by Larry Katz
How to handle market declines early in your golden years.
Stock prices are up substantially from their March 2009 lows, but there is always the possibility that markets will retrench. What will happen if stocks tumble soon after you retire?
Let's use an example of two unrelated individuals, Sue and Joe. Each one has $1 million and retires at the age of 65 with a portfolio comprised of 50% global stocks and 50% bonds. Each plans on withdrawing an initial $50,000 (5% of beginning portfolio value) and will increase this amount with inflation each year. Each expects to live to 100. They retire at different times.
Sue's portfolio supported her as she planned for 35 years, with enough money left so she could leave a large legacy. Joe, on the other hand, ran out of money prematurely.
Why the difference? It's all due to the randomness of returns in retirement.
Sue was fortunate enough that, in the first few years of her retirement, her portfolio earned relatively high returns net of inflation. Joe wasn't so lucky. His portfolio's returns were negative (after inflation) in the first few years of his retirement.
While we can't predict the future, we can use something called "bootstrapping" to analyze the impact of different sequences of returns on a portfolio. Bootstrapping, as we use it, starts with the returns for a portfolio similar to the one we recommend to our clients, for the 41-year period between 1970 and 2010.
To estimate a possible range of future returns, we then construct 41 hypothetical scenarios, each assuming that retirement began in a year from 1970 to 2010. We calculate all subsequent returns through 2010, then loop back to 1970 and the years following. While these 41 scenarios don't indicate future performance, they give us a reasonable range of outcomes to consider.
For each scenario, we use the Consumer Price Index (measured for the 12 months ending the previous December) to increase distributions annually.
Consider three separate examples:
Scenario 1: Sue retired in 2009. The first year, her portfolio returned 20.2%, inflation was 2.7%, for a real return of 17.5%. The second year of reitrement, the portfolio gained 13.5%, or 12% after inflation. Thirty-five years after retirement, Sue can expect her $1 million starting portfolio to be worth $8.1 million.
Scenario 2: Joe retired in 2007. In his first year, stocks gained 6.3% and inflation was 4.1%, leaving 2.2% as a real return. The second year was worse, with the portfolio losing 16.4% after inflation. The hits put Joe at a disadvantage, and at his withdrawal rate he can expect to run out of money in 29 years.
Scenario 3: Similarly, someone who retired in 1973 would have experienced a 6.8% loss in the first year, but with 8.7% inflation the real return would have been minus 15.5%. In the second year, the after-inflation return would have been negative 20.6%. Against those odds, the retiree would run out of money in 33 years.
In retirement, positive returns increase the size of the portfolio, while negative returns and distributions make it smaller. As a general guide, we believe that portfolios can generally sustain a 4% initial distribution, increasing by the rate of inflation each year.
Sue and Joe each started taking out a more aggressive 5%. Sue's portfolio (Scenario 1) benefited from high returns and low inflation in the first two years of her retirement, and that decreased the distribution rate to a more sustainable level over time. Her portfolio eventually generated returns in excess of distributions, leading to good growth.
Let's look at two possible scenarios for Joe, Scenario 2 and Scenario 3. In the second scenario, the portfolio suffered an extremely poor return of -16.4% in the second year after Joe retired. As inflation continued raising his distributions, his portfolio could not keep up with them and ran out of money in 29 years.
The third scenario shows two bad things happening early in retirement -- negative portfolio returns and high inflation. These caused the portfolio to shrink at the same time that distributions increased rapidly. This combination led to unsustainably high distributions, and the portfolio failed in 33 years.
Advice for Future Retirees
What can investors do to keep from ending up like Joe, given all the uncertainty about future returns?
1. Have more at the start
The adage for a vacation is to take half the luggage and twice the money, since people know it is not unusual to spend more than planned.
The same applies to the size of retirement portfolios. The best advice is to retire with a portfolio that is worth more than you think is necessary, rather than with a portfolio that will last only if everything goes exactly right.
2. Stress test your portfolio
When planning for retirement, assume negative portfolio returns and high inflation in the first two years of retirement. If the resulting smaller portfolio can support the higher inflation-adjusted distributions over a long life span, you're probably doing OK.
3. Have a Plan B
When considering retirement during a time of either negative market returns or high inflation, analyze your situation closely to see if your portfolio can sustain the resultant long-term stresses. You will improve your probability of success by delaying retirement for a year or two, decreasing your spending, or taking some part-time work -- or a combination of these options.
Your retirement can be more like Sue's if you recognize that the best way to cope with future uncertainty is to save more while you can and to spend at a sustainable rate in retirement.
Copyrighted, MarketWatch. All rights reserved. Republication or redistribution of MarketWatch content is expressly prohibited without the prior written consent of MarketWatch. MarketWatch shall not be liable for any errors or delays in the content, or for any actions taken in reliance thereon.