THE LAST THING RETIREMENT INVESTORS> needed was a year like this. Already facing soaring health-care costs and the steady demise of guaranteed pensions, investors have lost some $2 trillion of stock value in their 401(k)s and other retirement accounts since the stock market's peak in October 2007.
Now the danger is that investors will set themselves back further by succumbing to fear and failing to adjust their portfolios for some badly needed growth. Those at greatest risk are folks who bailed out of deflated stock portfolios and are sitting in Treasuries earning just 1%. Investors with shrunken portfolios probably aren't getting the growth they planned on, either.
"People have to ask themselves, "Is my retirement plan still moving me toward my goal?" Chances are, after what we've been through, the answer is no, " says Mark Cortazzo, an investment adviser at Macro Consulting of Parsippany, N.J. "If you were going somewhere and got lost, you would create a new route to get to your destination and forget about your old route. That's what investors have to do."
Adopting a repair strategy now, rather than waiting until the markets have rebounded, could well reduce the sacrifices you will have to make in coming years to compensate for recent market declines.
JUST HOW FAR HAS THE MARKET set back your planning? Steven Sass, associate director of research at the Center for Retirement Research at Boston College, found that the typical investor who has eight years until retirement and plans to use his nest egg to supply 75% of his retirement income will have to save 23% more per year or work two-and-a-half years longer to make up for the market declines of the past year.
His analysis assumes a 5% annual return above inflation, which is in line with historic returns for a portfolio with two-thirds in stocks and the rest in bonds. Any smaller return would mean working even longer, saving even more or making other big sacrifices, such as spending less money in retirement.
The good news -- and yes, there is some -- is that right now you'll find some once-in-a-generation kinds of opportunities in both the stock and bond markets, and you don't have to take on a whole lot of risk to take advantage of them, says Larry Palmer, managing director of Citigroup's Citi Family Office in Los Angeles.
Stocks in general are on deep discount, but dividend-paying stocks are particularly attractive right now. For the first time in 50 years, the yield on stocks has risen above the yield on 10-year Treasury bonds, says Jeremy Schwartz, research director at WisdomTree, a firm that runs index funds of dividend stocks. The yield on the 10-year bond is 2.7%, compared with 3.4% on the Standard & Poor's 500 and 5.5% on the WisdomTree Dividend index, which tracks a broad array of U.S. dividend-paying stocks.
Dividends provide a cushion on the downside and, contrary to their reputation as a boring staple of retirement income, they can turbocharge a portfolio over the long term. "As much as 95% of wealth created in stocks comes from reinvested dividends and not from the price appreciation," says Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School of Business and senior investment-strategy adviser at WisdomTree.
STILL-HIGHER YIELDS CAN BE SCORED on real-estate investment trusts. Because of a handful of ailing commercial real-estate companies, REITs are so deeply feared by investors that double-digit yields are not uncommon.
"REITs have been sold off tremendously, and while some have high debt and should rightly get sold off, they're all getting painted with the same brush," says Christopher Cordaro, an investment adviser at RegentAtlantic Capital in Morristown, N.J. "Our rule of thumb is to get into REITs when their dividend yield is above the 10-year Treasury yield -- now we're at about three times that."
Soaring yields are also plentiful on fixed income, as fear about the credit market continues to cripple demand for all bonds but Treasuries. In the high end of the corporate and municipal markets, you can easily find yields "previously reserved for much scarier, high-yield credit," says Jason Brady, manager of Thornburg Limited Term Income Fund (Ticker: THIIX) and Thornburg Limited Term U.S. Government Fund (LTUIX).
The tax benefits on munis make their yields especially savory: Average muni yields are 2.9%, and yields of 5% or more are easy pickings. Lew Altfest, a New York financial planner, says he recently bought a double-A rated New York City municipal bond with a 6.4% yield, which is equivalent to more than 10% pretax for an investor in the top tax bracket. The risk? "That New York City goes under," Altfest says, and that is remote. What's more, Altfest points out that the tax-free benefit of munis will probably only get better if income-tax rates rise under President-elect Barack Obama.
SO, HOW DO YOU COBBLE THESE opportunities into a portfolio you can live with? First, step back and take a look at the bigger picture: asset allocation.
Ideally, you should rebalance back to your original pre-crash asset allocation, advisers say. Your stock exposure is likely to be diminished either because you moved money into cash or simply because the stock market has contracted so much. Addressing that now would be an opportunity to buy stocks when prices are at ultra-low levels.
It would also ensure that you get the most out of a rebound -- whenever it finally occurs. "If you held 70% in stocks before, you may be at 50%. But you want to be in 70% on the way up, not 50%," says Steven Condon, an investment adviser at TruePoint Capital in Cincinnati.
