How to prepare for Recession

Wednesday, October 16th

How To Be Financially Ready For An

Upcoming Recession: 5 Things To Do Now

The economic signs are troubling, and getting worse.  More and more seasoned investors believe a recession is imminent, and that trillions in wealth could be lost.

While the thought of the market crashing can sound pretty terrifying, there are important things you can do to prepare yourself, and lay the groundwork for a successful retirement, even in an economic downturn.

Here are five investment strategies you can implement right now to be financially secure even after a recession.

1. Understand Diversification vs. Correlation

Diversification

We’ve all heard that we need to diversify. However, true diversity doesn’t just mean investing in lots of different stocks and bonds – what it means is that each investment is doing a different job.

Many people think that they’re diversified already. But in reality, they’re just assembling a bunch of separate funds or holdings that are doing the same jobs.

If all of your investments are doing the same job, then that will leave holes in your protection and performance.

Do note that diversification doesn’t guarantee protection from loss during a recession. However, it does help mitigate risk from specific investment losses.

Ok. Now that you understand diversity, it’s time to look at…

Correlation

So, when we said that true diversification means allowing each investment to do a different job, this means choosing investments that do not correlate with each other. Correlation means the directions in which stocks are moving in relation to one another.

So, if two stocks rise together, they correlate at a ratio of 1.0.

If, on the other hand, two stocks move in the complete opposite directions, with one falling and one rising, then their correlation ratio would be -1.0.

Correlation

The key to creating your portfolio is
fill it with several different kinds of funds that are as noncorrelated as possible.

This is the real goal of diversification, and it’s crucial during a recession.

However, diversification is becoming harder and harder to do because of something known as…

Globalization

Diversification is becoming more and more difficult because of globalization and the global economy.

Here’s a little history..

Not long ago, you could buy an international investment with low correlation to your domestic holdings.

Now, unfortunately, the correlation between domestic and internal stocks

Globalization

has risen due to the globalization of economies around the world and the expansion of multinational companies.

The increased correlation has led in turn to increasing amounts of stock intersection (or fund overlap). This happens when many different funds invest in the exact same stocks.

So, when you invest in multiple funds, you’re likely holding the same stock many times over.

Why We Still Need to Diversify

So you might be wondering: if diversification is getting harder, then why is it still the best strategy?

Well, unless you can pick the right stocks all the time, you need to diversify. Diversifying is like eating right – it’s right for the long term.  Diversification allows you to spread out the risk and cushion yourself more from the blow of a recession, thus protecting your hard-earned money.

2. Know What Stage of Life Investing You're In

The effects of a recession and the stage of life you’re currently in are unfortunately closely related.

We break down these 3 life stages as accumulation, preservation, and distribution.

Each stage has its own goals and objectives. A recession can complicate things though, especially for the preservation and distribution stages.

1 Accumulation

This stage starts in your 20s and continues through your early to mid-50s.

Most people are making advancements in their lives at this stage: starting a career or a family, etc. With other larger expenses taking priority during this time, there’s usually less money being allocated to retirement accounts.

A recession can make this accumulation phase more difficult for sure, but if you do manage to save more, the ups and downs of the markets will likely not affect your future retirement.

This is because markets have always rebounded in the past eventually, whether it took 4 years (great Recession) or 14 years (the dot-com bubble).

2 Preservation

This stage of life happens approximately 5 years before retirement. Making the right decisions at this stage before a recession is critical.

At this time, you should NOT be trying to double or triple your money. Preserve it! You don’t want to lose your nest egg just before your retirement.

If there’s an iceberg ahead (recession), you need to steer the ship to safety so that you stay on your original course.

Preservation

3 Distribution

When you enter retirement, your priority is to replace your paycheck.

Social Security and a pension can replace much of your income but often people must begin taking money for their retirement accounts.  The challenge is deciding how to withdraw from your investments while still making sure that your money lasts as long as you do.

