Nearing retirement? Is it time to de-risk your investments?

Americans can no longer subscribe to the buy, hold and pray mentality that currently dominates 401(k) investing, especially as they approach retirement. There are no dress rehearsals when it comes to retirement … it has to be right the first time.

I believe that retirees need to de-risk their investments in an orderly fashion the older they get. Equities are very volatile no matter if the trend is up or down. A retiree on a fixed income cannot ride the ups and downs in the stock market and take, say, 4% out of their portfolio every year to live on when the markets are down.

The last 10 years is a good example. Here is the S&P 500 (broad stock market index) return for the 10 years ending 12/31/2010:

2010 14.32

2009 27.11

2008 -37.22

2007 5.46

2006 15.74

2005 4.79

2004 10.82

2003 28.72

2002 -22.27

2001 -11.98

The annualized rate of return was 1% for these years, if you left all of your assets in this fund for 10 years. But, for retirees who had to withdraw money from their equity investments to live on, they were much harder hit. Taking money out in 2001, 2002 and 2008 makes it much harder to recover because the later positive returns are applied to a much lower base. If this repeats for the next 10 years, retirees on fixed income will be on food stamps sooner than they think.

I think that we are in a completely new investment environment since 9-11 and retirees may not want to rely on any historical data before 9-11 in your planning. You may want to ask your financial advisor about well-diversified investments with, say, 60% in fixed income (primarily bond ladders and TIPs …Treasury Indexed Annuities), 40% equities (strong weighting in dividend paying common and preferred stocks), and some estate properties with rents. If retirees had this type of portfolio on 1/1/2001, they could “live off” the dividends, principal repayments, interest and rents without having to sell equities at the bottom. This would have a much better outcome than a portfolio heavily weighted in stocks.

Some will say that retirees need to be heavily invested in stocks to account for inflation and a longer than expected lifetime. Here is how I answer these concerns:

1. The Social Security life expectancy table indicates that a male aged 65 can expect to die in 17 years or age 82. This is an average and this retiree may die earlier or later.

2. Inflation: The heavy equity volatility may not be appropriate for someone on fixed income with a 17 year time horizon. Using TIPs, dividend paying equities, real estate and inflation protected annuities will help keep pace with inflation. You may give up some additional investment return, but you will sleep better at night. Your question should be: is the possible additional stock market return worth the risk of continued stock market volatility?

3. Longevity: While this retiree is expected to die at age 82, he may live to age 110. How can the retiree deal with this risk? He could buy an annuity at age 65 that starts payments at age 82 for the amount he will need at that age, adjusted for inflation. This “longevity annuity”, allows him to only have to plan for investing the remainder of his assets for 17 years and eliminates the guessing and risk.

For more information, David Pitts wrote a good paper on low-risk portfolios for asset liability management and I’m sure that he would be happy to send you a copy.