For Gen X investors, dotcom bubble hits portfolios near retirement

While baby boomers dominate discussions about retirement, Gen Xers are marching in the same direction, and in many cases, without the significant financial advantages of the previous generation. Retirement at age 55 in America is generally a vestige of the past funded defined benefit pension plan. Now, most people in the 50-55 range are still looking at the next 10 to 15 years. That extends the years they continue to contribute to 401(k) plans and IRAs to grow their wealth, and time in the market is the biggest long-term advantage investors have. But the closer one gets to retirement, the more ill-timed market crashes can set them back.

Gen X is the age group – roughly defined as those born between 1965 and 1980 – most affected by the move from defined benefit to defined benefit pensions, as workplace pensions are reduced. Only 14% of Gen X workers have a traditional pension, compared to 56% of boomers, according to a study by the Alliance’s Retirement Income Institute. When broken down by generation, Gen Xers are the least financially prepared generation for retirement in almost every way. “While baby boomers dominate the headlines, Generation X is facing a major retirement crisis,” the authors write.

This situation can leave Gen Xers watching their retirement fund carefully. A decade of strong returns has put many investors, especially those who have been out of the workforce for a few years, overweight S&P 500 mutual funds and ETFs, rode the stock market’s record gains into retirement. But history is full of crashes, which unfortunately happened at the worst possible time.

The Amazon dotcom bubble stock chart is a good example. Investors who bought at the dot-com high of 1999 had to wait a full decade before the stock regained those old highs, finally reaching new records in late 2009. The broader S&P 500 tells a similar story of the road to recovery. After bottoming out in October 2002 following the dot-com bust, the index took nearly five years to climb to a new high in 2007 — a high it didn’t hold, as the Great Recession wiped it out almost immediately. Measured from the bottom of that second crash, in March 2009, it took another four years before the S&P 500 finally cleared its old peak of 2007, in March 2013.

Depending on how you count, that’s between four and thirteen years of being underwater, depending on which wreck and which hole you’re measuring. And for someone three to five years from retirement, that’s not an academic timeline.

Certified financial planner Ernie Cave, founder of Cave Wealth Management, says the downside will eventually increase, but only when it’s important to retirees. “History shows that markets recover, but tenants cannot choose whether that recovery takes one year or several. If you are forced to sell funds while you are depressed to generate income, those stocks are gone forever and can no longer participate in the recovery,” said Cave. That’s why what financial advisors call “sequence-of-returns” risk is so dangerous.

How to gradually move away from the S&P 500

For starters, investors who are thinking about retirement should avoid getting overwhelmed by the S&P 500’s gains and how well it has performed for them.

“One of the biggest mistakes I see is that investors are going to retire with almost all of their assets in the S&P 500 fund because we’ve done so well over the last decade,” Cave said. The S&P 500 is an excellent long-term investment, but it may not be the right place for the money you’ll need during the first few years of retirement, he added.

“The problem is not having an S&P 500 fund. The problem is asking this fund to pay next year’s bills and fund retirement 25 years from now,” said Cave.

He advocates directing retirees to the “war chest.”

“Typically we’re looking for about two years of expected portfolio distribution secured by cash or very short-term investments, about five years of expected withdrawals covered by cash, treasuries, CDs and high-quality bonds. The remaining long-term assets can remain invested for growth,” Cave said.

The purpose of the retirement war chest, according to Cave, is not to spend on dividends or to end market downturns. “This is to reduce the chances that the retiree will be forced to sell long-term investments at once,” he said.

Investors nearing retirement don’t need a small exposure to stocks, but they do need a clear separation between money they will spend soon and money that can stay invested for the next market cycle. “Retirement doesn’t eliminate the need for growth. It changes what dollars can wait,” Cave said.

Some Gen Xers are on their way to retirement – literally – and that has hopefully limited their exposure to market volatility. A smooth approach is to gradually shift the portfolio from stocks to bonds as the investor approaches and passes retirement, which reduces exposure to market downturns when they can be most painful.

“The dynamic approach is gradually changing the portfolio as the client approaches retirement,” says Elias Friedman, CFP and founder of Kadima Wealth.

Build a temporary bond tent

Another hedge against a market crash is the bond tent, a strategy to temporarily increase bond holdings in the years before and after retirement — the most dangerous window for market downturns.

“Both options can reduce the opportunity to sell shares after a major decline in the stock market. In my experience, clients are more familiar with the glide method of investing,” said Friedman.

Unpacking the bond tent isn’t about waiting for some signal that danger has passed, Friedman says — no one can reliably call that time, and trying to do so is market timing by another word.

“The client has many options about how to handle this risk. For example, consider a bond or a CD ladder or low- to mid-growth securities. You don’t have to put all your money back into the market at once,” Friedman said. “Smart clients will do this prudently and periodically balance the portfolio. This helps reduce some of the risks.”

Either way, Friedman says any change should be gradual rather than a big redistribution change in retirement. “Think of it like driving cross-country on the highway and hitting the brakes. I find that slowing down makes driving less stressful and more comfortable,” he said.

But this market is different from the past in at least one important way, says Asher Rogovy, chief investment officer of Magnifina, a registered investment advisor: AI and the increasing prominence of a handful of technology stocks in the S&P 500.

“Traditionally, 20 to 30 stocks provided sufficient protection against a certain risk of the company. Today, it is estimated that 40% to 50% of the S&P 500 market value resides in companies tied to one topic: AI,” said Rogovy.

If past is precedent, that could mean this won’t end well, Rogovy said. “We’ve seen this story before. The dot-com bubble involved similar levels of index concentration, and the result should give us pause,” he said. “Concentration risk is associated with balanced indices. Significantly, investing equally in each S&P 500 company would have avoided many declines and achieved new highs sooner,” said Rogovy. The S&P created an equal-weighted version of the index in 2003, and now there are many funds and ETFs that offer the option of having exposure to the underlying S&P 500 equally weighted.

But Rogovy doesn’t think there’s a pure stock strategy that can completely escape a market crash, so he says the most important decision for anyone approaching retirement is to differentiate between stocks and bonds. “Because most people know stocks better than bonds, that’s where an investment advisor can prove valuable. By combining a bond allocation with systematic valuation and investing, an advisor can build a portfolio to withstand volatility to protect a client’s retirement,” he said.

For Gen Xers right now, the biggest risk is holding companies in the S&P 500 fund, says Mike Dunlop, CFP and founder of Ignite Planning in Cedar Falls, Iowa. “Currently, seven of them make up more than 30% of everything. For a 50 to 55-year-old person, the real risk is not a crash, a crash at the wrong time – or the risk of a recovery sequence,” said Dunlop.

“If the market drops by 30% the year you retire and you withdraw money to survive that year, you sell down to buy groceries and gas, that group does not get a chance to recover,” he said. “A person who is about to retire doesn’t have a lost decade to give up,” he added.

His fee-only financial planning firm was pulling a portion of clients’ assets out of an S&P 500 fund or a total stock market index fund and moving back into a large amount — “the same stock market, not betting the entire retirement on the top seven names,” Dunlop said.