Retirement Plans in a Down Stock Market

After writing my piece yesterday on fear and the economic situation, a very eloquent reader named “Maggie” wrote to me:

I completely agree with your assessment on the economy, particularly if you’re young. There is no crisis that is well served by panic and I don’t think that the current economic situation is anywhere near as bad as the Great Depression.

That doesn’t change the fact that many people (myself included) are looking at their 401(k) statements for the year and are seeing 20-30% drops for the year. I looked at my 401(k) and I saw that it’s down about 19% for the year.

I’m about six years from retirement, or at least that was my plan until this year. Now that I’ve lost so much money, I don’t know if I can retire then. I will probably have to work several more years beyond that, because even if the stock market goes up 20% the next two years, I’ll still only be back to about where I started.

Got any suggestions?

Watching the sunrise by sutefani on Flickr!Maggie tells a story that’s been repeated in the media quite often over the last week or so. My mother-in-law and father-in-law are also likely in the same group as Maggie – they’re in their mid 50s and are building a solid nest egg in their 401(k)s, but have watched some sizable chunk of that savings vanish this year.

If you’ve already lost that money, it’s gone. There’s no magic way to get back what you’ve lost. For some people who are getting close to retirement age, that means you will have to work a few years more. Your retirement date probably went from 2014 to 2020 or so. That’s unfortunate.

But the blame doesn’t go to the flailing of the stock market. The blame actually goes towards poor asset allocation in your retirement account.

Stocks are inherently a risky investment. If you look at the long term history of the stock market, there are a lot of years where the stock market goes up 15 to 20% in a year. There are also a lot of years where the stock market drops 20% in a year. Over the very long haul, these average out – that’s why holding a broad range of stocks (like in an index fund) is a good idea if you’re investing for the far future.

The problem comes in when that future isn’t quite so far any more. If you’re getting close to retirement, your investment in stocks becomes less of an investment and more of a gamble.

Think of the stock market as being kind of like a coin flip. Think of each year as being like a single coin flip, where a heads flip will get you a 15% gain and a tails flip will get you a 10% loss. The more times you flip a coin, the more likely you are to get a roughly equal mix of heads and tails results.

Since I’m thirty years away from retirement, I have a lot of coin flips ahead of me. I’ll likely see some runs of heads and some runs of tails, but over that long period, it’ll approach an even split in flips. That even split will mean a pretty good return on my investment.

But let’s say you’re now five years from retirement. That means you have only five coin flips. There’s now a measurable chance (a little over 3%) that all of your remaining flips will be bad, losing you a significant amount of money. Instead of being a volatile investment, it moves more towards being a gamble.

So what’s the solution? Most money managers recommend that as you get closer to retirement, you should slowly start taking your money out of stocks and putting it into something safer, like bonds or money markets. These investments won’t return as well over the long haul as stocks, but they’re as steady as can be – a 2% to 6% return that comes in like clockwork.

You’ll hear a lot of different methods for how to do this. My suggestion for most people is to do it automatically – simply put all of your retirement money into a Target Retirement fund that’s close to your retirement date. For example, I use a Target Retirement 2045 fund for my Roth IRA (which matches when I turn 67).

A Target Retirement fund automatically does this transition for you. Right now, my Target 2045 fund (since I’m so far from retirement) is almost entirely in stocks (and it’s been painful to watch it drop). But I have many, many years for it to rebound. When I start to get closer to retirement – in 2020 or so – the fund will automatically begin to adjust, reducing the amount of my retirement money that’s invested in stocks and increasing the amount that’s invested in other things. When I get very close to retirement, most of the money is not in stocks.

Unless you know the ins and outs of risk management and asset allocation, there’s no reason to not use a Target Retirement fund in your 401(k). Call up your plan manager and see if there’s anything like it available to you. If you want to push the risk a little bit (but, of course, remember what 2008 has been like), then use a fund that’s a little bit past when you want to retire. If you’re conservative, use an earlier fund. Then just dump all your contributions into that fund, sit back, and relax.

The next time the stock market flops, you might worry about it a bit, but it won’t be cataclysmic. You’ll be appropriately diversified without having to even skip a beat.

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40 thoughts on “Retirement Plans in a Down Stock Market

  1. Battra92 says:

    Very smart idea. I’d even go so far as when you are that close to retirement start looking at the old CDs at least for some liquid assets.

  2. jtimberman says:

    The value may be down, but the money isn’t gone until you sell.

