Rosalind Evans
The stock market may face volatile times in light of the current federal debt-ceiling impasse and the potential for an impending recession. This scenario can be particularly daunting for retirees who depend on their investment income.
It’s standard advice for retirees to incorporate stocks into their nest egg, as they are a powerful tool for long-term growth, countering the damaging effects of inflation over the retirement years, something that cash and bonds typically fail to do.
However, over-withdrawing from stocks during prolonged periods of depreciation can pose a significant risk for retirees, especially those who have just entered retirement.
Luckily, there are measures retirees can take to minimize this risk.
Morningstar’s director of personal finance and retirement planning, Christine Benz, explains, “Retirees have two primary defences if they are drawing from their portfolio to cover living expenses.” The first is to shift the source of withdrawals, for instance, to draw from cash or bonds instead of stocks when possible. This allows retirees to tap into assets that haven’t lost value, Benz suggests.
However, this is only sometimes feasible, as evidenced by 2022, when both stocks and bonds experienced sharp declines.
The second strategy is to reduce the total amount withdrawn from investments, says Benz.
The importance of caution for retirees The issue at hand is that during a market downturn, investors are forced to sell more stocks to maintain the same income level. When the market stabilizes and rises again, the portfolio has less capacity to grow.
If retirees aren’t mindful of this dynamic, they may exhaust their funds earlier than planned in their retirement years.
Here’s an example: Often, retirees base their annual withdrawal on a percentage of their portfolio, usually between 3% to 5%. Suppose they continue withdrawing the exact amount after a significant market decline. In that case, the withdrawal rate might increase to 7% or 8% — an unsustainable rate that could negatively impact the portfolio, warns David Blanchett, head of retirement research at PGIM, the investment management division of Prudential Financial.
Blanchett adds that the key is to remain flexible within the limits of each retiree’s financial situation.
Uncertainties of economic downturns and market retreat It’s important to note several variables.
Firstly, a stock market downturn isn’t a foregone conclusion. U.S. lawmakers could reach a debt-ceiling agreement by early June, staving off potential financial chaos.
And although Federal Reserve economists predict a possible mild recession later this year, it’s not guaranteed. A corresponding market pullback isn’t assured either; there have been periods like the early 1980s and 1990s when stocks didn’t contract during recessions, as per a Morningstar analysis.
Also, adjusting withdrawal behaviour is more crucial for younger retirees, particularly those in good health and who expect to rely on their nest egg for many years.
For instance, Charles Schwab provides a scenario involving two recently retired individuals, each with a $1 million portfolio and $50,000 annual withdrawals (inflation-adjusted). The difference is the timing of a 15% portfolio loss. The first individual experiences failure in the first two years of retirement, with a 6% gain annually after that. The second person gains 6% annually for the first nine years, suffers a 15% loss in years 10 and 11, and gains 6% annually. The first person would exhaust their funds after 18 years, whereas the second would still have around $400,000.
Being flexible may be easier for some retirees than others.
Some retirees might have their basic needs (like food and housing) covered by guaranteed income sources such as Social Security, pensions, or annuities. If their investments are primarily used for discretionary spending, such as holidays and leisure, they may find it easier to reduce spending from stocks or their more expansive investment portfolio.
Approaches to flexibility Retirees can employ several strategies to maintain flexibility in withdrawals. These could involve a “guardrail” strategy or skipping inflation adjustments in down years.
A straightforward guideline involves using your estimated lifespan to calculate a safe annual withdrawal amount, suggests Blanchett.
Numerous online calculators are available to estimate your lifespan and, consequently, how long your retirement savings need to last. Blanchett recommends the Actuaries Longevity Illustrator provided by the American Academy of Actuaries and the Society of Actuaries.
The calculation is straightforward: Divide one by your estimated lifespan. This will give a reasonable starting point for a safe portfolio withdrawal rate in percentage terms.
For instance, if a retiree estimates a lifespan of 20 years, they would perform the following calculation: 1/20 X 100. This results in a 5% withdrawal rate.
Blanchett stresses, “Continually monitoring your withdrawal rate is critical.”
retirees must tread carefully in volatile markets and ensure they have strategies to safeguard their nest egg. Flexibility and continuous withdrawal rate monitoring can significantly enhance their financial resilience in a potential stock market downturn. By employing sound financial strategies and tools, retirees can ensure a sustainable flow of income throughout their golden years.
