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How Market Volatility Can Affect Your Retirement Plans
For all investors, market volatility is a fact of life. Stock and Bond prices fluctuate from day to day, and markets ebb and flow over time along with the economy and business cycle.
Those saving for long-term goals can usually overlook temporary volatility in the interest of long-term gain.
But for retirees, who increasingly rely on their investments to fund their living costs, market volatility can mean the difference between living comfortably and just scraping by.
In fact, retirees are particularly vulnerable to market downturns, especially in the early years of retirement, because of their dependence on portfolio income, their limited investment horizon, and their need to make sure their savings last throughout their retirement.
To better understand how market volatility can affect the longevity of your retirement nest egg, consider the following hypothetical example. The chart below shows three different investment scenarios, each of which assume rate of 3% inflation.
In Scenario #1, Mr. Jones' investments got off to a shaky start with three straight years of negative performance. When he factors in his 7% annual withdrawals, in addition to the poor performance, he will have depleted almost half of his nest egg in just 10 years.
In Scenario #2, Mr. Jones experienced a steady 6% rate of return over 10 years. After factoring in his 7% withdrawals, his portfolio would be worth considerably more after 10 years than in Scenario #1 — $373,895 versus $229,109 — but such consistent market performance over an extended time period is unrealistic.
Scenario #3, look at what could have happened if Mr. Jones had experienced positive returns early in retirement and hadn't experienced investment declines until much later. As the chart indicates, his portfolio would have come much closer to retaining its original principal value — $479,744 — despite his annual 7% withdrawals.
This example points out the importance of timing in relation to investment gains or losses when you are in the early years of retirement. Positive returns early on can mean a lifetime of financial comfort, while early losses can mean running out of money in the midst of retirement. Unfortunately, the timing of market losses and gains is something that we cannot control.
Market Volatility — A Historic Inevitability
How likely is it that a market decline will coincide with your retirement timing? No one knows for sure. We do know what history tells us — that over long periods of time the stock market has delivered positive returns on an average basis. But we also know that in the shorter term, stocks fluctuate in response to many factors.
For instance, through the market boom of the 1990s, personal investment portfolios were swelling and the stock market reached an all-time high. Then the bubble burst in the technology/Internet sector, corporate scandals the likes of Enron dominated the headlines, and many investors lost a significant portion of their retirement savings. Those who were unlucky enough to be on the brink of retirement — or worse, those who were recently retired — found themselves making radical adjustments to their retirement plans in order to get by.
There have been many other periods of decline throughout history — even though the particular events that triggered them may have been different. And there will no doubt be more periods of market decline in the future.
Although market fluctuations are a normal part of investing, they can still pose challenges to investors, especially those entering or already in retirement. History shows that the probability of experiencing a bear market — defined as a 20% drop in stock values — in any of the first five years of retirement is 46%.
Points to Remember:
1. Although market volatility is a normal part of investing, it can pose serious challenges to investors, especially those entering or already in retirement.
2. Market declines in the early years of retirement can dramatically increase the probability of running out of money in later years.
3. Maintaining conservative withdrawal assumptions — spending no more than 4% of a portfolio's value each year — may help maintain a cushion against future market declines while supporting a hypothetical payout schedule of 20 years or more.
4. Maintain a sensible asset allocation of stocks, bonds, and cash investments and rebalance it from time to time to ensure that it doesn't expose you to damaging investment setbacks.
The guidance of a financial advisor can be especially beneficial in the years leading up to and entering retirement. We have the tools and techniques to help recognize and deal with the financial risks that you will be facing. Click the blue button at the bottom right to schedule a free one hour meet'n'greet to see if we can help you make smarter financial decisions!
Partial content provided by Standard and Poor’s Financial Communications.