Last week, we had a question from a reader: “My dad is nearing his retirement goal of having $2 million in investments. Most of his portfolio is in stocks now, but once he reaches that goal, what should he do? If he were to cash out, he’d have a bunch of taxable gains which would set him back on the $2 million. Leaving it in those investments seems risky too.”
Can your retirement portfolio handle another correction like this?Capital Preservation
First of all, when you’re fully retired and you are spending down the retirement fund, the main goal should be capital preservation. We don’t really know what percentage of his portfolio is in stocks, but we’ll assume 80% for simplicity sake. This is way too much stock for someone who is soon to be fully retired. The stock market is a great investment in the long run, but it’s too volatile in the short term. If you are withdrawing from your retirement fund and we have another big recession, the $2 million portfolio could take a big dive. During the Great Recession, many retirees sold at the bottom and never got back in to take advantage of the recovery.
How much investment in stock?
I believe a retiree should have some investment in stocks for some growth, but most of their portfolio should be in stable fixed income investments like bonds. Experts recommend anywhere from 0-40% stock holding after you retire. That’s not very helpful, is it? One rule of thumb is to take 100 and minus your age. So if you’re 65, you should have at most 35% invested in stocks (100-65.) While it depends on your risk tolerance, I think the rule of thumb is a good guideline.
Nobody likes to pay tax
The big concern above is the taxable gain. The S&P500 doubled since the bottom of the market in February 2009 to December 2012. If he wants to reduce his portfolio from 80% to 40% stock, he would have to pay a ton of taxes and probably have to put off retirement for a few years. That could be true if all his investments are in his taxable brokerage account. However, I suspect he must have some tax deferred and tax protected accounts as well. Nearly 50% of our net worth is stashed in our IRAs. If his accounts are similar, then he could convert his stock holdings to bonds in his IRAs. This way, he’ll have more stability and defer the tax payment until later.
Alternatives to stock market
It’s risky to have too much investment in the stock market, but we definitely don’t want to keep it in cash either. Inflation will erode the value every year and pretty soon $2 million will be worth a lot less. Here are some alternatives to the stock market.
Annuity – We can pay a lump sum in return for a guaranteed monthly annuity payment. The annuity payout is tied to interest rate, so the return is not very good now that the interest rate is so low. We will probably be better off waiting until the interest rate is higher. I need to do more research on different types of annuities to see which one makes the most sense for us.
Bonds – Bonds are a great alternative to the stock market. When the stock market goes south, investors turn to bonds. To diversify further, we can invest in a mix of US government bonds, TIPS (inflation protected), US corporate bonds, and international bonds.
CD – CD yields are very low at the moment and I will be holding off until the interest rate improves. Once the rates are better, I’m planning to build a CD ladder for a nice guaranteed income.
Real Estate – Rental properties are a great way to generate income in retirement, but they can be a lot of work. Investing in an REIT (real estate investment trust) is much easier and the payout is usually very competitive.
Gold and other precious metals – Gold is a good alternative to the stock market as well because the price always goes up when there is economic turmoil. Personally, I don’t have any investments in gold, but will keep an eye out when the price comes down.
P2P Lending – Peer to peer lending is another way to generate some extra retirement income. My P2P investments are returning nearly 13% and I’m very happy with that. However, if we have a recession and people lose their jobs, I fully expect the return to drop precipitously. P2P lending is risky and I wouldn’t invest more than 5% of our portfolio there.
Long Term Care Insurance – Let’s think a bit differently for this last one. What can devastate your retirement portfolio even if all your investments are safe? Yeap, it’s health care. A long term care facility can cost anywhere from $4,000 to $10,000 per month. If your family has any history of Alzheimer’s, dementia, or Parkinson’s disease, long term care insurance can offset that risk.
Invest more conservatively after retirement
As some financial advisers say – why keep playing the game if you already won? It’s not worth the risk to have most of your portfolio invested in the stock market after you retire. When the next big correction hits, your portfolio will lose a lot of value and it will be difficult to recover. Investing conservatively will preserve that $2 million portfolio. At this point, our reader’s dad should probably talk to a professional financial planner, perhaps one at Personal Capital if he just wants a free checkup. It will give him an idea of what to invest in and how to retool his portfolio for post retirement.
As always, I would love to hear how retirees invest their savings. How much of your portfolio is invested in the stock market? Would you be fine if the stock market take a 30% drop?