During a recession, taking those withdrawals can be have a greater impact on how long the money lasts because you are now taking funds from accounts that have just dropped in value.

Why These Stages Are Important

Stage of life investing is essential to understand because volatility of the same investments can vary significantly over different periods.

During the accumulation phase time is on your side (even during a recession) and you can usually expect consistent and predictable returns over the long haul.

However, when you shorten the time period of the same investments, the returns will be more volatile and unpredictable. This can put your retirement plan into jeopardy.

The Solution: TDFs?

This realization that investment strategies should change depending on the stage of life you’re in has led to the rise of target-date funds (TDFs).

With a TDF, as you approach retirement age, the makeup of the fund is adjusted to be more conservative, to reduce risk to the portfolio.

TDFs have grown more popular as employers now automatically enroll employees in them as part of their 401(k).

Most employees make no changes to this default option provided by their company, so the money has continued to pour into TDFs.

The Problem With TDFs

Many have assumed that the “glide path” of a TDF would automatically provide a safe landing for their retirement funds.

But 2008 proved this notion to be terribly wrong

TDFs that had a date of 2010 (just 15 months before the crash in  2008) showed investors losing on average 24% with losses ranging between 9-41%.

As to why this happened, the average fund had more than 50% invested in stocks only 15 months before the market crashed!

When the next recession hits, this could happen again.

So, if TDFs aren’t the answer, then what is?

The solution is to have a comprehensive investment strategy that can help you be disciplined and wise during every stage of life. It will help you to adapt to the changing market conditions, and give you the confidence to stick with the plan.

3. Don't Lose What You've Already Got

When most people meet with us, they think that they aren’t taking too many risks in their portfolio. However, many are surprised to find out they are taking much more risk than they thought.

During retirement, success is built on protecting your nest egg. This is because the impact of losses on your portfolio will be far more significant than the effect of the gains.

That is why our #1 job is to protect your money, and our #2 job is to grow it.

The good news is that you can limit your risk while still growing your money during retirement – even during a recession.

The key is to not take risks that will cause you to fail in retirement and run out of money.

Limit Your Risk

The Impact of Losses on Your Portfolio

You can lose on a portfolio in 3 different ways:

  • 1 by losing the money you have invested or grown over time
  • 2 going forward and having less money to invest which makes all future gains less than what they would have been
  • 3 losing the time in the market at your pre-loss value

Now that you understand how seriously losses can affect your portfolio, the next thing to understand is what’s known as a “sequence of returns.”

Sequence of returns

This is one of the most important concepts to understand and might be the most critical factor in determining how long your assets will last you during retirement.

The sequence of returns simply means the sequence (order) in which your investments produce positive and negative returns.

For example, compare these two scenarios when withdrawing money during retirement:

  • If during your retirement, you experience more negative returns at the beginning, and positive returns near the end, you’ll have less money left over later on.
  • On the other hand, if you experience positive returns at the beginning and negative returns in the end, you’ll have more money left over.

The 4% Rule Called Into Question

For years financial advisors told clients they could safely withdraw 4% and they would never run out of money due to the average returns being high.

However, there is a difference between average returns and actual returns. The markets don’t produce a steady average rate of return year after year. Therefore, the long term averages can’t protect you from the significant impact of actual losses at the start of the withdrawal period.

Your retirement success is critically dependent on the returns and losses at the beginning of your withdrawal period.

In a practical retirement plan contingencies need to be made and anticipated to protect your nest egg at this decisive stage.

Or to put it differently:

Negative returns in the 1st few years after you start withdrawing funds (the distribution phase) will cause you to deplete your account balance at a much greater rate than if you had received those negative returns at the end of the investment.

Two Different Sets of Rules

What this shows is that the average rate of return over time doesn’t matter during the distribution phase. What matters is the sequence of returns.

The lesson to be learned here is that when you begin taking money from your account the timing of returns is the critical factor.