  3. Matt says:

    I’m have to take issue with your high recommendation of target retirement funds. I’m 24, and have invested $8,500 in Fidelity’s target 2050 fund since May 2007 when I started working. I’ve lost 23.72%.

    They’re not a bad option for people who don’t want to think about asset allocation, but even those people might be better off modeling their allocation after Kiplinger’s long-term portfolio, for example.

    I guess I disagree with the idea that you need to be a financial management guru to come up with a practical asset allocation.

  4. Mike P says:

    I’m a big fan of funds that have a built-in retirement date. For most people, they make the process perfectly simple.

    I would, however, argue that if a person is 5 years from retirement, her relevant investing time frame is more than 5 years. (Or, to use your analogy, she has more than 5 coin flips left.) After all, you don’t take all of your money out on the day you retire, do you?

    Even once a person has retired, she’s still looking at a time frame that (hopefully, and most likely) encompasses 2-3 decades.

    The only way to make it through a retirement that lasts decades is with a significant portion of your portfolio still in equities rather than debt. Luckily, your retirement-target-date fund will actually take care of this for you. :)

  5. Trent – The target retirement funds have a simplistic appeal (and I used to own one) but there are asset allocations that can and should be used if your goal is to maintain a stable standard of living both before and after retirement, i.e., consumption smoothing. That may require owning fewer equities early in life, ramping up in midlife, ramping down early in retirement, and then back up later in life, all depending on risk, college saving, and on other sources of income such as SS and pensions. Target retirement funds do not provide that kind of allocation. But for the pure set and forget personality, they are better than managed funds.

  6. Doug says:

    I think this posting is only somewhat helpful to Maggie. We don’t know her asset allocation – it may already be conservative as she approaches retirement. Unless you want a low, but safe, rate of return that may not keep up with inflation, most financial analysts recommend having some percentage of one’s portfolio in stocks, even into retirement. Vanguard Target Retirement 2045 is projected to have about 50% stocks 5 years from retirement. So having her 401K in a similar fund would likely not have been much help during this period. I think Maggie is looking for advice on what to do, not what she should have done. And without knowing how she’s currently allocated, I don’t think it’s appropriate to recommend that she move her stock funds into a Target Retirement fund at this time.

    I do agree that the Target Retirement funds are worth looking at: they are perfect for investors who don’t want to bother re-allocating on an annual basis and are happy to let the experts take care of it for them. Just be aware that they still have risk because they maintain an exposure to the market even into retirement.

    Commenter #2 is absolutely correct. If Maggie sells, she locks in her losses. They’re only paper losses until then.

  7. djc says:

    If I were her, and not knowing the details of her asset allocation, I would suggest redirecting her future 401k contributions for the next six years or so into conservative investments like an inflation protected bond fund or money market fund. Then at least her exposure to stocks will go down, and she hasn’t locked in her losses by selling all her holdings at once.
    The only decent fund in my 401k is an S&P 500 index fund so I have almost all my 401k funds in that, but fortunately I have a SEP-IRA with Vanguard which represents about 50% of my portfolio, so I have diversified those holdings more recently to balance out the large cap/US equities held in my 401k. I have about eighteen years to go to retirement, and currently have an 85/15 stock/bond split and I am going to put 50% of my future contributions into bond funds for a while to ramp up my bond holdings.

  8. Trent says:

    “I’m have to take issue with your high recommendation of target retirement funds. I’m 24, and have invested $8,500 in Fidelity’s target 2050 fund since May 2007 when I started working. I’ve lost 23.72%.”

    If you’re 24 and you’re saving for retirement, your time horizon is way, way out there. You should be heavily in stocks because they’re a long term investment. You’re essentially looking at one coin flip – your first coin flip in a series of 35 or so. This coin flip was a bad one, but the history of the market says you’ll have more good ones than bad, and you have many coin flips yet to come.

  9. Trent says:

    “And without knowing how she’s currently allocated, I don’t think it’s appropriate to recommend that she move her stock funds into a Target Retirement fund at this time.”

    The only advice I gave her is to readjust her time horizon. If she’s not doing that, she’s gambling. If she does do that and switches to a Target Retirement account that’s 10 or 15 years out (like Target Retirement 2020), she’s still going to be heavy in stocks, but it’ll start adjusting towards bonds as the years pass.

  10. Kevin says:

    Matt @ 8:57 – Trent wasn’t saying you had to be a financial guru or else you should use a target retirement fund. He merely said if you’re not interested “in the ins and outs of risk management and asset allocation” they would be a good choice.