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As a fellow dividend investor, my thought after reading this post is – he is missing something. Perhaps your reader should be more concerned about the portfolio’s income, not capital preservation. I believe you missed an opportunity to advise your reader to the alternative of dividend stock investing. For instance, suggest re-balance their portfolio to dividend paying stocks with emphasis on dividend reliability and growth – who cares about the capital amount if the portfolio’s dividend payments are meeting/exceeding income needs and are rising at or faster than inflation? Dividend payments are made based on the quantity of shares held, not the stock’s current/future/past price. I believe your advice to rebalance to fixed income assets greatly increases inflation risk.
Interesting and elaborate read. I believe most of us who have been through retirement planning have had this question at some point in time or other. I completely agree with you that after retirement the goal should be capital preservation and invest more conservatively as inflation can erode earnings quite quickly.
We should invest in dividend stocks. I think this is more vulnerable.
I guess another question is if there is anything other things being counted. Is this just all stocks, some real estate, some of money not tied up. I mean $2 million in retirement is vague. I think a healthy mix of stocks, bonds, cds, and other forms you mention would work but it also depend on how much he wants to draw per year and his risk tolerance. You dont want to be to risky but you still want to make some money your funds. Heck at 2% that would be 40k per year alone. If there are no car or house payments that might be enough.
Wouldn’t one start out retirement by withdrawing say 3.5%-4% of their portfolio initially, and then simply increase it by inflation every year in retirement. As for portfolio management, examine the times when they think it’s good to get into the market and out of the market much like they should when they are accumulating?
The problem is most retirees can’t time the market very well. It’s much more difficult when you’re withdrawing because you can’t dollar cost averages in.
That’s true. It’s difficult to sell when the stock market is down, but retiree still need income. That’s why a retirement portfolio should be more conservative.
For broad diversefication across many asset classes, one alternative is to consider investing in PAUDX or PASDX (Pimco Mutual Funds) managed by Rob Arnott. Generally these funds have portions invested in bonds, equities, currencies, corporate bonds, commodities and spread the exposure to include established and emerging markets with the percentages shifting over time based on fundamental valuation metrics. Rob Arnott runs Research Affiliates and has established a pretty good track record for many years.
You certainly don’t want to put all you eggs in one basket; bonds, equities, treasuries or anything.
I agree with some of the comments that this is a great problem to have, but no one wants to pay taxes. That amount of stocks does seem like a large percentage, but it would also depend on his age. If he’s 50, it might make sense. If he’s 67, not so much.
Each thing is good to some extent-real estate, P2P lending, stocks, but one must remember that each thing (even a savings account) carries risk. It’s how you much your risk and how you diversify. It takes some research and studying to be able to really figure out a combination that works for you as an individual, rather than what the experts say.
I’ve got roughly 30-35% of my net worth in the stock market, with the rest in real estate, CDs, private equity, etc.
I’m actually pretty bullish on the markets over the next 4 years. But, I’m also SUPER bullish on real estate in superstar cities and have a lot of investments elsewhere, so I’m happy with this percentage as a retiree.
Sam
I think we have about 50% in stock market right now with real estate taking up most of the rest.
I hope you’re right about real estate. If we have another run up, I’ll probably take profit from our real estate investments. 🙂
Joe, this is my very situation. My thoughts and real life experience might be interesting to some readers. I was at this same critical mass six years ago; my wife retired, and I almost did too, but some remarkable “Black Swan” events have kept me working much longer than I anticipated in 2007. The decades to come promise more events like this. Only recently did my nestegg get back up to that amount it was in 2007.
Putting aside my questions of why this reader is asking this question on behalf of his father’s $2 million, if your reader’s father is at $2 million today, he has had a nice run up since 2009. One point on the taxes; even if $1 million of it is a capital gain (doubtful), the long-term rate is 15%. The rate isn’t going lower, and $150K on a nut of $2mm doesn’t seem like a showstopper. If there is truly complete indecision, accrue half of the gain, and pay $75K. I say this as someone who watched $700,000 in unbooked capital gains turn into -$150,000 in losses in just 15 months. When that happens, all tax problems go away.:-)
Some thoughts…
Stocks – I experienced the 57% drop in the S&P 500 from 2007-2009. For those who think that was a “once-in-a-lifetime” event, please know that the S&P 500 declined 50% in 2002. These events have shaped my outlook on future risk. The NIKKEI was over 40,000 20 years ago, and is under 10,000 today. The NASDAQ was over 5,000 in 1999, and under 3,000 today.
