The recent market selloff was frightening for anyone saving and investing for retirement. But the prospect of a major slump in stock prices can be especially upsetting for people who have recently retired or are close to calling it a career.
If you're in that position, here's how to gauge the risk you might face — and how to reduce the possibility you'll have to revamp your retirement plans in the next bout of market turbulence:
Understand How a Crash Can Mess Up Your Plans
Imagine this scenario: You've been saving and investing regularly throughout your career and now plan to pull the trigger on retirement within the next year or so.
By that time, you figure your nest egg will be worth upwards of $1 million, large enough — assuming you follow the 4% rule — to generate about $40,000 in inflation-adjusted withdrawals.
Combine that income with the Social Security benefits you've racked up, and you figure you should have enough money to relax and enjoy the retirement you've worked and planned for so diligently.
Then, just as you're preparing to exit your job, boom! The stock market starts to swoon.
Before you know it, your nest egg's value has declined 20%, and instead of starting out retirement with $1 million, your account balance has been trimmed to $800,000. Suddenly, clouds have appeared over a retirement outlook that seemed so sunny just a short time ago.
Go to a tool like T. Rowe Price's Retirement Income Calculator, plug in a $1 million portfolio, and assume an initial 4% (or $40,000) withdrawal that will subsequently be adjusted by the inflation rate. The calculator will tell you there's roughly an 80% chance that your nest egg will be able to sustain that level of withdrawals for at least 30 years, or, if you retire at 65, until you reach age 95, a reasonable planning assumption given today's long lifespans.
But assume you'll draw that same $40,000 (adjusted annually for inflation) from an $800,000 nest egg, and the outlook isn't as rosy. You've essentially raised your withdrawal rate from 4% to 5%. And as a result the calculator lowers its estimate of your chances of sustaining that $40,000 in real income throughout retirement to about 55%, or a little better than a coin toss.
You could maintain an 80% or so chance of your nest egg lasting 30 or more years by applying the 4% withdrawal rate to your nest egg's new lower value of $800,000. But that would represent a substantial reduction in inflation-adjusted income from $40,000 a year to $32,000, a cut of more than $650 a month.
It goes without saying (but I'll say it anyway) that these are estimates, and not guarantees. That said, it's clear that a significant drop in stock prices on the eve of or in the early stages of retirement has the potential to put a serious crimp in your retirement plans.
This is why it's important that you come up with a way to deal with the possible fallout of such a market setback before it actually occurs.
Prepare for the Next Market Setback
Step #1: Review how much of your nest egg is invested in stocks, as that will largely determine how much your portfolio's value will drop if the market slumps.
Basically, you want to avoid taking a huge hit to the value of your savings, since the combination of investment losses and portfolio withdrawals can dramatically shorten the longevity of your nest egg, especially if that combo occurs just before or soon after you've retired.
There's no single stock/bond mix that's ideal for everyone. As a rule, you want to invest enough in stocks to maintain your nest egg's purchasing power over the long term, but not so much that you'll incur stomach-wrenching losses and end up selling in a panic during a market meltdown.
For many retirees a stock stake in the range of 40% to 60% in the initial stage of retirement makes sense, although what's right for you will depend on such factors as your risk tolerance, the size of your nest egg, how much income you need to draw from it, and what other resources (a pension, cash value life insurance, whatever) you have to fall back on.
Step #2: Go over your retirement budget to see if there are ways you might lower your spending — and thus portfolio withdrawals — to give your nest egg a better chance to rebound from any investment losses. (Don't have a retirement budget? Then I suggest you create one, which you can do by going to BlackRock's Retirement Expense Worksheet.)
To the extent possible, you'll want to identify discretionary expenditures (travel, entertainment, dining out, etc.) you might reduce or eliminate rather than essential ones, which probably offer less leeway for cutting back.
Step #3: Look for ways you might generate some extra income to pick up the slack of smaller withdrawals, such as taking out a reverse mortgage or picking up part-time work.
And while postponing retirement entirely may be a more extreme solution than you'd prefer, working longer to give your nest egg a chance to recoup losses can be an effective move that's worth investigating, assuming that staying on the job is an option.
Step #4: Remember to be patient. While it's important to be aware of — and prepare in advance for — the impact a market downturn might have on your retirement prospects, you should also keep in mind that even a significant market setback doesn't necessarily doom you to a post-career life of penury.
Just as markets slump, they also recover, and as stock prices rebound, so too can your prospects for a secure retirement.
For example, someone who retired on the eve of the financial crisis with a nest egg invested 60% in stocks and 40% in bonds would have seen the value of his savings fall by about 20% and the chances of his nest egg lasting 30 years decline to between 50% and 60%, just as in the scenario I outlined above.
But had that person withdrawn 4% of savings, increased that initial draw by 2% annually to maintain purchasing power, and rebalanced the portfolio back to 60% stocks-40% bonds at the end of each year, the sharp rebound in stock prices would have restored the chances of his savings lasting to age 95 to the original 80% or so within a few years.
Indeed, the market's performance has been so strong that this hypothetical retiree could even consider boosting withdrawals.
Of course, there's no assurance that the next market setback will mirror the last one. It could be less severe. But then again stock prices could also drop further and stay depressed longer.
But by taking reasonable steps to mitigate the effects of a market downturn, you should be able to improve your chances of proceeding with your retirement plans with as little disruption as possible.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question you would like Walter to answer online, send it to him at email@example.com. Follow Walter on Twitter at @RealDealRetire.
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