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Stock market pullback is a big risk early in retirement. What to know


New retirees — or anyone on the verge of retiring — may want to consider what an extended stock market dip would mean for their portfolio over the long term.

While Monday’s market slide has been partially reversed, it is a reminder that even if the stock market recovers quickly, there can be significant risk to your portfolio in the first years of retirement due to the “sequence” of losses. That risk basically is about how the order, or sequence, of stock returns over time — combined with your portfolio withdrawals — can impact your balance down the road.

Wade Pfau is a professor of retirement income from the American College of Financial Services. “If there’s an early downturn, it can destroy a whole retirement program.”

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The Dow Jones Industrial Average shed 1.8% on Monday, while the S&P 500 Index dropped 1.7% and the Nasdaq Composite index lost 2.2%. Although stocks climbed a bit on Tuesday, there’s persistent uncertainty among investors over whether a bigger pullback is on the horizon. 

For long-term savers — those whose retirement is many years or decades away — such market drops matter less because there’s time for their portfolios to recover before they need to start relying on that money for cash flow.

In retirement, the stakes are greater.

Avani Ramnani (certified financial planner), managing director of Francis Financial, New York, stated that if there is a significant loss in the markets and you are taking out withdrawals, it could mean you take more from your portfolio.

Ramnani stated that if this happens in early retirement, the recovery could be weak. This can put you at risk of losing your ability to recover or have you reinvest less than you should. It may also jeopardize your retirement life.

To illustrate how sequence of returns risk can impact your savings: Say a person had retired at the turn of the century with $1 million invested in the S&P 500 and withdrew $40,000 each year, with withdrawals after the first year adjusted 2% for inflation.

The order in which those returns occur is more important than the returns themselves.

Wade Pfau

Professor of retirement income at the American College of Financial Services

In 2020, the remaining balance would have been about $470,000, according to Ben Carlson, director of institutional asset management for Ritholtz Wealth Management, who crunched the numbers for a blog post.

In the above scenario, the portfolio would have been subject to a bear market at the outset of the person’s retirement, when the S&P lost 37% over three years, 2000-2002, but enjoyed a long-running bull market that began in 2009.

However, if the order of yearly returns were flipped — the gains posted by the S&P at the end of the 20 years happened first and that early bear market happened last — that same person would have more than $2.3 million after withdrawing the $40,000 or inflation-adjusted amount each year.

Pfau stated that it’s not just the returns in a given time, but how they are distributed over time that matters.

How to combat the risk

The good news is that there are options for mitigating the risk.

Pfau suggested that spending less is the best way to reduce risk. Pfau stated that spending less consistently means less money to withdraw.

An alternative strategy to reduce your portfolio’s performance is to increase your spending. 

Ramnani said, “You need to look at all your expenses and determine if you have any that can be stopped.” You might not take a holiday or put off large-scale renovations that would need a lot of distribution.

Pfau also said that you can reduce the risk of your portfolio. Pfau said that you can have a low stock portfolio in retirement and increase it as time goes by, or to meet short-term needs, use bonds instead of stocks.

Pfau explained that this is a way to reduce volatility.

You should not have assets that aren’t in your portfolio, but can still support your spending when stocks fall.

Pfau stated that you would store the money as a reserve while your portfolio recovers. 

Pfau suggested that a buffer might be cash, reverse mortgage lines of credit, or permanent insurance with cash value. As long as it is protected against market losses, this could work.

You may be able achieve your goals considering the performance of the stock market over the past decade.

Pfau stated that you could eliminate some volatility.