These are the times that try retirees' souls -- and those of near retirees as well.
Big drops in the stock market obviously can devastate retirement accounts. But the people most at risk are those who have just retired or who are about to retire.
That's because dipping into a shriveled nest egg can dramatically increase your chances of running out of money. The cash you take out won't be there to earn future returns when the market recovers; what's left would have to earn extraordinary gains to make up for the double-whammy of market losses and your withdrawals.
"It's the mathematics of compounding," explains Taylor Gang, a wealth manager with Evensky & Katz, one of the country's leading financial-planning firms. "It grows your money on the upside but shrinks it on the downside. If you have a 50% loss, you need a 100% gain to get back to the same point."
How bad can it get? Pretty bad:
- Studies by mutual fund giant T. Rowe Price (.pdf file) found that people who tap the recommended 4% of their nest eggs in the first year of retirement and who increase that withdrawal amount by 3% each year to compensate for inflation stand only an 11% chance of running out of cash before they die -- if they retire in a normal market.
- If they retire in a bear market, however, and do the same thing -- 4% initial withdrawal, adjusted thereafter for inflation -- their risk of running out of money can shoot to more than 50%.
The first five years in retirement are critical, said Christine Fahlund, a senior financial planner for T. Rowe Price, because the average retiree has many years ahead.
If a bear market occurs in the second five-year period, "it isn't quite as bad," Fahlund says.
Time for a game plan
Here's your game plan if you're in the retirement danger zone:- Get help. Retirement calculations have too many moving parts, and the consequences of mistakes are too serious for you to go it alone. Seek advice from a fee-only financial planner who has plenty of experience with retirees. You can get referrals from the National Association of Personal Financial Advisors and the Garrett Planning Network. Mutual fund companies, including Vanguard, Fidelity and T. Rowe Price, also have advisory services, as do many brokerage firms.
- Don't bail on the stock market. Typical retirees need to keep at least half of their portfolios in stocks or stock mutual funds to offset inflation's effects. Keeping all of your money in so-called safe investments -- bonds, Treasurys, savings accounts, certificates of deposit or money market accounts -- ensures your purchasing power will decline over time as inflation and taxes erode your nest egg's value. Hiding in cash "is not going to work, not when you have so many years ahead of you," Fahlund says. "You simply have to have the growth" that stocks offer in the long term.
- Consider putting off retirement. The simplest solution may be waiting to retire until the market is firmly back in positive territory. You may still have to deal with future dips, but at least you're not starting out by scooping money from a shrinking pool. "Our advice right now is that if you don't have to retire, don't," Fahlund says. "Of course, a lot of people don't have a choice. They're already retired or being forced out."
If that's the case:
- Consider part-time work. Whatever you can do to reduce your initial withdrawals will help stretch your nest egg. "A part-time job that pays $20,000 . . . is the equivalent of having saved an extra $500,000," Fahlund says, because a 4% withdrawal of $500,000 would produce $20,000.
- Trim or freeze withdrawals in bad markets. Financial planners differ on how much and when you should cut back, but the T. Rowe Price simulations found an investor who retired in 2000 with a 4% withdrawal rate would be unlikely to run out of money if he trimmed that initial withdrawal amount by 25% within two years. That's a drastic cut, though, and one most people would be unwilling or unable to make, Fahlund says. An alternative is to freeze your withdrawal in a bad year, then for one or two years afterward. "When it's time to take that 3% increase, don't take it," Fahlund recommends. "Defer that (increase) for up to three years. You can manage on literally a fixed income for that time." You can explore the numbers using MSN Money's retirement income calculator.
- Set aside a cash cushion. Gang's company insists its retired clients keep at least one year's worth of expenses in cash or cash equivalents, such as short-term-bond funds. That stash grows to two years if the client doesn't have a large guaranteed income stream, such as a pension, to cover most expenses. A fat cash cushion also can give you the comfort level to ride out market downturns without panicking and selling. "The whole idea is to protect the grocery money and help manage behavior," Gang says.
- Keep your home equity on tap. Selling your home or using a reverse mortgage to extract its value might be a reasonable way to supplement your retirement income if you have substantial equity, as I discuss in "55 and haven't saved a dime? Yikes." The problem here is obvious: With today's declining home values, you may get less out of your house than if you wait for the real-estate market to recover. But no one really knows how long that will take. Talk to your financial planner about your options, but if you don't need your equity to make ends meet, you could be wise putting off a sale or reverse mortgage until market conditions improve.