Savvy investors well know the pitfalls of investing after the market has enjoyed the kind of rally it has over the past five years. Reams of Morningstar data corroborate investors' tendency to put money to work in asset classes, categories, and individual funds after they've generated explosive returns, leading to poor take-home gains for the investors who, in essence, buy high and, later, sell low.
That scenario may well be playing out yet again in the "great rotation" right now, as investors have switched their attention from bonds to stocks in earnest. Meanwhile, equity valuations aren't what they once were. Although some investors--including Oakmark manager Bill Nygren and Morningstar's analyst team--don't believe stocks are crazily overvalued at current levels, there's no shortage of less optimistic signals. The Shiller P/E, which encompasses earnings over the past 10 years to help smooth out cyclical swings, is trading significantly above its historical average, and fund managers like Steve Romick (Fund Manager of the Year in Morningstar's allocation category) say they're finding little to buy right now.
Extremely strong market environments can prompt investors to jack up their portfolios' risk levels when, in hindsight, they should have been doing the opposite. But rising markets can also lead to other, less-obvious financial traps, including those related to IRA conversions, staying on track with a savings and investment program, and deciding when to retire.
Extrapolating Happy Days Into Your Retirement Planning
Account balances look plump these days, and that can make a comfortable retirement--or even an early retirement--look doable. Indeed, research by Rui Yao and Eric Park demonstrated that the more consecutive years there are of market gains, the greater the number of retirement-eligible adults who decide to hang it up. Given that U.S. stocks have posted gains--in some cases very strong gains--in five of the five past years, it wouldn't be at all surprising if many workers in their 50s and 60s were running the numbers on when they can retire.
So what's the problem? Unfortunately, rising markets give with one hand and take away with another. Yes, account balances look ample, but that phenomenon is invariably accompanied by rising valuations. And rising valuations can subject new retirees to one of the biggest pitfalls of portfolio management during retirement--encountering a losing market shortly after beginning withdrawals. When that happens and a retiree doesn't adjust his or her withdrawals downward, the probability that the portfolio will sustain itself throughout retirement drops, too.
Unless your plan is to take your retirement assets and plow them into an income annuity or some other very short-term asset that delivers you the income you need, your portfolio is subject to that sequencing risk. It's counterintuitive, but as Professor Yao has discussed, you're better off embarking on retirement when market valuations are low than when they're at a high point.
Alternatively, if you'd rather not defer your retirement date, you can take a more conservative and/or flexible tack toward withdrawals. Given that very low bond yields and not-cheap equity valuations could limit the potential for strong future investment gains, Morningstar head of retirement research David Blanchett and co-researchers Wade Pfau and Michael Finke have suggested that 4% is no longer a safe withdrawal rate. Instead, retirees who wish to take a static dollar amount from their portfolio, adjusted for inflation, are better off using 3% as a starting point. Another option--and one that's emerging as a best practice in the realm of retirement-spending rates--is to employ a market-sensitive withdrawal rate. If a large market sell-off materializes, reducing spending or, at a minimum, forgoing an inflation adjustment can dramatically improve the portfolio's odds of survival.
Stepping Off the Gas in Accumulation Phase
The current market environment doesn't just carry risks for retirees and pre-retirees; accumulators can also run into pitfalls. One of the big ones is assuming that stock market appreciation will contribute as much toward your goals as it has in the recent past, and giving yourself license to step off the gas with your savings program.
Seeing a higher portfolio balance (as well as rising home prices on Zillow) can deliver a double whammy to an investing plan: The wealth effect that accompanies rising portfolio balances makes it easier to justify extra expenditures and also easier to rationalize lower future contributions.
It can also be tempting to embed the market's recently strong gains into your planning assumptions, and that's another pitfall that accompanies rising markets. Even though the U.S. stock market has returned 20% on an annualized basis over the past five years, long-run stock-market gains are less than half that much. If you're using a retirement savings calculator or running your own numbers to gauge whether your savings plan is on track, it's only prudent to scale your equity-return projections way back to account for stocks' likely reversion to the mean. Employing conservative return assumptions--for both equities and bonds--is apt to illustrate the virtues of stepping up your future savings rate rather than reducing it in light of the market's recent gains.
Converting Entire Traditional IRA Balances to Roth
The strong recent market also carries potential pitfalls in the realm of tax planning--specifically, when deciding whether to convert traditional IRA balances to Roth.
Whether to convert traditional IRA assets to Roth depends on a Rubik's cube of factors, including one's tax bracket today versus what it will be in the future, the presence of non-IRA assets on hand to pay the taxes due, and whether a retiree expects to need the IRA assets in retirement or will be passing them to heirs.
Even if you've decided that these factors line up in favor of a conversion, it's still possible to goof up the timing. Because you'll pay ordinary income tax on your IRA balance when you convert (or, if you've made nondeductible contributions to an IRA, on the investment appreciation in your holdings), you're generally better off converting IRA assets when your balance is at a low ebb (say, late 2008) than when it's at a high point.
Trouble is, your portfolio's high-water mark will only be evident in hindsight. People who conduct an IRA conversion that, in retrospect, was poorly timed (and they paid more taxes than they needed to) have a valuable escape hatch: They can recharacterize their IRA balances back to traditional and convert again at a later date. But you can also avoid that bother and hedge your bets by conducting partial IRA conversions.
Not only does a partial conversion allow you to convert just enough of your IRA balance so that you can remain in a lower tax bracket despite the hit of conversion-related taxes, but it also allows you to hedge against a variety of future market scenarios. If your IRA balance heads straight up from here (and that's a very big if), you'll have gotten some of your IRA assets into the Roth column at an advantageous time, thereby limiting your conversion-related tax bill. But if the market--and in turn your portfolio holdings--cool off down the line, you'll be able to reduce the taxes due on conversion of those shares.