With the Dow Jones Industrial Average (DJIA) crossing the elusive 20,000 barrier last Wednesday for the first time, a lot of people are excited about investing in the stock market. Never mind the fact that the DJIA has tripled in price from its low of 6,470 on March 6, 2009, increasing at a mind-boggling average annual rate of return of 40% for the last eight years.
If you have an aggressive portfolio and are within 15 years of retiring, you need to protect it from a sizable decline. When the Dow lost 52% in 17 months between October 1, 2007 and March 6, 2009, no one saw it coming. A lot of people who were planning on retiring in 2008 and 2009 were forced to postpone retirement.
Given the stock market’s unsustainable climb in the last eight years and the associated possibility of a significant market correction, it makes sense to insure your investment strategy. Assuming a portfolio of at least $500,000, one of the best ways that you can do this is by allocating 20% to 25% to one or more deferred fixed income annuities.
Aggressive Portfolio With No Income Protection Plan
Let’s assume that you’re 58, single, are planning to retire in 10 years, and you have an aggressive portfolio with a value of $1 million. Let’s take a look at two scenarios:
- Your portfolio declines 50% over the next 17 months.
- Your portfolio increases 10% over the next two years and then declines 50% over the next 17 months.
In scenario #1, the value of your portfolio has decreased from $1 million to $500,000 at the end of 17 months. In scenario #2, the value of your portfolio has increased from $1 million to $1,210,000 before decreasing to $605,000 17 months later.
You would probably agree that whether the value of your portfolio is 50% or 60% of its initial value, this doesn’t bode well for your retirement planning. It will take a long time for you to recover your loss. You’re also getting closer to your planned retirement date. Furthermore, your portfolio isn’t designed to provide you with any predictable retirement income.
Aggressive Portfolio With Income Protection Plan
Let’s suppose instead that you decide to insure your $1 million portfolio from a potential market decline by transferring 20%, or $200,000, into a deferred income annuity offered by a highly-rated life insurance company that will pay you lifetime income beginning when you retire in 10 years. The life insurance company will also pay (a) a death benefit of $200,000 to your beneficiaries if you die before your income start date or (b) up to 10 years of payments to you and your beneficiaries if you die within the first 10 years after your income start date.
In scenario #1, the value of your remaining portfolio of $800,000 has decreased to $400,000 at the end of 17 months. In scenario #2, the value of your portfolio has increased from $800,000 to $968,000 before decreasing to $484,000.
By transferring $200,000 into a deferred income annuity, you have reduced your portfolio loss by $100,000 or $79,000, depending upon the scenario as follows:
- Scenario #1: Investment portfolio of $400,000 + deferred income annuity of $200,000 = $600,000 vs. $500,000 with no income protection plan
- Scenario #2: Investment portfolio of $484,000 + deferred income annuity of $200,000 = $684,000 vs. $605,000 with no income protection plan
In addition to reducing your portfolio loss, by transferring $200,000 into a deferred income annuity, you will receive annual income of approximately $20,000 for the rest of your life beginning at age 68 no matter what the stock market does. If the investment source is nonqualified funds, approximately 50%, or $10,000, of your annual income will be nontaxable.
Insure Your Portfolio
I believe that the 20,000 Dow is more than just a milestone given the breakneck pace at which it was achieved assuming that your reference point is March 6, 2009. It is instead a wake-up call for anyone with an aggressive portfolio who is within 15 years of retiring who doesn’t currently own any fixed income annuities. If this describes your situation, now is the time to income-proof your portfolio before the next major downturn when you’re that much closer to your planned retirement date.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.