Taxes – Six years ago I was in 100% stocks, and 1) thought there was no realistic possibility of more than a temporary correction; and 2) I considered my risk tolerance of even a 50% correction to be something I could weather. Neither turned out to be true. This year and last, I happily paid the capital gains taxes to reduce risk, and preserve capital. Today, 12.5% in stocks, 12.5% in bonds, 75% in CDs and Money Markets).
Annuity – if one compares the real rate of return for turning a lump sum over to a financial institution, it isn’t competitive even with CDs or intermediate-term bonds. The risk of 1) the institution cratering (Lehman? AIG? Washington Mutual? Indymac?); 2) premature death, leaving all this money to the institution; 3) the fees and administration charges eating away at real return, make this unappealing with more than 30 years to go.
CDs – are at lifetime lows. But I am now willing to accept a return under inflation in order to preserve capital. I have set up ladders that allow flexibility, and am keeping some ‘dry powder’ in case a buying opportunity presents itself. I am willing to sit on this money until things become less volatile and more predictable, however long that may be.
Bonds – Priced too high for me to acquire more, and I only see downside in the future. I continue to divest, and if I am getting out too soon I can live with that much better than the alternative.
Gold (and other commodities) – I also lived through the gold run up to $850/ounce in 1980, and drop to $200/ounce, and not get up to $850 until 2008 28 years later. This doesn’t factor inflation, which when applied means that even today at $1,700/ounce it has not regained the buying power it had in 1980. Gold generates no dividends or interest. Something to think about.
Calculations of 7% real equity returns and 4% withdrawal rates we have seen as “rule-of-thumb” were based on a much more predictable history than the time we live in now. Speaking for myself, I am not seeing these types of returns and acceptable withdrawal rates going forward. I cannot sustain another catastrophic loss of capital. There is a very real emotional price to pay, as well. The stress and frustration are remarkable, and it can be relentless as events, over which one has no control, play out over years.
Well, I wish your reader’s father well. This is a good problem to have, and I don’t have any guaranteed answers but this is what I am doing based on my experiences and outlook. Thanks for reading.
Thank you for your perspective. I think most people overestimate how much risk they are willing to take. I’m that way too, but I’m still young. Once I’m getting closer to 65, I’ll try to reduce risk as much as I can. 12.5% in stocks and bond and the rest in CD sounds very safe. I don’t like the price of bonds right now either. We’ll see what happens in 2013. Maybe it’ll be the right time to move into bonds next year.
JayCezzy you are a very wise man, and your comments helped me a lot. Thanks!
I invest $50,000 in Tesla 5 years ago. I feel good about that decision now))
I’m with krantcents on this one….everybody has different retirement needs but cash flow is essential for all retirees and ideally, you want increasing cash flow in retirement to combat inflation.
So, I say, yes, you always want some money in stocks even in retirement but not likely more than 60% of your portfolio in stocks. That’s too risky.
The bond allocation-age formula is a good rule of thumb but not an absolute.
Cheers,
Mark
I think 60% is still a bit high. I’ll probably go for 30-40% when I’m 65.
Can you write an article on REITs? I’ve heard wonderful things about them, and I wanted to buy some shares in REITs through my IRA, but my advisor at Merrill Lynch didn’t really advise it. He thought it was too risky! He said however that there are funds that include REITs, but he didn’t want me to just buy into one REIT. Any comments or insights?
I have to do more research. I’ll work on it. 🙂 Vanguard VNQ is probably a good start.
Everybody has different retirement needs, but you want growth as well as income in retirement. I would want a mix of income producing stocks/bonds as well as some growth funds. You still nee a diversified portfolio or asset allocation to avoid too much risk.
I had never heard that saying “why keep playing the game if you already won?” before, but it’s brilliant!
I personally don’t feel people should have too much of their overall net wealth in one asset class. As you said – When you are at retirement age the game changes to be all about preservation of capital. What better way to preserve capital than to diversify across many different assets.
Not sure I agree with you in regards to bonds though. They have certainly become far more risky in the last few years.
Thanks! I like the saying too. 🙂 I think bonds are still great investments, but the price is high at the moment.