    Maggie may have been helped by this strategy, or not. We don’t have her asset allocation or holdings in front of us to look at and evaluate. 6 years is a long time though, the market could bounce back and then some by then.

  11. Carlos says:

    Trent- Your advice, here, is spot-on. As you get close to retirement, a majority of your assets should be in fixed income vehicles (whose NAV doesn’t flux dramatically).

    When you’re young, typically, holding 80% stocks and 20% bonds is smart. At the end of your high earning years, 20% stocks, 80% bonds makes sense. This is, essentially, the allocation that target retirement funds utilize…

  12. Elisabeth says:

    I guess if nothing else, this whole mess has taught me what it means when they say “go aggressive when you’re younger.” I’m 26, and I’ve had a 401k for about 5 years. My dad told me to go with mostly stocks, since I was young. I did, but didn’t really think much about it, since retirement is so far away. But I could have seen myself just leaving that money there forever. But now? As I get older, I will definitely make sure my money is invested less aggressively! I can’t imagine what I would do if I were about to retire right now.

  13. KC says:

    My mother and father are both “retired” but like most people they are still working on a part-time basis (they are 64 & 63). They have about a year’s living expenses liquid (cash or CDs). They haven’t touched their 401ks. One receives a monthly pension and SS, the other just SS. My dad’s mother is still living and healthy at 90 years old and I think its safe to say he has a good chance of living to that age, too, meaning another 25 years of his life he’ll need money.

    But what they’ve done is to have no debt – home paid off, cars paid in full when purchased, no consumer debt, etc. If they fix up the house, take a nice vacation or anything of that nature its done with cash – no debt. But my father is staying fully invested in the stock market in blue chips and index funds. AS I said, he expects to live another 25 years – thats long term. He can’t afford to go conservative now. And currently he’s buying a lot of nice dividend paying blue chips at a discount. He’s securing future income in a quite conservative manner.

  14. Great suggestion for “Maggie,” Trent. You never push a specific investment strategy nor do try to pass yourself off as some kind of guru. It is good to know about Target Retirement funds so we can do our own research on them. If they fit for us, fine.

    I’m know you have definite views on your own personal investment strategy, put you never try to force them on your readers. You might be the least offensive financial blogger on the Internet.

  15. Kevin says:

    Trent –
    You should change your slogan from “financial talk for the rest of us” to “least offensive financial blogger on the internet”. Sorry, couldn’t resist.

    Have a great weekend!

  16. Todd says:

    This post is fabulous, Trent! It’s perfect timing because next week my company’s financial manager is coming to the office to talk about the current “financial situation”. I was taking notes of all the good information, but quickly realized it would just be easier to print it out instead of transcribing it by hand. Although, I am only 23 I am sure there are many older coworkers who will love this article. Thanks.

  17. Shannon says:

    Trent, thanks for the tip about the Target Retirement funds! I just now called USAA and had my “starter” Roth IRA switched over to their 2030 fund–the financial advisor that walked me through it agreed that it was a good move, based on my assets. I also set up the electronic transfer thingy so now I can transfer money a bit a week into it via computer magic.

    Your blog has been my go-to for a lot of great tips these days, so thanks.

  18. michael says:

    You’re right, Trent, and I’ll say once again: Lots of younger people are right now moving their 401Ks out of stocks and into bonds. Don’t do it! Now — in this abysmal market — is exactly the time people should be moving INTO stocks (or, if they’re already there, staying there).

    Dollar-cost averaging can only work in you invest in weaker markets.

  19. Susy says:

    True true, I just opened a Vanguard 2040 target retirment account for myself this morning (my husbands was opened in May). I love the ease of these accounts. I still lost tons, but overall my investments are only down 9% this year so I’m not doing too bad.

  20. Sally says:

    So I’m 28, I’ve only had a 401K for about a year (through my employer), and I don’t have a clue when I’m retiring. Should I just wait until I do know about my retirement until putting it in a target?

  21. Michelle says:

    My husband and I are actually putting MORE of our retirement money into stocks right now (he’s 27, I’m 25) because right now, with stocks being cheap, we’re getting more for our money. And when they rise again (like they always do), then we will have more shares that are worth more money. But, this only works because we aren’t looking to retire for another 40 years.

    If you want to gamble, go to Vegas. But don’t expect to come out ahead.

