Drawdowns Happen

Stocks don't make new highs every single day, so most of the time you're going to be underwater from your portfolio's high-water mark. Former hedge fund manager and applied mathematics professor Robert Frey gave a great talk on this subject, called 180 Years of Market Drawdowns (you can watch the talk here).

Frey highlights that even though markets trend higher over time, drawdowns happen all along the way. And they occur often. In fact, you are likely to be in a drawdown state more than 70 percent of the time; a quarter of the time the drawdown will be 20 percent or more.

That is the most important concept to get comfortable with: As an investor, you will constantly be in a drawdown state. Not coming to terms with this leads to second-guessing, which could prompt changes based on emotion. Behavioral finance tells us that most people look at their high portfolio value as the benchmark. If their portfolio went from $50k to $100k and then down to $90k, they feel as though they lost $10k rather than being up $40K. They then regret not having sold or done something differently.

A second takeaway is the importance of diversification, not just across different asset classes but different countries as well. Drawdowns can last a long time. The main stock index in Italy has been in one since 2000, and Japan's Nikkei since 1989! Any investor in those countries who has only invested in their home markets has experienced their own "great depression."

Corona Virus Panic

In the most recent Outlook I said, "Expect volatility to continue. Historically, the biggest up days occur within correcting markets so the swings will be both ways, driven by the headline of the day." Talk about an understatement. Thousand-point swings in the Dow have been occurring daily, even within the same day.

I started to write a note last week, but even as erratic as markets were, they actually finished higher than February's month-end.

Things began to change over the weekend. The main catalyst was that Russia opted out of a Saudi-spearheaded proposal to deepen crude production cuts. With coronavirus tanking demand, Saudi producers wanted to cap supply to prop up oil prices. Russia was unfazed. Allegedly tired of production cuts favoring U.S. shale producers and holding back energy investments because of the cuts, the Kremlin decided enough was enough.

Oil opened Monday down 30 percent, a move we hadn't seen since the Gulf War in 1991. Led by a sell-off in energy producers, stocks had their largest drop since the financial crisis in 2009. The Dow lost 2,000 points, its greatest point loss in history. On the more accurate percentage scale, however, it was 7 percent, only the 23rd worst one-day loss. (One month into my first Wall Street job out of college, the Dow lost 508 points in the October 1987 crash, which was 22.6 percent. Now that was a crash.)

While lower oil prices are welcome, and will certainly help the majority of Americans going forward, there is a more immediate impact. The U.S. is a net exporter of oil, and it is a highly leveraged industry. A lot of corporate debt (especially high-yield junk debt), as well as banks in the oil patch, will be under tremendous pressure. If lending markets start to freeze, the effect will ripple across the broader economy.

The main story of course is the coronavirus. It seems to be turning into a full-on black swan event. Global travel and tourism add $4 trillion to the world economy every year. With the trade wars and other factors already having slowed global growth last year, it looks like the world economy will not get through this unscathed. When you hear the comparisons to the flu, and see the actual numbers of victims, covid-19 doesn't appear to be all that bad. But then you see statements like that of German Chancellor Angela Merkel's today, that up to 70 percent of the German population will likely contract the coronavirus, and that her government's priority is about "slowing its spread."

I've been asked by several people how what's going on now compares to the financial crisis in 2008-09. For me, the much better comparison is 9/11. Like now, it was an event that literally came out of left field. The hit to the heart of the financial capital of the world closed the stock exchange until the 17th. When it finally opened, it fell 7 percent and ended the week down 14 percent. Then, like now, airlines and other travel-related companies were down closer to 50 percent. The bank I worked at was completely shutdown. It would be months before we were back to operating normally in our temporary location in New Jersey, and many other firms suffered the same fate.

Uncertainty was everywhere. The week after the attacks, letters containing anthrax were being mailed to media outlets and senators offices, resulting in five deaths. These headlines weighed heavily on the market.

The economy was in a different place then. We were in the midst of a recession caused by the aftermath of the crashing of the tech bubble. The attack certainly prolonged its length, but by 2003 things started heading back up.

Now, we have been in a period of steady--although unspectacular--growth, about two percent a year. Many are saying that coronavirus will put us in a recession. That's hard to say. It is a health scare, not a financial one. Because of changes made in the wake of the financial crisis, banks balance sheets are strong. They won't be a drag on growth going forward.

On the positive side, it's a global problem that will bring about a coordinated response. Bonds in our portfolios provide the ballast needed to help offset the sell-off on the stock side. Our accounts are holding a decent amount of cash, raised over the past six months or so due to valuations that will be deployed at cheaper levels. And here is an update of a chart I have shared with many of you in the past:

Plan to Retire at 65 (Even If You Really Want to Keep Working Longer)

It's common to hear people say, "I'll be working till I'm 70" or "I'll never be able to retire." I sometimes counsel clients that they might need to work part-time or on a consulting basis before stopping work entirely.

