When it comes to retirement planning for myself, I like to use the same worst-case scenarios I did when I was flight planning during my flying days.
The first and most essential aspect in flight planning – the one you can never ever screw up – is fuel planning. As the saying goes, there are no gas stations in the sky.
When it comes to fuel planning, you had better bank on everything going wrong – weather, time in route, being vectored off course by some air traffic controller… you name it, you better plan for it.
[ad#Google Adsense 336×280-IA]In the Navy, everything that could go wrong, usually did.
In retirement, unless you have a secret stash of money somewhere offshore or hidden somewhere in the floorboards of your bedroom, you had better start planning for the worst-case scenarios.
It beats the heck out of falling out of the sky at 79 years old.
Flying Through Retirement
One of the easiest and best ways to do that is to avoid stock-only portfolios.
I can clearly remember wondering, back in my younger years, why anyone would ever own anything but stocks. At the time, it made no sense to go outside of equities.
In the late ’80s and early ’90s, we had been on a tear in equities for years and it showed no signs of stopping. Not long term anyway. And it didn’t.
All the numbers stacked up in the positive column for holding only stocks.
Why bother with anything else? As long as I was diversified in at least 10 companies and five industries, why worry? Give it time and it would come back, right?
Well, almost right, if you have the time to let it work. One of the many problems with getting older, besides waking up at 3:00 a.m. every morning, is that time is running out.
Today, the idea of only owning stocks or cash equivalents, which is what most people hold, is horrifying. I can’t imagine not diversifying into bonds and dividend-paying large caps or blue chips.
My, my, how 25 years can change things.
Two Scenarios
Ignoring the basic rules of diversification will result in running out of money in retirement 10 to 20 years sooner than the best retirement plans estimate.
That’s 10 to 20 years of living on just Social Security! Yuck!
Yes, even if stocks keep up their long-term winning ways – and I’m confident they will – you’ll still be risking it all by not assuming everything can go wrong. And it will.
Here’s the problem.
Just a few years of negative returns early in retirement will wipe out your portfolio 10 years early. The easiest way to make this happen is to own only stocks.
Take a look at the chart below. This is how bad it could be.
These numbers are based on a $1 million portfolio with a 5% average annual growth rate and a 5% annual withdrawal rate beginning at age 65.
If you take big losses in the first three years, as compared to the same losses later in retirement, the outcomes are very different.
You did everything right in both scenarios. You saved your money. You invested properly to get to retirement in good shape. And you still ended up broke at 79. Just 14 years into your golden years.
As outrageous as this scenario seems, since most people adhere to only some of the rules of diversification, this will be the reality for most investors. With the life expectancies we have now, going broke at 79 is no joke!
Scenario 2 in the chart assumes a 39% drop in the first three years you’re retired. Between 2007 and early 2009, we took a much bigger hit in stocks, around 50% to 65%.
And the bad years don’t have to happen in a row. They can be spaced out over the first third of retirement and the outcome is virtually the same.
I’m sorry this is so negative, but go back over the last 25 to 30 years and count the number of bad years we have had. It’s more than three.
Thankfully, there is an easy fix to avoid this money mess. It can actually increase your long-term returns and income and add stability to your portfolio.
Key Ingredients
The easiest to implement, and the most effective approach, is to hold a combination of the kind of income equities Chief Income Strategist Marc Lichtenfeld recommends in his dividend-stock service, The Oxford Income Letter, and the types of bonds I recommend in Oxford Bond Advantage.
But, and this is key, you must also use the age percentage I recommend to my bond readers. That means you must hold the same percentage as your age in lower-risk investments (i.e., corporate bonds, ultra-conservative dividend-paying stocks).
So, at age 65, you should have about 65% of your holdings in lower-risk investments. At 70 years old, 70%. You get the picture, I’m sure.
Right now, Marc’s average dividend from his Oxford Income Letter portfolios is about 4.8%, and the average yield on the bonds I recommend, that’s income from bonds, is around 7%. That’s an average of 5.9%.
Even in the worst-case scenario, if you are earning 5.9% in income from just 65% of your holdings (assuming you’re 65), you avert almost all of the devastation a prolonged down market can cause.
You would be withdrawing the income generated by stocks and bonds and not your principal in the down years. Your principal would remain intact to continue to grow when the market turns around. That’s where the magic happens.
The alternative is to have to sell off securities at depressed prices during a prolonged down period to generate enough cash to distribute as income. The result is less principal to grow when the market turns around. This is where the bad things happen.
The killer in this scenario isn’t just the down years. Stocks will come back. It’s that you have to sell into a down market, at losses, to pay your bills. The loss of principal in this scenario doesn’t just hit your account balance, it degrades all of your growth and income going forward.
Strength in Weakness
I can’t guarantee holding corporate bonds and dividend-paying stocks will prevent all the effects of a prolonged down market. There are too many variables to make that kind of promise.
But this formula of stable, ultra-conservative dividend stocks and corporate bonds, bonds that will pay their interest and return $1,000 in principal at maturity no matter what happens in the market, virtually eliminates the effects of a prolonged weak market.
When you add in the psychological advantage these income producers offer, you also reduce the chance of panic selling in a down market. And panicking will crush a lot more retirement plans than any down market ever will.
Diversify in retirement or get used to flying to vapors.
— Steve McDonald
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Source: Wealthy Retirement