You had it all worked out: by the time you both retired at the end of 2007, you and your spouse had accumulated a tidy nest egg. You planned to withdraw 4% of the value in your first year of retirement to supplement the other sources of income you would have. Each year after that, you’d increase the amount by 3% to cover inflation. Sophisticated computer simulations performed by your financial advisor concluded there was a 90% likelihood that your portfolio would produce the income you need over a 30-year retirement.
Then 2008 blew up your plans.
According to mutual fund manager T. Rowe Price, market performance in the first five years of retirement is the most critical period. The returns the financial markets dish out during this time can make or break your retirement lifestyle. A loss of last year’s magnitude is devastating.
Don’t blame your financial advisor or her computer program. A 30% to 40% annual decline in U.S. stock prices has only happened a couple of times in the past 71 years. A meltdown of the kind of global proportions we experienced last year had never occurred.
None-the-less, the computer actually did take this kind of a highly improbable scenario into consideration, which is why it didn’t predict a 100% probability of success. Remember: a 90% likelihood that something will occur means there is a 10% chance it won’t .
While a 30% hit to anyone’s portfolio is a huge blow, the impact on someone who is retired is especially severe for the simple reason that she isn’t pulling in earned income that could be added to her portfolio to help repair the damage. What’s worse, since retirees are withdrawing money, cashing out investments that have declined in value, it results in liquidating assets at an accelerated pace. This further increases the chance that you will deplete your assets prematurely.
However, as the chart below illustrates, you may not have to do anything too drastic to help your portfolio get back on track. In fact, T. Rowe Price found that extreme measures, such as moving 100% of your money into fixed income investments, could make things much worse .
Likelihood Retiree Will Not Run Out of Money Over 30 Years
Source: T. Rowe Price
This analysis assumes that: 1) your investments are divided among stocks (55%) and bonds (45%) and, 2) in the first year of retirement your portfolio loses 30% of its value. For the sake of argument, let’s say it started out with a value of $1 million and dropped to $700,000.
As line “A” illustrates, if you stick to your plan to withdraw 4% ($40,000) in Year 1 and increase this amount by 3% each year (Year 2: $41,200; Year 3: $42,436; Year 4: $43,709, etc.), the probability your investments will produce this income drops from 90% to 40%. In other words, there’s a 60% chance of failure.
However, if, instead, you simply hold your withdrawals steady over the next 5 years, your probability of success increases substantially -- to 60%.
Likelihood RetireeWill Not Run Out of Money Over 30 Years
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