The problem of incorporating working beyond what would be considered normal retirement age into your long-range planning can be a costly one. According to the 2013 Retirement Confidence Survey, co-sponsored by the Employee Benefit Research Institute and Mathew Greenwald & Associates Inc., 47 percent of retirees last year stopped working earlier than they expected. For many, circumstances out of their control, such as health issues (for them or their spouse) or the loss of their job, were the reason. These retirees say they are not confident they will be able to pay basic living expenses, let alone medical or long-term care expenses.

The takeaway from this is that you don't want to make working longer an integral piece of your retirement plan. If, for example, a 50-year-old client has the choice of increasing his or her savings rate to make it feasible to retire at 65, or keeping the rate the same and retiring at 67, I would advise her to increase her savings rate. That is a variable that she can control. If she is lucky enough to have the ability to keep working later in life, then it will be a choice she can make, not one she has to make.

Borrowing From Your 401(k)

Some clients found themselves short of funds in the midst of a condominium conversion recently and covered the shortfall by borrowing from their 401(k)s. It made sense to them because a unique feature of a 401(k) loan is that, unlike other types of borrowing from a lender, the employee literally borrows their own money out of their own account, such that the borrower's 401(k) loan repayments of principal and interest really do get paid right back to themselves (into their own 401(k) plan). In other words, even though the stated 401(k) loan interest rate might be five percent, the borrower pays the five percent to themselves, for a net cost of zero. Which means as long as someone can afford the cash flows to make the ongoing 401(k) loan payments without defaulting, a 401(k) loan is effectively a form of "interest-free" loan.

The caveat, though, is that paying yourself five percent loan interest doesn't actually generate a five percent return, because the borrower that receives the loan interest is also the one paying the loan interest. And borrowing from a 401(k) causes you to lose out on tax efficiency. Loans are repaid with after-tax dollars. In other words, someone in the 25 percent tax bracket would need to earn $125 to repay $100 of the loan. Savers' 401(k) money is taxed again when withdrawn in retirement, so those who take out a loan are subjecting themselves to double taxation.

But the real cost of borrowing from a 401(k) plan is that it exacts a big opportunity cost. Borrowers miss out on any compound growth that their investments would otherwise have earned in the market. Many plan participants either stop contributing to their 401(k) or reduce their contribution for the duration of their loan, so they also miss out on the company match.

Unless the money is repaid quickly, the loan represents a permanent setback to retirement planning. So for a short-term shortfall like my clients experienced, it can be a good solution. For any payback period of more than six months to a year or so, check out other options.

Longevity Insurance

One of the hardest risks to manage in retirement is the uncertainty of longevity: How long the retiree will live, and therefore how long of a time horizon needs to be planned for. Planning too short can lead to asset depletion if the retiree lives longer. Planning for too long leads the retiree to unnecessarily constrain retirement spending for a future that never occurs.

A special type of annuity is designed to address this problem. Longevity insurance is a deferred-income annuity, in which a person pays a lump-sum premium to an insurer in exchange for a guaranteed lifetime income stream that begins several years later--perhaps well into the person's 70s or 80s. Until tax law changed over the past few years, these annuities could not be widely used in 401(k) retirement plans and IRAs because those plans require account holders to begin withdrawals at age 70½.

Workers can now satisfy those rules if they use a portion of their retirement money to buy the annuities and begin collecting the income by age 85. Anyone with defined contribution plans such as 401(k) and traditional IRAs is allowed to circumvent the Required Minimum Distribution (RMD) rules up to the lesser of $125,000 or 25 percent of their retirement plan balance, to the extent that it's invested in "qualifying longevity annuity contracts" (QLACs). A key requirement is that QLACs provide that lifetime distributions begin at a specified date no later than age 85. Someone with a $500,000 account balance, for instance, can buy the maximum amount.

The annuities must also be relatively basic and cannot be loaded up with many of the special features, like cash-surrender options, that insurers often offer. But annuity providers are permitted to sell a feature that guarantees that the annuity owner's beneficiaries will receive the premium amount originally paid, minus any payments already made. They can also provide an option that would continue paying the income to a beneficiary after the annuity owner's death.

Buying an annuity that doesn't begin making payments until much later is more cost-effective than buying an annuity at retirement and collecting the income immediately. The reason is straightforward: There is a higher chance the individual will not live long enough to begin collecting payments, and the money from people who die earlier benefits those who live longer.

For example, take a 68-year-old man who buys an income annuity and immediately begins collecting lifetime income of $1,000 a month, or $12,000 a year. His premium would be about $170,000, according to New York Life. But if the same man bought the annuity at age 58 and waited 20 years to collect his payments, he would pay less than $40,000 for the same $12,000 in annual income.

Given the fact that people are generally living longer, combined with the uncertainty of the sustainability of a traditional investment portfolio as a source of retirement income, a QLAC can be a welcome option.