Many individuals, who invest in the stock market for retirement purposes, begin to lower the percentage of stocks in their portfolio as they get older. The closer they get to retirement and the larger their retirement nest egg grows and the more cautious they become. These individuals will tend to allocate their assets more heavily to bonds, purchase shares in balanced mutual funds or in their most recent adaptations, life cycle funds.

Balanced Funds

A balanced fund is a mutual fund with an investment approach that seeks to soften market volatility by taking a less aggressive investment posture. It typically combines bonds and stocks in the same portfolio. Balanced funds also often diversity their stock holdings by purchasing a percentage of dividend paying stocks, which historically have less radical price swings than stocks that make no distributions. The net result is an overall portfolio that is less risky and is a more dependable provider of income.

There are many different kinds of balanced funds. Each one has a stated investment objective. Be sure the stated objective matches your needs and be sure the fund management is following their own investment policy and not getting caught up in some bull or bear market frenzy. When purchasing a balanced fund there is no guarantee that the portfolio has been optimized. The distribution of securities within the portfolio might be the one that provides the lowest risk for the return generated, but it also might assume much more risk than an alternative portfolio providing the an identical return. Check the funds prospectus for information on how the portfolio was designed as well as additional sources of information on mutual funds and managed portfolios (link???)

Life Cycle Funds

Life cycle funds are one of the new trends in retirement planning. They are funds that allocate assets in accordance with the age of the individual investor. Young investors will have the majority of their funds placed in high growth opportunities. Older individuals are switched to balanced portfolios with a greater and greater emphasis on bonds and other conservative commitments. Life cycle funds are common in 401k plans and provide the advantage of ease and automation.

Balanced Portfolio Risk

It is indeed prudent for those individuals nearing retirement to carefully guard their life’s savings. The stock market is unforgiving and demands diligence from every investor. A balanced fund or a life cycle fund or even a carefully allocated portfolio is not immune to risk. All funds in the stock market are at risk. If your adjusted portfolio allocates 40% of your funds to the S&P 500 stocks, then 40% of your funds are at risk. We have seen that on several occasions the market has taken over 25% of a portfolio’s value, with very little warning. If your nest egg is $350,000 and 40% of it experiences a 25% loss, then you are $35,000 light in your retirement fund.

In our earlier statistical study of the S&P 500 stocks, out of 444 year-to-year periods, the market experienced a 25% or more loss 10 times. (link??) In other words on an annual basis your odds are 2.25% that your 40% portfolio will loose $35,000 or more. If we consider the possibility of a 20% loss ($28,000 gone), our chances rises to 4% in any one year holding period. .

Statistics are a great measuring tool, but we must be careful how we apply them. In the previous paragraph we calculated the odds of encountering a massive market decline as fairly small. However, this was on a year-to-year basis. People do not invest in the market for just one year. They invest for many years. If you stay in the market over a number of years, the chance that you will encounter a major market decline becomes almost a certainty. The real questions are, not if, but when the decline will occur and when it does, how much of your nest egg it will take?

What the market gives, it often takes back. If a major market decline occurs early in your investing career, you will reap substantial profits from your fortunate timing, because your will most probably benefit from the market rebound. If on the other hand, you encounter it toward the end of your accumulation period, near retirement, it will be disastrous if you are not prepared. There is also the distinct probability, that if you are investing over a 10 to 20 year period, you will encounter more than one substantial bear market. How well you protect yourself from these inevitable period of extreme market risk, will determine in large part the size or your retirement fund.

If we look at the buy-hold S&P stock performance in 10 year periods from 1970 to year end 2007, with the exception of period from July 1972 to July 1982 it always shows a profit. However, during many of the periods the amount of profit is not very large. What the study does not tell us, is how much profit the market downswings took from investors? The statistics measure money-in versus money-out. If I have a substantial amount of profit that I have accumulated over the years, the statistics give me a fall sense of security, because they do not count my profits, when they calculate the probability of a loss. That risk to any assets that have been accumulated in the market, is only apparent from the one year statistics.

Let’s look at a sample asset allocation for an individual well on the road to retirement success. He or she holds assets worth $35,000 and has they are allocated according to the following table.

Notice that the above portfolio contains substantial risk. 40% of the funds are still subject to stock market fluctuations and the bond portion could loose a substantial amount also, if interest rates move downward. Consistent earning from the portfolio is mostly from the bond portion, but the stocks do contribute a small amount of annual dividends. Based on historical data, we can expect the portfolio to produce an average annual income of 3.88% (3.71% from the 60% in bonds and .57% from the stocks)

The table below provides similar statistics for an indexed-annuity account. Over the same period of time it is projected to yield between 8.53% and 10.37% annual return. The portfolio has no market risk and a guaranteed floor of 2% minimum interest. Principal is completely guaranteed by the insurance company.

Unfortunately an apples to apples comparison is not possible between a balanced portfolio and an indexed-account. Indexed accounts do not totally lend themselves to same statistical analysis that we have applied to measure stock market risk. Historical indexed performance data is not easy to assemble. These are not publicly traded products and there is not a central market. In addition each depositor enters the portfolio at a different time and there are literally hundreds of variations between indexed products. To further complicate the matter, the statistics that we applied to the stock market are specifically intended to measure market risk- i.e. the risk of losing the principal. The principal in an indexed account is guaranteed. There is no market risk. One is a savings instrument and the other is an investment vehicle. They are not directly comparable. They are apples and oranges. (see ???)

** Note: The results of both tables were projected on the basis of the S&P 500 Stock Index performance from the period of January 1970 to December 2007

Saving Versus Investing

In the later phases of retirement accumulation, it is important to consider whether you should be saving or investing and how much of your retirement assets should be allocated to each accumulation method. Savings has some strong advantages during this period of an individuals financial life, including: high liquidity, competitive returns, the absolute lack of market risk, and if a portfolio is properly structured, virtually no risk of any type.

The tax advantages and stock market linked returns of indexed annuities and indexed life insurance cash values make these products a strong contender for your retirement dollars in the later phases of your retirement life cycle. Additionally, the death benefit features of an indexed life policy can help to optimize other aspects of retirement planning and allow you to squeeze the maximum income out of your retirement assets. (see triple threat & gove insurance policy ???)