Retiree 1 - Michael is 85, a widower, needs about $50,000 a year for his expenses, and is just beginning to have some medical problems significant enough that he is concerned he may need to give up driving and get some type of assisted living, home health care, or nursing home treatment before long. He has both children and grandchildren but does not want to move in with his relations if this can be avoided. He has long-term health care insurance which, with Medicare, he expects will substantially reduce the costs of a major long-term illness or injury. He also has chosen to take full advantage of the new Medicare prescription drug provisions.
With respect to his financial assets, Michael has long felt he understood the stock market and so has a habit of keeping a large proportion of his assets in stocks or stock mutual funds. However, in the 2000-2002 bear market, his portfolio lost about one-third of its value. Following this decline, his equity assets now stand at about 65% of his non-real estate holdings, and he's not been able to significantly increase that percentage without dipping into his bond assets or money market funds. Because of the uncertainties in the market, as well as in his own circumstances, he's been unwilling to do that to any large degree.
To assess Michael's proper equity percentage, we first look to The Vanguard Group and Fidelity Investments' stock percentages, in their "life cycle" mutual funds, that adjust allocations depending on their client retirees' ages. With both companies, we find that, for current retirees aged 80 or above, the recommended equity allocation is just 20%.
Reviewing Michael's situation, it appears that he likely has sufficient funds, if he is careful with his portfolio, to retain assets through the remainder of his life.
However, his holdings are vulnerable to a major potential threat. With equities at 65%, any significant downturn in stock markets would severely reduce his net worth. And, at age 85, he is unlikely to live long enough to recoup those losses. After a major bear market, it sometimes may require ten to twenty years for complete recovery of average stock prices.
There is no reliable way to know just when such a big drop in equities could occur. The only certainty is that markets fluctuate widely and tend to go down more when, as now, prices are generally elevated, with higher than normal price to earnings and price to book value ratios and lower than normal dividend percentages per share.
Investors sometimes bid stock prices up out of all proportion to the underlying worth of shares (and could continue to do so for at least a few more months), but Michael's ability to maintain most of his nest egg intact partly now depends on good luck, though the odds seem to favor a new downturn before stocks move substantially higher.
Fortunately, though, his annual financial requirement of $50,000 can be easily met with his present portfolio amount. He might, to consider the other allocation extreme, even convert his entire holdings to Certificates of Deposit, short-term bonds, or money market funds, and so have both great security of his holdings plus the ability to live off them for up to at least twenty years.
But this level of caution is probably unwarranted. And even given Michael's advanced years, he needs to use part of his assets as a means for his net worth to potentially grow and so offset some of the effects of inflation. A well managed 20-25% of his portfolio in stocks or stock mutual funds can help accomplish this.
He might, however, be well advised to reduce his equity exposure. It is now over three times the level suggested for his age and thus involves excessive market risk.
If Michael wishes to retain greater involvement in the stock market than with about a quarter of his portfolio, he can do so through specialized annuities that invest one's assets in stock mutual funds yet provide a fixed income (for example 6-7%) for an extended period, i.e. not less in years than the initial value of the mutual fund annuity holdings divided by the percentage dollar amount. Thus, for an annuity with a present mutual fund market value of $250,000 and providing income at 7% a year, Michael would receive $17,500 for 14.3 years, after which any further payments would depend on whether the mutual fund holdings, after moderate expenses, had in the interim increased beyond their current market value. (For particulars, I defer to readers' financial consultants. Within our extended family, such specifics are available through Frank, a Raymond James Branch Manager.)
Besides such annuity instruments and about 20-25% in direct stocks or stock mutual funds investments, the balance of Michael's financial asset portfolio could be invested in cash equivalent holdings (such as money market funds), in short-term bond assets, or in closed-end bond funds, this last type asset to be held indefinitely, simply for the income. For instance, ACM Income Fund, Inc. (ACG), effective 6/2/04, at $7.95, had a yield above 10% a year and was trading at a significant discount to its net asset value. Van Kampen Strategic Sector Muni. Trust (VKS), at $13.15, was providing an essentially tax free yield of 6.7%.