  22. K says:

    Sally – You will be 60 in 2040, so I would pick this one (which is what I have, same age), or one 5 years on either side. They will be only slightly different. The difference is that a 2040 fund may have 85-90% stocks while a 2010 fund (someone who is retiring now) would have a smaller percentage in stocks. You need to switch from bonds to stocks gradually as you get closer to retirement and these funds do all the switching work for you. So since it’s likely that you will work till 55-65, I would choose a 2040 fund if you like the automatic option. Some 401ks do not offer the target date funds, in which case you should put maybe 65% in an S&P index, 20% in an international index, and 15% in a fixed income fund. Then you will want to rebalance this every year or so. They say 110 minus your age is the percent you should have in stocks.

  23. Chris says:

    Has anyone thought of an annuity? I know that’s a dirty word in some circles, but if you’re 55 and you want to make sure you don’t outlive your income (which is pretty much the whole purpose of retirement planning), why not supplement whatever social security you may have with an annuity to guarantee yourself a minimum level of lifestyle? Keep the rest diversified among stocks, bonds, alternative investments, and cash and you will be well on your way. We insure everything else in our lives, why not insure our retirement?

  24. Lurker Carl says:

    I recommend buying individual bonds instead of bond funds. Bonds can and do lose value, you have no control over the quality that a fund manager purchases or the frequency of trades. Why pay a fund manager to do what you can easily do for youself?

  25. mkb says:

    Right on, jtimberman.

    Since my plan doesn’t offer a target fund, I’m managing my stock:bond ratio myself. How often should I be rebalancing? Vanguard seems to recommend waiting until your percentages are at least off by 5, but I’m wondering if that’s too conservative. Thoughts?

  26. Helen C says:

    It would be more accurate, and less offensive, to speak of “appropriate” and “inappropriate” asset allocation. And even so, one may have (apparently) the most appropriate asset allocation, do (apparently) everything right, be (apparently) perfect — and still lose. There really, truly are no guarantees. It really, truly is impossible to control what happens. Right now, to me, compassion, humility, and a sense of humor are looking more important, maybe especially than anything material.

  27. Jim says:

    Trent’s main point here is 100% right. The closer you are to retirement the less of your retierment assets should be in stocks. Its unfortunate to see the news stories of people with 5 years or even already retired who are losing 20% or more of their retirment funds due to stock losses. Those people have had too much of their money in volatile and risky stock market. On the other hand young people (like Matt in #2) really should have all their assets in higher risk stock portfolio. If you have 30-40 years until you retire then you should have your money in the higher risk assets which have higher average return rates. Yes if you are young now then today you might have lost 20% or so in the past year. But that is OK and should be tolerated. Don’t pull all your money out and get frightened. You’ve got years and years of investing ahead of you to see that money grow and grow.

    Jim

  28. Jennifer says:

    I looked around my 401′s site, and there is indeed a program similar to the Target program you mentioned… it does seem to be a good fit. I couldn’t quite convince myself to go “agressive” with the market the way it is, but the moderate option seems nice. Thank you for the suggestion! I’ll still keep an eye on it to see where it goes, but this is a much more comfortable place to be than the “oh, this one looks good” method for someone who has no clue.

  29. Sarah says:

    Chris, while an annuity can be a good idea, inflation will eat away at its value over the course of your retirement (which could be twenty years or more). Thus you can’t just sell your portfolio and dump it all into an annuity when you hit 65.

  30. Jillian says:

    The coin flip is a great way of explaining that concept, thanks!

  31. Kacper says:

    Hmmm.. interesting topic, but I have mixed feelings about this approach. On one side it sounds logic to move assets from stocks when you are closer to the retirement.

    But going this way, you generally shorten your period of flipping the coin. The shorter period, the less average results you get. And for best results we really want as many coin flips as it is possible. So the longer period of time in stocks the better results (on avg) we get). So it sounds counter intuitive to take assets from stocks. What do you think about that?

  32. Asav Patel says:

    Absolutely True. When you are near your retirement you should shift your capital in Debt funds.
    This is the advise for those people who are in their 50s means in their pre-retirement ages.
    But for those who are young today, i would rather suggest different way to secure your Financial Future….
    The wasy is start your own Business or start developing and growing your own Asset. Say for example, let’s take the Example of Trnet. Trent will not have any financial worries in future not because he is investing money and he is a personal finance writer so he knows everything about money. But because Trent has started developing his own Asset from October 2006 and that asset is “The Simple Dollar”. This blog.
    This Blog is trent’s Asset and it will continue producing enough Cash flow for Trent until he lives and forever means for his future generations also.
    So what i want to stress here is that, i want to tell youngsters that start your own Business or Asset development (Like Trent, Bill Gates, Warren Buffet, Mukesh Ambani, Mark Zuckerberg the founder of facebook.com) as early as possible in your Life. Because this is the only way to have no Financial Worries in future. Your own Business or Cashflow Producing Asset………..!!!!!!

