Market dips are inevitable. If you have been saving for retirement for decades, then you are no doubt aware of market fluctuations and have weathered a few yourself.
When you are saving for retirement, particularly when you are still several years out, these dips can help build your portfolio. Since you are still contributing, your contributions buy a greater number of shares at the cheaper prices.
But what happens when you retire and start taking withdrawals from your account? Withdrawals during a down market can have a significant impact on the long-term health of your portfolio.
In this article I’m going to explain the risk of taking withdrawals in a down market, as well as a few ways you can protect yourself.
Market Dips and Sequence of Return Risk
The impact of market declines in retirement is not the same as the impact of market drops before retirement. There is a very simple reason for this. It has to do with the direction of the money flow in your account.
When you save for retirement, you make recurring deposits. As I mentioned previously, this means you are BUYING additional shares each time. When the market drops, the shares are cheaper. It follows that you can buy more of them for the same number of dollars contributed. In fact, periodic dips in a pre-retirement portfolio can be very good.
Take a look at this example. I’ll use simple amounts to keep the math from getting messy.
Assume you contribute $100 each month to your retirement account. In this example we will look at three months. In the second month the market drops, but comes back to its original value in the third month. Each month you purchase shares of an index fund with an initial price of $50.
It looks like this:
1st Month: You buy two shares. ($100/$50 = 2)
2nd Month:The price drops to $25 and you buy four shares. ($100/$25 = 4)
3rd Month: The price once again is $50 and you buy two more shares.
What is the result? You end up with 8 shares. Since the final price is $50, your portfolio value is $400 even though you only contributed $300 and the starting and ending prices are the same.
The entire increase in your portfolio value is the result of being able to buy the two additional shares when the market dropped.
This works in your favor as long as you are contributing.
Withdrawals – Reversing the Flow in Retirement
What happens when you reverse the flow and start taking withdrawals? Without even looking at the math involved, reason should tell you that the impact is reversed as well.
Let’s look at the math anyway though. It’ll be fun…
We will follow the same example, simply reversing the cash flow. Instead of contributing to the portfolio, we will take $100 monthly withdrawals. In this case, you have to sell shares at the current price to get the cash to take the withdrawal.
- You sell two shares and withdraw $100.
- The price drops to $25 and you sell four shares. (4x$25 = $100)
- The price once again is $50 and you sell two more shares for $100.
The result? You SOLD 8 shares (which have a current market value of $400) despite only withdrawing $300. That is $100 in lost value that you’ll never get the benefit of.
Sequence of Return Risk
This fluctuation is especially problematic for retirees and near-retirees. In academic and industry lingo, we call this sequence of return risk.
Put simply, the closer you are to retirement the more risk you face due to the ups and downs of the market.
This is true on both sides of retirement. The few years leading up to, and the early years after retirement are when you are most exposed.
The idea, then, is to protect yourself during this critical period.
Withdrawal Strategies for a Down Market
There are few things you can do to protect your retirement account from withdrawals in a down market. The options you have depend on whether you are already retired or not.
Prepare in Advance with an Income Floor
If you are still working and haven’t started taking withdrawals, you can prepare for a market decline in advance. A good way to do this is by investing in fixed investments now that will pay guaranteed amounts when you start to take withdrawals.
This will keep you from having to sell your more volatile investments in a down market.
You can do this is with a bond ladder. Say you are 55 and want to retire at 65. You can buy bonds today that will mature when you turn 65,66, and 67 (as an example). If the market tanks when you turn 65, you’ll have income from your maturing bonds.
You won’t need to sell your shares at reduced prices.
If you have a fixed income floor in place before retirement, the effects of a severe market decline right as you retire will not be as bad.
If you are closer to retirement, you can gain a lot by delaying. I know this may not be what you had in mind, but it can be an incredibly powerful strategy.
Why? Your benefit is amplified.
First, the obvious. When you delay retirement do you NOT take withdrawals. As we saw previously, withdrawals during a market decline are especially inefficient. You would have to sell shares when the market is down. You avoid these withdrawals altogether when you delay.
However, you also contribute even more to your savings. These contributions are especially beneficial because you buy cheaper shares.
By “simply” delaying retirement you reverse the effect of the market downturn.
Reduce Your Withdrawal
If you are already retired and taking withdrawals, a market decline still doesn’t have to mean disaster. You can improve your portfolio outcome with a plan to reduce withdrawals if needed.
This doesn’t mean that you reduce your withdrawals every time the market moves. It also doesn’t mean that you must take a drastic pay cut either.
Even reducing your withdrawals by a reasonable amount during big market declines can help. A variable withdrawal strategy can give you a systematic way of adjusting your withdrawal based on the impact of market performance.
Plan for Smaller Withdrawals
Simple withdrawal strategies like the 4% rule already incorporate volatility into the plan. In fact, the 4% rule is the result of a “worst case” study of retirement withdrawals.
The idea underpinning this strategy is that you withdraw a smaller amount than you might reasonably be able to take in exchange for a very small chance of depleting your portfolio.
You’ll spend less in retirement and most likely end up with a significant estate to pass on.
The Best Way to Plan
The strategies above are ways to think about withdrawals in a declining market. Like most things in retirement withdrawal planning, there isn’t a single correct way. Educate yourself, and then apply what you learn to your own situation.