Your retirement
With stock markets plunging, nest eggs are cracking and retirement dreams are slipping away. But don't hit the panic button yet. With a solid strategy, there's still hope for your golden years.
If you have several years, if not decades, to go, don't worry. Yes, your 401(k) and IRAs have taken a significant hit. But history shows that you'll make up 80% of your bear market losses within the first year of the recovery, according to Standard & Poor's Equity Research.
If you're planning to retire in the next few years, the answer is still yes, with a bit of effort. Why? The decade before you quit your job and the first five years that you're out of the work force are vulnerable times. How much your investments earn - or lose - during this time will go a long way toward determining how much money you can afford to spend for the following 30 years or more.
Say you planned to quit this year and begin withdrawing 4% of your retirement funds annually. If you started with a $1 million retirement portfolio last year (split 70% stocks, 30% bonds), the market has already cut that down to $833,000. That means if you pulled 4% of your remaining money out, you'd be left with just under $800,000 after Year One, cutting your odds of having your money last 30 years from nearly 80% to less than 50%.
Sounds scary. But you can fix this problem. For starters, pledge to work one more year. A study from T. Rowe Price found that putting in another 365 days at the job would boost your annual retirement income by 7%. Work three years more and your retirement income could soar by 22%.
By staying at your desk longer, you can also delay taking Social Security benefits. For each year you put off starting your benefits between ages 62 and 70, you boost your Social Security payments by 8%.
What if you don't want to - or can't - work longer? You still have an option: spend less. The traditional advice is to withdraw 4% of your assets in the first year of retirement and boost subsequent withdrawals by the inflation rate. But in this type of market, consider withholding your inflation adjustments for the first three years after you retire. T. Rowe Price found that a retiree with a 55% stock/45% bond allocation in 2000 would have cut his odds of running out of money by half simply by following this approach.
Every long-term investor has to face nerve-rattling times like this - likely more than once - and your success will hinge on your ability to keep a cooler head than many others around you.
If you own a diversified portfolio, your asset-allocation strategy has probably protected you from the worst of the storm. While the S&P 500 has lost more than a quarter of its value over the past year, a portfolio consisting of 70% stocks and 30% bonds has fallen around 17%, thanks to the gains fixed-income funds enjoyed.
Still, markets like this are a good time to check if your asset-allocation strategy is still appropriate for your time horizon and if you need to rebalance. You'll likely find that you own too big a stake in bonds - or at least more than you bargained for.
Let's go back to that portfolio of 70% stocks and 30% bonds. If you hadn't traded in the past year, the market would have shifted your mix to 62% stocks and 38% fixed income. That might feel good now because bonds are less volatile, but it will mean that you will lose out on the higher returns on stocks when the market eventually recovers.
If you're selling bonds to add to stocks, what's safe to buy? It's fair to assume that the government's efforts to bail out Wall Street will add to our national debt, which will likely push up interest rates. Basic-materials stocks tend to do well when rates rise. So consider T. Rowe Price New Era (PRNEX), which owns energy and mining stocks. New Era is a member of the Money 70, our list of recommended funds and ETFs.
Also, beef up your blue chips. As Lehman and WaMu shareholders learned, not every large company can weather tough times. But as a whole, the category clearly can. The Vanguard 500 Index (VFINX) is the safest way to invest in the largest American companies.
Another sound option is the Fairholme fund (FAIRX). The managers of this Money 70 fund follow the Warren Buffett school of investing. They buy a stock only if it's trading well below its intrinsic value - perhaps a richly populated universe after this market meltdown.
If you see that the bond portion of your portfolio is underperforming, consider Treasury Inflation-Protected Securities (TIPS), one of the few types of bonds that can do well when rates rise.
If you're living off a collection of dividend-paying stocks, it may feel as if you've been hit by the perfect storm. Not only have financial stocks, which generate around a quarter of all the dividends produced by the S&P 500, taken a huge beating - they've sunk nearly 45% since the start of this bear - but 30 blue-chip financial firms have cut their dividends.
Worse still, not all of the income you'll receive this year will be eligible for the beneficial 15% tax rate. For dividends to qualify for the rate, the company that issues them must pay taxes on them. And since many banks and brokers are reporting huge losses, they may not owe a penny to Uncle Sam this year.
As long as you diversify among different stocks as well as different sectors, dividend investing still has a lot of appeal. One strategy that's holding up, relatively speaking: Instead of focusing on companies with the highest yields - which could simply be a sign that a payer's share price has tanked or the dividend is at risk - concentrate on companies that are consistently growing their payouts over time. By doing so, the Vanguard Dividend Growth fund (VDIGX) has kept its exposure to the financial sector to only around 11%, and the fund is down just 10% so far this year, about half what the overall market has lost.
In the wake of the near failure of AIG, another worry for retirees is whether to buy an immediate annuity. In exchange for handing over a lump sum of money to an insurer, you get monthly or annual payments guaranteed for life with one of these policies. In this environment, it's hard enough to have faith that your financial institution will be around for the next three months, let alone three decades.
But bear in mind that no major insurer has failed in this meltdown. Even though AIG required $85 billion in loan guarantees to stay in business, it was the parent company that needed the help - not its insurance subsidiary.
In the event your insurer does fail, your state's life and health insurance guaranty association will attempt to find another carrier to take over the failed firm's contracts. If that can't be done, state guaranty funds will cover at least $100,000 in benefits (around 20 states cover more).
There is one reason to hold off awhile before you enter a new contract: Rating agencies like A.M. Best, Moody's, Fitch and Standard & Poor's are likely to re-assess the financial health of insurers in the wake of the financial crisis. Wait to see which insurers maintain the highest ratings.
An oft-quoted Warren Buffett bit of wisdom goes that the stock market is designed to transfer money from the active to the patient. Keep that in mind when you wonder when this crisis is over for good.
Let's remember what this crisis is all about. It's not just about problems with bad mortgages and toxic mortgage-backed bonds. "That's just the tip of the iceberg," says Charles de Vaulx, portfolio manager for International Value Advisers. The reason that we're still stuck in a bear market and that loans are hard to come by is the ongoing crisis in confidence in the financial system that greases the wheels of the economy. It may take months, if not longer, for the markets to get enough courage to overcome this.
Whether you're an investor or a would-be borrower looking for a sign of better days to come, pay attention to the so-called overnight London Interbank offered rate. Libor is a rate banks charge one another. The lower it is, the greater the likelihood that banks are willing to lend freely - and the sooner this credit crisis may be over.
Historically, Libor has run fairly close to the federal funds rate, which the Fed is currently targeting at 2%. But lately the overnight Libor has fluctuated between around 3% and 6%, an indication that banks still perceive a great deal of risk in the market.
In the short run, that's not great news for investors or consumers waiting for banks to start lending again. In the long run, however, the fact that banks are starting to consider risk isn't necessarily bad. After all, says Steven Romick, manager of the FPA Crescent Fund, "the reason we're in this mess is that financial institutions tried to make money without any regard to the concept of risk."
Additional reporting by Joe Light 