Money Accumulates and Grows

Remember this regarding the rules that govern how your money accumulates and grows:

  • 1. one set of rules applies while you accumulate and build your nest egg
  • 2. the second set of rules apply when you are spending that nest egg.

The problem is that nobody tells you the rules change with the different life stages, so people don’t realize it until it’s too late.

4. Fees Are More Important Than You Realize

Fees. Something that is usually an afterthought for most people is a major factor in the success of your financial plan.

In a CNBC survey of 10,000 households, 53% didn’t know what they paid in fees for investment services. [PAGE 106 of ebook] [NEED THE SOURCE] (changed to 53%, source is Harris Poll, June 2018)
https://www.nerdwallet.com/blog/investing/financial-fees-study/

In our experience, that number is much lower as many prospective clients who walk in don’t know and understand all the fees they are paying.

And it makes sense. Fees are not a fun subject for investors.

In addition, Wall Street has spent years and billions of dollars in an effort to hide the fees you are paying and because finance is already a difficult enough subject area, and the vast majority of people don’t take the time to try to find the true cost of their investments.

However, fees are the #1 factor in your investment success. So, it would help if you had at least a general understanding of what you’re paying for the different types of fees.

We’ll list the most common fees here:

The 401(k) Fee Structure

401(k)s are actually of the biggest culprits for investment fees because many people view their 401(k) as a benefit provided by their company.

67% of Americans think they pay no fees at all for their 401(k).

However, the fees from your 401k are paid by the employee not the employer.

The hidden fees inside the various investment options can add up and impact the value of your nest egg.

But not knowing the total fees you’re paying when investing is a big mistake.

Now let’s look at the most common types of fees that apply to mutual funds.

The Expense Ratio

This ratio includes a few things in it that you need to know about:

  • The management fee – the cost the fund manager charges for picking and adjusting holdings inside the fund. The fee can range from 0.5-1%. This is regardless of whether the fund goes up or down.
  • It also includes “administrative costs,” these are a bunch of small costs like postage, record keeping, coffee machines, etc.
  • 12B-1 fees – this is a marketing fee that goes towards broker commissions, as well as advertising and promoting the fund.

The average expense ratios range between 0.2% – 2%, but the average is about 1.4%.[PAGE 109 of ebook] [NEED THE SOURCE] ETFBD.com

https://etfdb.com/compare/highest-expense-ratio/

Transaction Fees (Hidden Costs)

There are many “invisible” unreported costs for funds, and the most notable ones occur when the manager makes changes to the portfolio makeup. So how much will these end up costing you?

According to a study that analyzed portfolio holdings and transactions for 1800 equity funds from 1995-2006, these invisible costs can be even higher than the expense ratio.

Altogether, they have a considerable negative impact on fund performance.

Transaction Fees

The average transaction costs were 1.44% compared with the average expense ratio of 1.19% [PAGE 109 of ebook] NEED THE SOURCE] SOURCE: “Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance,” Roger Edelen, University of California, Davis, 2013.

The study also found that funds with the highest transaction costs underperformed funds with the lowest transaction costs by 1.78% a year, almost a 2% difference! [PAGE 110 of ebook] NEED THE SOURCE] SOURCE: “Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance,” Roger Edelen, University of California, Davis, 2013

Loads

These fees are for the broker’s commission. There are different types of these fees, depending on what class of mutual fund you’re purchasing.

Class C has no load fees, which means it’s often better than Class A or B funds.

The load fees are in addition to the expense ratio and transaction costs and can impact returns dramatically.  Even if these funds performed the same as the benchmark, the additional fees will result in a lower return.

As a result, many mutual funds underperform and produce lower returns than the benchmark.

Double Dipping

Some brokers charge a management fee and then invest your portfolio into funds with the fees mentioned above.  This is called “double-dipping” where fees are stacked on top of fees, resulting in even worse performance of the investment.

Taking steps to reduce fees is often the difference between your portfolio underperforming or outperforming the market.

5. Creating an Efficient Income Stream

Creating an efficient income stream for retirement has become more important as more people retire without pensions.

