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By Christine Benz and Jeremy Glaser | 03-01-2017 10:00 AM

How Retirees Can Brace for Market Volatility

With experts forecasting lower equity returns, Christine Benz says those who are early in retirement are most vulnerable and offers some ways to prepare.

Jeremy Glaser: As the stock market continues to rise, Morningstar's Christine Benz thinks that retirees should start preparing for some market volatility.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: So why, after this big run of eight years, really, of market rally, should retirees start considering market volatility?

Benz: Well, I'm not in the business of making short-term market projections--I really don't know, the market could continue to rally. But one thing I think about is--we do this annual survey of some market experts about what they are thinking about long-term equity market returns going forward, long-term bond market returns going forward--most of the experts who we surveyed, and we're looking at some strong people here like Jack Bogle and the folks at Research Affiliates and Grantham, Mayo, Van Otterloo, all tell investors that they should tame their expectations for U.S. equity market returns. In fact, most are forecasting sort of low single-digit real returns or even lower for the U.S. equity market.

And that means to me, we're not going to suddenly wake up and be in an environment where the market return's say 2% for the next 10 years. What will happen is that the market will sell off pretty dramatically, at some point, and then it may go back up. But we probably just won't have a steady stream of low return. So, I think we have to brace ourselves for equity market volatility. I am a believer in reversion to the mean--we have had this tremendous rally, as you said, Jeremy, really going back almost exactly eight years. So, investors have to assume that we won't have this uninterrupted upward trajectory, that we will have some volatility and some down swings going forward.

Glaser: Let's take a look then at how you can brace yourself for market volatility. The first thing you think is really boosting your cash reserves and making sure you have adequate cash reserves.

Benz: That's right. So as you know, I am a big believer of this bucket system for managing your retirement portfolio. The basic idea there is that you do have enough parked in liquid reserves to tide you through a few periods of equity market volatility or even maybe some down swings in your bond portfolio. So, I sometimes shorthand it by saying, well, retirees should have one to two years worth of living expenses in liquid reserves. But I wanted to step back and talk about what I am saying there. 

So, the starting point really is to think about what your income needs are, then think about how much of them are going to be replaced by certain sources of income. So, if you have a pension, if you have Social Security you can take that off of your need for liquid reserves. What's left over is the amount that you would need to park in liquid reserves. So, say my needed living expenses are $50,000 a year, I am getting $30,000 of that in Social Security, and I want two years in liquid reserves--that would mean that I'd have about $40,000 in cash. So, don't overdo it, because there is an opportunity cost to having too much in cash.

Glaser: This could be a good time to rebalance, too.

Benz: Absolutely, and I have been evangelizing about this for a few years, and frankly it hasn't paid off. You would have been better just letting your equity portfolio ride. But when you look at what a 50-50 portfolio eight years ago would look like today--so, a 50% equity, 50% bond portfolio back in March of 2009--well today, because stocks have performed so well, it would be about 75% equity, 25% fixed income. So, investors who have taken hands-off approach, yes, they have been rewarded, but their portfolios probably have too much risk in them, especially given that they are now eight years older.

Glaser: So, let's talk about faux diversification. You say this is something that investors really should look to avoid.

Benz: So, if you are going through this rebalancing process, chances are if you haven't done anything you need to top up your bond position, and I think the thing you want to be careful about is really reaching for those types of bond portfolios that have performed well in the recent past. So, we've seen a great rally in junk bonds. We've seen a great rally in emerging-markets bonds. Some of the all-in-one income-focused funds have performed really, really well. So, you want to be careful about these products--not saying that you don't want to own them at all--but you want to be mindful of the fact that at the end of the day, we will tend to see them perform at least directionally in line with the equity market. So, they won't fulfill that role of ballast that we look for our bond portfolios to do. So if you are topping up your bond position today, I would be adding to the high-quality piece of the bond portfolio, don't get so worried about the fact that there may be some interest-rate-related volatility, they may not have performed especially well recently. Those are the securities that I think will be there to deliver diversification when the equity piece of your portfolio is going down.

Glaser: You don't have a lot of control, or any control over market returns, but you can control your spending. You think that's important to keep in mind during any potential market volatility.

Benz: Absolutely. There has been a great and growing body of research in the realm of sustainable withdrawal rates. In fact our colleague David Blanchett has contributed to this research. And one big takeaway from all of the research, even though the conclusions have varied somewhat, is that it's really important to think about reining in your spending in periods when the market is going down. The individual for whom this is especially important is the one who is just embarking on retirement or may be in the first couple of years of retirement, because for such folks they probably calculated their withdrawal rate based on a pretty enlarged balance. We've had this good market environment--that's the cohort for whom a big equity market downdraft could prove the most disastrous.

So, if folks have just embarked on retirement those are the ones who have, who should be paying most attention to thinking about potentially reining in their spending in a period in which the equity market is going down. If someone has been retired for 10 or 15 years, well they have really made it through the vulnerable period. You are most vulnerable early in your retirement years, you are less vulnerable later on. So they are the ones who can potentially think a little bit less about pulling in their spending. But the early retirees need to be careful.

Glaser: And finally, do the best that you can just to tune out the volatility.

Benz: This is easier said than done, for sure. We had a group of retirees in the office filming a round table with us for our Retirement Bootcamp coming up, and they talked about that feeling of starting out on withdrawal mode knowing that they are not going to be adding to their portfolios. That's the group who can feel really, really nervous when the market goes down. So, the best advice I can give is just to simply try to tune out the day-to-day market volatility. If we do have some equity market downdraft it may prove short-lived, it may be longer-lasting. But recognize that these things usually do recover. I think that's been one great lesson that we've had. The financial crisis was terrible investors endured terrible losses, but these things come back and portfolios recover. So, I think the best advice is just to try to tune out the noise as much as is possible.

Glaser: Christine thanks for your thoughts today.

Benz: Thank you Jeremy.

Glaser: From Morningstar, I'm Jeremy Glaser. Thanks for watching. 

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