  33. Sara R says:

    The problem with this idea is that a coin flip is a random event. The performance of the stock market is not random. In the short term, it’s unpredictable, yes. But you can see trends over the longer term. There are a lot of reasons to think that the “coin flips” over the next 10 or so years are going to be increasingly negative: baby boomers retiring and leaving their peak stock market investing years, massive deleveraging because everyone took on too much debt, money printing leading to decreased value of the dollar, upcoming Social Security and Medicare crises, Peak Oil–need I go on? Conventional wisdom assumes that the stock market will go on the way it has over the last 25 or so years, on average, but enough of the fundamentals have changed that I think that that is an unwise assumption.

  34. Roger says:

    Trent, great post again. Just one comment: not all target retirement funds are created equal. Vanguard’s funds, for example, are known for being fairly conservative. While this doesn’t change the basic advice for those who simply want a set it and forget it retirement plan (find a good fund company, choose the retirement year nearest to when you want to retire, regularly add additional funds, enjoy a well-financed retirement), for others, it might be worth looking at the fund family’s other retirement funds to see what the retirement fun they’re considering will look like in 10, 20, or 30 years, and deciding whether that will be more or less conservative than they desire.

    @Sarah (Comment #24): There are inflation indexed annuities, which increase the annual payout to keep pace with the rate of inflation. The initial payout is smaller than with fixed rate annuities, but the real spending power of the money you’ll receive will keep pace with real-world costs (more or less). (Thank you, Money magazine!)

    @Kacper (Comment #26): Almost every commentator suggests keeping at least some funds in stocks, even after retirement (the old adage about ’100 minus your age should be in stocks’). This allows you to take advantage of future ‘heads’ flips in the stock market, while keeping plenty of money to live on in safer assets, like bonds (where ‘heads’ might be up 6% and ‘tails’ is down 3%, to continue Trent’s metaphor) and cash equivalents like money market funds (where you’re using a two-headed coin, but each head result only gives you a 3% annual boost). This allows you to reap many of the benefits of increased stock value, while cutting down the risk.

  35. Katie says:

    The only issue I would mention here is that some seemingly incredibly conservative investments have proven themselves to be worth only pennies on the dollar as of late. Pension funds and various conservative investment vehicles, for instance, held Fannie and Freddie paper (debt from Fannie Mae and Freddie Mac), which were seen practically as Treasuries. These folks – many of whom did know a great deal – really got burned (as did shareholders, investors, and those who listened to these guys). Recently, the federal government shored up money market funds – which were seen as liquid CD’s – because one large fund reported it lost 3% of investors money when Lehman collapsed.

    I don’t mean this as a criticism! I just wanted to point these things out. It seems to me that a lot of folks have been lulled into thinking that various investment tools are quite safe when they are more at the mercy of the credit markets than we would like to think. :-(

  36. Phil A says:

    “What’s the most you ever lost in a coin toss?”

    -Anton Chigur “No Country for Old Men”

  37. Jackie says:

    So my biggest question…I havent contributed the max to my IRA this year yet…should I? Or should I just wait for the market to get better? I am 24 years old right now. I just hate seeing all of my money go away :(

  38. Sarah says:

    Yes, the closer you are to retirement, the less you should be in stocks, but you can’t be completely without stocks. Maggie may be freaked because her retirement accounts have taken a dive, but let’s assume she retires at 60 and lives to at least 90. That’s still 30 years in retirement and 30 years is still a long time horizon.

    People need to change their perception of saving for retirement. Most think that once they hit retirement, they should work on maintaining their money, but at least a portion (I would say 40% or so depending on asset allocation) should still be stocks to maintain growth.

    So Maggie may need to work for a few more years, but if her asset allocation includes a healthy infusion of cash/cash vehicles, she should be able to live off that and leave the stocks to recover/continue to grow.

  39. onaclov says:

    My 401K is killing me, I have to keep telling myself, its better in the long haul, but 38.75% down since jan 1 2008 cuts me deep….

  40. Jamie says:

    What I really love about your posts is that you explain these things so simply that I can understand what I thought I never could. Thanks man!

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