The 4% withdrawal rule has traditionally been recommended as a safe withdrawal rate. But due to increased market volatility and longevity, this rule is being called into question.

As a result, investors are struggling to determine the right strategies, risk levels, and returns they will need to maintain an income stream that lasts as long as they do.

The Ideal Withdrawl Rate

One of the big mistakes retirees make is not creating a detailed income plan.  Instead they just start taking money from various accounts once they retire not considering how that will impact their future income streams.

It is critically important to understand that the withdrawals you make at the beginning of retirement can impact your options later on.

So how much can you withdraw?

Well, the amount of income you can get in retirement depends on 3 factors:

  • 1. how much you start with
  • 2. how fast you grow it
  • 3. how quickly you consume it.

The challenge is not knowing how long the money actually needs to last.

Life Expectancy

With modern medicine, these days if you are already 65, there’s a 47% probability you or your spouse will live into your 90s.  [Page 138 of ebook] [NEED THE SOURCE] Can’t find this stat – actual number is lower, via the US Social Security Administration: https://www.ssa.gov/planners/lifeexpectancy.html

Remember the sequence of returns? When you start withdrawing, the sequence (or order) of positive and negative annual returns is often the most crucial factor for how long your money will last.

The best way to mitigate the risk of depleting your money is to not make

Life Expectancy

withdrawals from accounts that are experiencing negative returns.

In addition, creating income sources that provide guaranteed lifetime income can be a very effective strategy in retirement.

Efficient Income Strategies

At the end of the day, the amount of income you are able to access in retirement comes down to three basic factors: how much you have, how fast you grow it and how fast you spend it.  Take out too much too early, or don’t grow your retirement account over time, and there may be very real consequences for your retirement.

In fact, the conventional wisdom that taking out 4% per year will not affect your retirement account long term is simply no longer true.  Half of all retirement accounts that follow this strategy will eventually run out of funds.

So instead of taking out withdrawals during downturns in the market, generating negative returns, you can take out an annuity.

Income Strategies

An annuity allows you to take out more than 4% each year without ever risking running out of money.  Insurance companies are able to guarantee this by spreading out the risk, and putting in controls over what and when you can take out without penalty.

If you choose to annuitize, the insurance company will still allow you to take money out at a withdrawal rate as high as 6%-8%, however the money is no longer available as a lump sum at retirement or death.  Instead, it will be paid out in installments.

Still, most people don’t want to forfeit their money should they pass away suddenly, so adding an income rider to the annuity has become more and more popular.  Adding an income rider guarantees for lifetime income and a rate of return, that still allows them to pass on any remaining balance to their beneficiaries.

It is important to understand when you add an income rider to an annuity, the insurance company calculates two values: the account value and the income value.  The account value grows based on the actual investment performance, the income value is calculated using a set or stacking rate.  Income value is almost always higher than account value.

Efficiency

Income riders usually cost between .5% and 1.25% per year and you can only access up to 10% of your principal per year without penalty.  However and annuity is guaranteed even if the account balance becomes exhausted – a benefit you will find with few other investment options.

So don’t get sidetracked by flashy claims of higher returns, with higher risk.  There’s no such thing as a risk-free investment.  Instead keep in mind the power of income efficiency.  If you manage it the right way, you can generate income streams you can live on for the rest of your life.

Conclusion

I know that we’ve gone through a lot of information in this post, but to summarize, here are the main takeaways for a successful retirement strategy:

  • Diversify your holdings, don’t correlate them.
  • Adjust your investment strategy depending on what stage of life you’re in.
  • During retirement, focus on keeping your wealth instead of trying to grow it.
  • Don’t ignore fees when investing!
  • Consider getting an annuity with an income rider.

Of course, this is just an overall summary.  If you might be interested in speaking with us and having us develop a retirement plan specifically tailored to you, regardless of what life stage you’re in, please get in touch with us today by clicking the link here.

Thank you!

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