Inflation and market downturns can make retirement a difficult choice. According to economists and advisers, the market’s performance in the first few years of retirement can considerably impact how long a nest egg lasts, partly because losses are larger when a portfolio is typically at its largest.
It isn’t always possible to time your retirement to coincide with a bull market. Researchers have found that even people who retired at the worst time to do so since 1926 would have made their money last 30 years by following specific rules.
The combination of market losses and withdrawals can leave a portfolio too depleted to last decades at the start of retirement, when a portfolio is usually the largest. According to Wade Pfau, professor at the American College of Financial Services in King of Prussia, Pa., and author of “Retirement Planning Guidebook,” the first five years after retirement are crucial to determining a sustainable lifestyle in retirement.
The 4% rule suggests that a 62-year-old retiree with $1 million should spend 4% of that on retirement. The proposed approach calls for spending 4% of a retirement balance in the first year, after which it is adjusted for inflation. The investor would have $960,000 after taking the first annual withdrawal of 4%, or $40,000. In the first year, a 15% loss would reduce the balance to $816,000. Approximately $527,000 would be left after two more years of similar withdrawals and 15% losses.
As a comparison, a 62-year-old retiree with $1 million who experiences 15% annual growth will have about $1.36 million after three years of $40,000 withdrawals.
History shows that people who retire in down markets can still recover their portfolios despite the market’s importance in early retirement. A person with 50% of their investment in stocks retiring with $1 million on January 1, 2007, would have had about $874,000 left after two years but would have about $1.63 million today thanks to the long bull market and low inflation that followed the financial crisis of 2008.
According to Mr. Pfau, a portfolio consisting of 50% U.S. large-cap stocks and 50% intermediate-term U.S. government bonds would be acceptable if you didn’t panic in 2008. It is also important for retirees who face losses to cut spending as much as possible since if you overspend with a portfolio that is simultaneously dwindling, that leaves you with less when the markets recover, according to Christine Benz, Morningstar’s director of personal finance.
The worst 30-year period for retiring began in the late 1960s. Back-to-back bear markets started around 1969 and 1973, plus high inflation hit retirees then. Even though many in that era could rely to some extent on traditional pension benefits, these factors led many individuals to drain their nest eggs faster than they otherwise would have.
According to economists, expect inflation and falling markets to continue for the time being. If prices continue to rise, investors may have to choose between withdrawing more from shrinking portfolios or cutting spending to protect their nest eggs, according to Pfau.
To make their money last longer, retirees can take the following steps:
When the market declines, cut spending.
Based on Mr. Pfau’s analysis, the 4% rule would have protected retirees from running out of money even during the worst 30-year period since 1926 for retiring, which was 1966 to 1995. If your portfolio incurs losses in a given year, Mr. Pfau recommends not taking inflation adjustments.
Changing spending even a little bit can have a dramatic impact, said Mr. Pfau. Using the 4% rule, someone who retired in 1966 would have run out of money after 30 years. In contrast, by spending 3.8% to start instead, the investor would have preserved most of their original nest egg after 30 years.
Don’t Panic
Pulling all your investments out at lower prices and repurchasing them at higher prices will hurt your portfolio over the long term. Think carefully before making major decisions regarding your portfolio. If you have questions you should talk to a financial advisor.