Retirement should be the time when you are less stressed and should have fewer worries, after all you no longer have the stress of the commute or your job. Many find those worries replaced with others including fears they might run out of money or be forced into a diminished lifestyle. Those fears are justified; inflation increases your expenses and diminishes the value of any fixed income you receive, health care costs are a great unknown, or you may live much longer than predicted increasing the chance you could outlive your resources. Guarding against some of those dangers by having the correct mix of assets to provide enough growth without taking on excessive risk may be challenging.
The risk that you might outlive your assets may be dramatically increased if you happen to retire at the “wrong” time. What happens for example if your timing is poor and you just happen to retire before a market decline? What does that mean for your portfolio? A declining market combined with the withdrawals you may need to make to create that “retirement paycheck” will put a severe strain on your portfolio and dramatically increase the odds that you may run out of money especially if you live for 20 or more years in retirement.
This risk, commonly called “Sequence Risk” or order of return risk (bad timing combined with withdrawals), is a risk that can devastate the portfolio of retirees.
An example will make it much clearer:
If you retired in 1996 and had a portfolio of $100,000 all invested in an S&P 500 index you would have experienced the following sequence of returns.
- 1996 – 23.10%
- 1997 – 33.40%
- 1998 – 28.60%
- 1999 – 21.00%
- 2000 – (9.10%)
- 2001 – (11.90%)
- 2002 – (22.10%)
- 2003 – 28.70%
- 2004 – 10.90%
- 2005 – 4.90%
If you were withdrawing $6,000 per year to meet your income needs in retirement your portfolio would have grown to $162,548 and your withdrawals would have been $60,000 for a total of $222,548.
Now consider an alternative universe where the order of returns is reversed as follows:
- 1996 – 4.90%
- 1997 – 10.90%
- 1998 – 28.70%
- 1999 – (22.10%)
- 2000 – (11.90%)
- 2001 – (9.10%)
- 2002 – 21.00%
- 2003 – 28.60%
- 2004 – 33.4%%
- 2005 – 23.10%
With the same $100,000 portfolio and annual withdrawal of $6,000 your portfolio would be worth $125,691, combined with the $60,000 in annual withdrawals it totals only $185,691. Now the $6,000 withdrawal represents 4.8% of your portfolio instead of 3.7% in the original scenario. If you were not making withdrawals the sequence would not have mattered, your portfolio would be worth the same with either pattern of returns, $238,673. There is no impact if you are not making withdrawals. (People in the “accumulation” phase of their life may benefit from dollar cost averaging.) It is the timing of the withdrawals that particularly impacts prospects for your invested assets. Selling an asset that has declined in price dramatically limits your ability to capture the upside during market recoveries. Managing sequence risk means you need to try to avoid the sale of asset classes that are in the throes of a bear market. Here are some suggestions:
Have enough in fixed income (bonds) – If you have a portfolio of $1,000,000 and need to withdraw $40,000 each year, have enough in bonds to guarantee the $40,000 is available for 7-8 years in case a bear market is very severe. That means having no more than 70% of your portfolio in riskier, growth assets.
Reduce your withdrawal rate – Manage your discretionary expenses so you can reduce the demands on your portfolio until the market recovers. There are various rules based approaches we’ve studied.
Have more recurring income through your Social Security claiming strategy or by buying immediate income annuities – Delaying Social Security till age 70 may dramatically increase your monthly income. Turning some of your portfolio into a steady income stream by annuitizing it can enable you to invest differently since you know you have a safe income floor.
Consider a Reverse Mortgage – Establish a Home Equity Conversion Mortgage (HECM) early on in retirement to act as a backup source of funds to tap during market declines.
We will discuss these strategies in future blogs.
Understanding your exposure to “Sequence Risk” and having a strategy to overcome it may be critical to your retirement.
Stephen C. Craffen, CFA
Interest rates have been low for years, dramatically impacting anyone who must hold a large position in cash. There may be several reasons why you need to hold a large cash position, perhaps you have some anticipated large expense looming, or you need to have a large cash reserve for an emergency. You might have thousands of dollars in cash, earning .25% in a money market account. Can you earn more?
Here are some of the investments you might consider and why they may not be good choices.
Floating Rate Loan funds – are funds that invest in bank loans, very often those that are below investment grade. Right now, some of these funds have yields that range from 4-6%, a huge improvement over a money market fund. Unfortunately, these types of funds are subject to more risk than one would expect. In 2008 when markets were crashing some of these funds also declined in value by 25-30%. During a financial crisis, the default rate for the loans these funds hold can also skyrocket and impact return. Exposure to that amount of risk is not what you want for your cash reserves.
High Yield Bond funds – High yield bonds are generally considered to be bonds that are rated BB or lower by S&P or Ba by Moody’s. They have historically provided high income over the years. Like every other class of bond, yields are now low when compared to their historical yield; yet their risk has not decreased. Like floating rate loan funds, in 2008 high yield bond’s return was -28%, illustrating how risky this asset class is during economic slowdowns or financial crises. Like floating rate loans their default rate also tends to rise dramatically during recessions.
Longer Term Bond ETF’s – May have a much higher yield than a money market account but they come with much greater risk not from defaults (for government bond funds or high-quality corporate’s) but instead from increasing interest rates. The market value of the bonds they hold can be quite sensitive to interest rate changes. For example, Vanguard’s Long-Term Government Bond ETF (VGLT) lost 1.8% for the prior year ending 5/31/2017. That includes it’s yield which is around 2.7% right now. If interest rates rise long term bond funds can easily have negative returns as high as 6% in one year, since the bonds they buy may decline in value that much or more for each 1% increase in interest rates.
