It's time for baby boomers to play defence.
After five years of surging stock prices, many people are nearing the end of their working lives while sitting on big gains in the equity portion of their portfolios. A bear market now could tear a massive hole in their retirement plans.
While that risk is always present to some degree, there's reason to think that the danger is particularly acute right now. One of the more reliable indicators of market valuation says that returns over the next few years are likely to be disappointing.
Fortunately, those nearing retirement can use several methods to reduce the risk of being caught out by a market downturn.
A new research paper by Wade Pfau, professor of retirement income at American College in Bryn Mawr, Penn., and Michael Kitces, director of research at Pinnacle Advisory Group in Columbia, Md., outlines two of the most promising strategies.
It's important to stress that these aren't magic formulas for timing the market. In fact, the co-authors emphasize that they may reduce your exposure to stocks years before a market decline actually takes place and put you back into stocks well after a market bottom.
Think of them instead as ways to reduce your retirement risk during the crucial early years of your retirement. A series of bad returns at that point, coupled with the need to withdraw money for living expenses, can team up to reduce your wealth to a point where it can no longer generate the returns needed to fund your spending.
"The first few years of your retirement are absolutely critical," Mr. Kitces said in an interview. "The person who wants to maximize their wealth will simply own the largest amount of stocks that allows them to sleep at night. Most of the time – about 96 per cent – they will wind up fine and in many cases with a couple of kajillion dollars. But if they happen to retire in 1929, or 1973, or 2008, they wind up going broke."
The strategies outlined by Mr. Kitces and Prof. Pfau are designed to help ensure that even retiring into a market disaster won't capsize your finances.
The first strategy consists simply of reducing your stock exposure in the early years of retirement then gradually increasing it as you age. This, of course, is precisely the opposite of the traditional strategy of paring back your equity holdings as you age.
The second strategy consists of reducing your stock exposure at times – like now – when the market is seriously overpriced in terms of what is known as the cyclically-adjusted price-to-earnings ratio. The CAPE ratio was made famous by Robert Shiller of Yale University, who used it as a key part of his argument back in 2000 that stock markets were overvalued.
That prediction proved to be spectacularly correct. More recent research agrees that CAPE is not a good short-term predictor of the market, but does have a strong ability to forecast medium and long-term returns.
Retirees and near-retirees should pay attention since the CAPE of today's market is far pricier than the historical average. If past is prologue, we can expect dismal returns over the decade to come.
Prof. Pfau and Mr. Kitces experiment with various permutations of their two strategies in their paper. Generally, they find that both strategies can temper retirement risk in today's environment without requiring extreme portfolio moves.
For instance, a "rising glide-path" strategy would see an investor beginning retirement with 30 per cent of his or her portfolio in stocks, then gradually increasing the stock allocation by two percentage points a year for 15 years until stock exposure hits its maximum level of 60 per cent. This makes you least vulnerable to stock market catastrophe in the early years of your retirement, but allows you to still enjoy the wealth-compounding effects of stocks as you age.
Even better, though, is using a valuation-based approach that shifts you from 30-per-cent stocks (when the market is frothy, as now appears to be the case), to 45-per-cent stocks (when the market is moderately valued), to 60-per-cent stocks (when the market seems cheap).
No approach will let you spend limitlessly, but both strategies reduce the risk of having a market disaster blow up your retirement plan. If last week's market tremors have caused you some grief, both approaches are worth a much closer look.