement portfolio starts with more aggressive vehicles and moves to safer assets, but that might not work in a world of high equity valuations, Benz notes.
In fact “lofty equity valuations make a good case for retirees starting out with a lower equity weighting,” Benz says, and by “starting out with more conservative portfolios, new retirees have a buffer of safe, nonequity assets that they can spend through as retirement progresses.”
This is the “reverse glide path” idea from Michael Kitces and Wade Pfau, which she points out is similar to a bucket strategy that allows retirees to rely on cash and bonds if stocks slide.
“If the stock market continues to perform well, the new retiree can subsist, at least in part, on the appreciation from equity holdings,” she writes. “But if stocks slide, as high valuations suggest they could at some point, the retiree can use cash and bond holdings to meet living expenses.”
Caveat emptor: Cash and bond returns are low or even negative today, and may be for a long time, so don’t “overallocate” to safe assets, she warns. Also, look at “buffer” assets such as reverse mortgages and life insurance cash value.
2. Intra-Asset-Class Positioning
Right now, Benz points out, the current U.S. bull market is dominated by a handful of names with “relative underperformance” of the rest. Hence, retirees and their advisors must look inside the portfolio as much of the overvaluation is being driven by a few mega-cap stocks, she says.
It may be time to look at small- and mid-cap stocks as well as foreign equities, which many analysts expect to outperform U.S. stocks in the next 10 years, she points out.
Caveat emptor: Attractively valued doesn’t mean it will outperform in a broad market selloff, she says. These stocks won’t save a client, but may improve a portfolio’s return potential in the future.
3. Withdrawal Rates
Be flexible when it comes to drawdown rates, that is, the amount taken out on a yearly basis. It could be 4% one year, 5% the next and so on.
New retirees should try to withdraw less in weak market environments, she says, which will allow the portfolio to “repair itself when the market eventually recovers,” she says.
Caveat emptor: Much research has shown that withdrawing too much in periods of market duress leads to shortfalls later on, Benz says.
4. Return Expectations
What returns should a client expect from stocks over a retirement horizon, especially if a bear market hits? Benz notes that many investors use a 8%-10% return, especially when looking at 20 or 30 years to retirement. But those in retirement have different issues.
“Once drawdown commences, there’s simply less room for error in the plan, and most retirees would rather be safe and assume too little help from the market than overestimate the market’s return and risk running out,” she states.
In other words, a 30-year retirement horizon should be looked at in terms of returns per decade, i.e. 3% over the next decade, and 8% in each of those after, which works out to 6% over the 30-year period, she says.
Caveat emptor: High equity valuations mean clients should make more conservative assumptions about portfolio returns, “especially if [the client’s] time horizon is fairly short,” Benz says.
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