Preferred Stock Funds – Companies may issue several classes of stock including common stock and preferred stock. Preferred stock is issued with a fixed and typically high dividend, right now yields are in the 4-6% range. If a company is liquidated preferred shareholders receive whatever is left after bond holders are reimbursed but before common stockholders. Preferred stock has much of the risk of common stock since it is effectively an unsecured debt (unlike a bond) but it lacks the potential for growth since the dividend is fixed and the preferred stock may also be callable. Because of these features we do not believe it is a good investment for most people. In a bad market, preferred stock acts like common stock. In one case, an ETF that invests in preferred stock dropped 61% from May 2007 to March 2009.
While this list is not complete, we hope we’ve given you a feel for the risks you may encounter in trying to get more yield. You increase your exposure to types of risk that generally do not exist with a money market account. Those risks in summary include, market risk, interest rate risk, and default risk. When we consider these options, I recall something a professor wrote on the black board when I was getting my Masters in Finance: TINSTAAFL. None of us could guess what the heck that meant until he told us: There Is No Such Thing as A Free Lunch.
Title: Voices: On the need to better understand risk
Quote: “Advisers are using the wrong software along with bad assumptions. I’ve also seen a lot of advisers throw up their hands at asset allocation software and decide not use any. I can see why they get frustrated, but I think abandoning the programs altogether is a bad idea. Finding better software that imposes realistic views on asset class returns or that uses a statistically viable method of incorporating the adviser’s views is still an improvement over the “seat of the pants” approach.”
Click here to view the article.
Title: Seeking Safe Investment Alternatives by Kevin DeMarrias
Quote: “We strongly caution people about taking on too much risk in attempting to increase their yield”, said Stephen Craffen, a Partner in Stonegate Wealth Management LLC in Fair Lawn. “They need to fully understand the additional risk they may be taking by investing in high yield bonds, preferred stock, etc.”
Stonegate Wealth Management, LLC is pleased to announce that Firm Founder and Partner, Stephen Craffen has been appointed by the National Association of Personal Financial Advisors (NAPFA), to act as the President of the North East/Mid-Atlantic Region for the 2012/2013 fiscal year. In accepting this honor, Mr. Craffen will be leading the region of the United States with the largest NAPFA membership.
Mr. Craffen has been a member of NAPFA since 1998. He has served as a volunteer for NAPFA in many capacities over the years. Mr. Craffen has served as a member of NAPFA’s new Leadership and Development Committee for the National Board, helping to establish the procedures that will be used to select future National Board members and he has served on the Eastern Region Conference Committee for several years. He has also organized and helped to run a series of educational symposiums on the East Coast for the past three years. Additionally, Mr. Craffen was a study group director for NAPFA’s Eastern Region.
NAPFA is the nation’s premier organization of fee-only financial advisors. As a member of NAPFA, Mr. Craffen adheres to a strict code of ethics and has signed an oath stating that he will not accept commissions of any kind.
Mr. Craffen is looking forward to leading the North East/ Mid-Atlantic Division of NAPFA stating,
“I look forward to continuing my service to NAPFA and helping it maintain its role as leaders in the financial planning field.”
Craffen founded Stonegate Wealth Management in 1993. The firm became a fee-only firm in 1998 to provide its clients with the highest levels of financial planning and investment advisory services on a cost-effective basis and without product bias. The firm has $210 million in assets under management. Steve is a Chartered Financial Analyst (CFA) charter holder, recognized as a hallmark of excellence in securities analysis. A graduate of Stevens Institute of Technology (1977 BE), he also earned a Master of Business Administration from Rutgers University in 1983, and a Masters in Financial Planning in 1998 from the College for Financial Planning in Denver Colorado.
Partners in the firm include Craffen, Thomas J. Geraghty, CPA, CFP, and Craig R. Marson, CPA, J.D.
For Release 9 a.m. EDT, May 18, 2012
Stephen Craffen on the Wall Street Journal: “Investing in Funds: Sell Your Laggards”
Title: When Funds Turn Cold, Do You Sell? by Michael A. Pollack
Description: Steve explains how to decide whether to stay or whether to go when top performing mutual funds turn into laggards.
“Keeley Small Cap Value, which focuses on smaller companies, sizzled in the mid-2000s. A 33% total return in 2004 beat its category average by 14 percentage points, putting it in the top 1% of its group.
But in 2008, its performance slid dramatically. Its average return of minus 2.5% a year for the three years through July places the fund in the bottom 4% of its Morningstar category for that period.
The fund appears to be a victim of its earlier success, says Stephen Craffen, an adviser in Fair Lawn, N.J. From around 2005 to 2007, it remained open to new shareholders, even as assets ballooned to more than $3 billion from around $300 million.
As funds swell, their managers have to take larger and larger positions to make a difference in overall portfolio performance.
Mr. Craffen, founder of Stonegate Wealth Management LLC, says he is gradually pulling clients’ money out of Keeley, selling shares whenever he needs cash to rebalance portfolios. Its performance hasn’t lagged as much in the past nine months, but I am fearful just because of its size, he says.”
Click here to view the entire article.
Title: Suspension of BP Dividend Hits Investors by Rebecca Olles
Description: Article weighs in on how BP cutting it’s dividend will affect individual investors both domestically and internationally. Steve is asked his opinion on the subject.
” Stephen Craffen, a financial adviser for Stonegate Wealth Management in Fair Lawn, said the suspension sets a bad precedent.
‘It bows to politicians by not paying the dividend,’ he said. ‘It will hurt local investors because they’ll hold back their dividends three quarters and hurt their cash flow and affect the value of the stock in turn.’ ”
Click here to view the entire article.
Annoucement: Stonegate Wealth Management’s very own Steve Craffen has been elected to serve on NAPFA’s Northeast Regional Board of Directors. We are very honored that he has received the opportunity to serve in such a position and very proud of his achievement.
Click here to view the entire election results.