What If You Retire or Need Income During a Bear Market? — Part 1
This is the first segment of a multi-part series aimed at educating investors on how to better plan for their retirement years.
The essence of investment management is the management of risks, not the management of returns.
— Benjamin Graham
Most people save and invest for specific life goals. For young investors, it could be the dream of owning a bigger home or the vision of sending their children overseas to an elite institution. For those who are middle aged or older, it could be in preparation for the day that you no longer have to go to work. In most cases, it will require drawing upon your assets which you have so diligently accumulated over the years.
So what happens if you were just about to retire, or maybe needed an income from your assets, right at the time when the market takes a turn for the worse? You have to acknowledge that there are some things that you just have no control over, one of them being — whether the market is up or down in the exact year you need your money.
However, there are areas of your investment and financial plans which you do have control over — such as choosing an asset allocation which will help you ride through volatile markets smoothly.
Asset Allocation Is of Paramount Importance
Assess whether your mix of stocks, bonds, and cash reserves reflects your current risk tolerance, and adjust if needed. For instance, a typical income-generating investment portfolio that we setup for clients is shown below. There is a reason why the portfolio was setup in a certain manner.
Equities: They are an important component in a retirement portfolio. You may ask why — considering that equities are volatile and can contribute to losses.
Quite simply, equities are one of very few asset classes in the world that are able to outpace inflation. Given that your retirement horizon can be 20 to 30 years or more, you definitely want to be invested in something that can maintain your purchasing power over the decades.
In addition, equities are split between asset class and market cap allocations. Asset class equity allocations attempt to target academically proven drivers of returns to give investors a higher than average return over the long term whilst market cap equity allocations track a standard index.
Bonds (Stick to High Quality)
Bond components in a portfolio perform two roles. One, it helps to generate a yield, or coupon. Second, and more importantly, it helps as a buffer against volatility, diffusing losses when markets tumble.
The portfolio contains a large component in investment grade fixed income and within that, a relatively large allocation to bonds which have shorter maturity. The reason for doing so is that we do not want the portfolio, which is supposed to be stable and generate income sustainably, to be suddenly impaired or to have its value drop drastically during a crisis.
The graph below shows default rates of bonds over time. You will notice that investment grade bonds typically have a very low default probability — even during crises like the dot-com bubble, 2008 GFC, and even recently during 2020’s COVID-19 sell-off. Default rates of high quality companies on aggregate did not even cross the 1% mark.
However for the speculative-grade or junk bond market, you will see that it suffers from a very high default rate whenever economic problems surface. Unfortunately, because these bonds pay very high yields - it is what attracts many investors, who rarely question about the possible risks of such investments. However, during crises, 1 out of every 10 bonds default which can have devastating effects on your capital.
More on Bonds: Bigger (longer) isn’t always better
The hunt for yield amongst investors has also given rise to perpetual bonds — bonds which promise to pay a coupon to investors in “perpetuity”. However, the headline numbers and exuberance towards these instruments tend to mask the higher risks that investors have to take when investing in these assets. The structure puts investors in these instruments just behind shareholders — meaning that investors do not have any recourse or claim to the company assets when there is a default, receive a return lower than equities, and have an uncertain horizon.
The chart below shows the various default rates of bonds sorted by credit rating (AAA is the best, CCC/C is the worst) and by time horizon or duration of the bond. The colour coded boxes simply shows that high grade bonds of up to 5 years in maturity (green) have the lowest default probabilities, compared to similar high grade bonds of longer maturities (orange). Contrast the default probabilities with the lower quality bonds (red).
Why Does This All Matter
How asset allocation plays an important part is explained next.
Let’s say that you are retiring in the midst of a very bad market cycle. Equities are down double digits and even some bond components are suffering from the turmoil. During such a period, the shorter maturity, higher quality bonds within the portfolio allocation not only holds its value but in many occasions rises further as investors rush to that particular asset class in search of a safe haven.
You do not want to sell or take a withdrawal from your assets which are temporarily impaired. So let’s say you have a $1M retirement “pension” plan and take a $50,000 annual withdrawal or income replacement. Assuming you get zero coupons or returns from your bonds, you are able to fund at least 5 years of retirement spending simply from the drawdown of the safe assets in your investments before you need to start touching the longer duration bonds or even the equities in your portfolio (see below).
Having a sufficient buffer of safe assets is vital in ensuring the longevity and sustainability of your income-generating portfolio. This ensures that you won’t be in a situation where you will be forced to sell your higher return (but more volatile) assets during a downturn. Compared to cash, these safe bonds also have an ability to generate a yield above standard deposit rates.
Your journey to financial independence and in your retirement years is a significant life-stage in itself. You are sure to experience bumps and detours along the way. However, with proper planning and commitment, you can weather any storm, ensure that you never run out of money, and remain on course to your destination.
For more information on the retirement and pension-type investments, come and chat with us.
