How Stocks Bear Markets Can Boost Your Retirement Investment Planning

By: Money_Morning

Martin Hutchinson writes: If you save for retirement through a 401(k) plan, or have large IRA or Keogh Plan assets, you probably hurled your last statement in the bin. If you'd been making contributions consistently over the last decade, your last annual or monthly statement probably showed that the current value of your plan was well below the amount you had actually invested.

At this point, the temptation to work as long as possible, and then blow what remains of your savings on a round-the-world cruise and a suicide pill is considerable.

However, such despair is unwarranted.

Unless you have already given up all paid employment, or absolutely have to retire in the next year or two, the current bear market may have made your eventual retirement prospects more secure, not less.

You see, the most damaging factor for your retirement happiness was not the current downturn, but the preceding decade-long bubble.

Let me explain. 

Savers who devote an equal amount each month to their long-term plans benefit from an important mathematical principle: Dollar cost averaging. Under dollar cost averaging, you put in the same amount of money each month, so that amount buys more shares if prices are low than it does if prices are high.

Thus, if a mutual fund trades at $1 in month one, $2 in month two and $1.50 in month three, then a dollar-cost-averaging investor investing $300 per month will buy 300 shares in month one, 150 in month two and 200 in month three. After his month three investment, he will own 650 shares at a cost of $900, for an average cost of $1.3846. Since the average price of the shares over the three months was month three's $1.50, he has made an extra $0.1154 per share compared with the average share price.

That's why prolonged bull markets are so bad for retirement investors (unless they are lucky enough to retire before the bubble bursts). In this case, the Standard and Poor's 500 Index stood at 459.27 at the end of 1994. Then after February 1995, when U.S. Federal Reserve Chairman Alan Greenspan moved to an ever-easing monetary policy with low interest rates, it took off for the stratosphere.  It passed its current level of 825 in early 1996, and except for a short period in 2002 has traded above that level ever since.

So, even though retirement savers from 1996-2008 thought most of the time that they were doing very well, in reality they were buying shares at an over-inflated price, and just about every one of their monthly contributions is currently showing a loss.

It's not the current bear market that has caused that loss. Stock prices in 1996-2008 were always at excessive prices, so a major correction was bound to happen sometime. If the correction had happened in December 1996, when Greenspan made his famous "irrational exuberance" speech, the market would have on average been substantially lower over the subsequent 12 years. And a retirement investor who had saved over that period would be substantially richer today because he would have owned significantly more shares of the mutual fund in which he had invested.

The wise retirement savers who have a few years to go should hope the current lower stock prices stick around, maybe even go lower still provided they recover before they has to draw on the savings or convert them into an annuity. By continuing to invest regularly at these lower prices, the return from dividends and capital appreciation will compound more quickly, particularly if they buy stocks that have a substantial dividend yield.

Even if their savings remain adequate, they shouldn't convert them into an annuity because annuity rates are currently very low. With long-term Treasury bonds yielding less than 3%, actuaries factor that exceptionally low return into their annuity calculations.

Right now, a 65-year-old man who buys an annuity can expect to receive only around $74 per $1,000 of investment, without any protection for inflation or guaranteed minimum return if he dies quickly. Once interest rates rise, as they are almost bound to, that annuity rate will rise in step with them.

Rather than convert into an annuity, the retirement saver should simply invest in stocks that are both solid and yield more than 7.4% - and there are still plenty of them out there. That way, he can achieve the same return as an annuity while preserving, and maybe even increasing, his principal - in addition of course to any further monthly payments he can make while still working.

By building a portfolio of such stocks including a selection from emerging markets, he can take advantages of the higher-dividend payouts frequently found outside the United States.

Finding stocks with dividend yields equal to or greater than an annuity yield was tough when the S&P 500 was at 1400. But at 800, it's a lot easier, even if you want to avoid the financial sector for obvious prudential reasons.

Such solid companies as General Electric Co. ( GE ), BP PLC (ADR: BP ), Du Pont ( DD ), Newell Rubbermaid Inc. ( NWL ) and Limited Brands Inc. ( LTD ) yield well over 7% currently, and that's without venturing into emerging markets companies.

If your retirement portfolio has been decimated, don't despair. At these lower stock prices it will be much easier to build its value up again, and because stock yields are higher you won't need so much capital to generate the income you want to live well.

Money Morning/The Money Map Report

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