Yet many investors are so deeply shaken that they're not ready to build their stock exposure to pre-crash levels. These folks should aim for less exposure than they had before -- but still hold at least half in stocks to stay well ahead of inflation, Condon says. While inflation, now at 2.2%, may not be weighing heavily on retirement investors, "every trillion dollars the Fed adds to the balance sheet increases the likelihood that inflation will increase in the next five to 10 years at a greater rate than we saw in the last five to 10 years," say Ernie Ankrim, chief investment strategist at Russell Investments.
Of course, this presumes that the stock market will surge again, as many market pros expect. But if you doubt that will happen any time soon, you can keep ahead of inflation by holding a bigger weighting in bonds, thanks to their unusually high yields.
Whatever stock weighting you choose, don't gloss over one of the basic strategies for maximizing risk-adjusted returns: holding a variety of types of stocks. Investors are notorious for holding big concentrations of their employer's stock in their 401(k)s and for shunning emerging-market stock or foreign stocks out of fear of taking on more volatility. The typical 401(k) investor holds 25% of his plan's stock holdings in his own company, according to the Profit Sharing/401(k) Council of America. And financial-service firms say that foreign stocks amount to only about 15% of most client's portfolios, despite recommendations to hold 25% or more.
Diversification among stocks, bonds and other asset classes may not have helped much in the rout of recent months. Just about all assets plunged. But if history is any guide, a diversified portfolio is likely to pull ahead of the market during a recovery, Cordaro says.
After the bear market in the early 1970s bottomed, in October 1974, a portfolio with 64% in U.S. large-cap stocks, 12% in U.S. small-cap stocks, 12% in international small-cap stocks, 6% in real estate and 6% in commodities handily beat the S&P 500 over the next five years, with an average return of 19.7%.
So, what's the right asset mix for you? Someone five years from retirement with $1 million to invest could do well with 32% in fixed income, 48% stocks and 20% alternative investments. With this framework in mind, you can fill each of the three baskets with investments that suit your appetite for risk.
Here is what Cordaro suggests:
Within the fixed-income basket, half of the assets should go into short-term corporate and government bonds and a quarter into international bonds -- with the rest split between inflation-indexed bonds and high-yield bonds.
For stocks, he advises a little more than half in U.S. names, with a heavy weighting toward large companies, and the remainder in foreign stocks. "We recently increased our exposure to small foreign stocks and decreased it to small U.S. stocks because foreign stocks are cheaper," Cordaro says. He also increased the stake in emerging-market stocks "because the price/earnings ratio is at 6 and the dividend yield is at 5%. And while growth is expected to slow, these countries are more likely to avoid a recession."
Cordaro's alternative-investment portfolio has three components -- real estate, commodities and hedging strategies. Hedging can be accessed by the average investor through mutual funds such as Highbridge Statistical Market Neutral (HSKAX) and Absolute Strategies (ASFAX).
You can use Cordaro's approach as a starting point and adjust it to your needs. For example, if you want to get more mileage out of dividend-paying stocks, consider using as much as half of your stock portfolio for companies paying high dividends and keeping the rest broadly diversified, says Wharton's Siegel.
Or, if you're having a hard time parting with cash for now, hold on to some and maximize the bond side of the portfolio. Says SmCitigroup's Palmer: "It's reasonable for people to say, 'I know I should be in the stock market, but I don't want to take this volatility -- so I'll give up the big rally but still get 8% or 9% in fixed income.'"
Another option is to reserve some assets for an investment that gives you market participation with downside protection, such as market-indexed certificates of deposit. These give investors a portion of the stock market's return and guarantee at least the return of principal. You typically earn 80% to 100% of the index's gain, but no dividends. Keep in mind, however, that at this point, paying extra for downside protection may be similar to "buying a snow blower after the big storm," Cordaro says.
And any adjustments you make to your portfolio may mean selling investments at a loss -- but that isn't necessarily a bad thing.
Harvesting losses and using them to offset gains can provide another bright spot amid the current market mayhem. You can use up to $3,000 in net losses to offset ordinary income. Excess losses can be carried forward indefinitely to future years. If you invest in mutual funds, you might be able to put losses to good use right away: Many funds have announced big capital-gains distributions for the year as a result of all of the selling they've had to do to keep up with redemptions. Fund investors will owe taxes on these distributions.
IF YOU HAVE BEEN SITTING on the sidelines in cash, your concern is less likely to be about taxes than about the wisdom of being in stocks at all. David Campbell, a principal at the advisory firm Bingham, Osborn & Scarborough in San Francisco, suggests moving 25% to 30% back into the markets now, and then dollar-cost averaging the rest over the next 12 to 18 months, buying a fixed-dollar amount on a regular basis in order to get the most shares at lower prices.
Strategies like that could add some real shine to the golden years.
KAREN HUBE, a free-lance writer based in Westport, Conn., is a frequent contributor to Barron's>.