It’s not even a month into 2016 and the stock market is already in turmoil. The S&P 500 index was down by double digit percentage and who knows where we will go from here. A few major stock indexes around the world already entered a bear market (20% decline) and I suspect that 2016 will be the bear year for the US stock market as well. This is actually good for most of us because a bear market is a great opportunity for the long term investor. However, a bear market is really bad news for one particular group of people – someone who just retired or will be retiring soon.
Studies have shown that retiring in a bear market is one of the worst things that can happen to your nest egg. This is because you have to sell some investments to fund your cost of living. Retiring into a bear market means you would sell at the worst time and it’s tough to come back from that initial setback. A study from T. Rowe Price showed that the first five years are the most crucial period of your retirement. After the first five years, a bear market would still hurt, but it won’t impact your retirement as much.
Historically, a bear market occurs about once every 3.5 years and lasts around 15 months. You’re almost guaranteed to run into a bear market in the first five years of your retirement. So what can you do if there is a bear market during the first five year of your retirement?
Avoid selling in a bear market
The worst time to sell your investment is when the stock market is down. One way to avoid selling is to use the bucket approach. We can divide our nest egg into 3 buckets – short, intermediate, and long term.
- Short term bucket – cash. Retirees should keep enough cash to fund one to two years of living expense. That’s including social security and any other income you have in retirement. So if you spend $50,000 per year and receive $20,000 in social security benefits, then you would need to keep at least $30,000 in cash. This cash bucket will help get you through the worst of the bear market.
- Intermediate term bucket – bonds. Bond funds are usually much more stable than stocks in a bear market. Retirees can sell their bond funds and use that income to replenish the cash bucket as needed. Another approach is to build a bond ladder. You can set up a bond ladder to mature every year with enough money to refill your cash bucket. Your bond bucket should have at least 5 years of living expenses. A bear market averages about 15 months, but it takes a while for the stock market to recover as well.
- Long term growth bucket – stock. A bear market is scary for retirees, but the stock market is great for long term growth. By setting up a cash and bond bucket, you can avoid selling in a bear market and wait for the recovery. Once the market recovers, you can sell some stocks to refill the short and intermediate term buckets.
The downside to the bucket approach is that your asset allocation will fluctuate quite a bit. Your bond allocation will drop in a bear market and you will need to rebalance when the stock market recovers. This approach also assumes that you have a significant portion of your retirement investment in bonds. If your asset allocation is 100% stocks, then this bucket approach won’t work.
Reduce withdrawal rate
Another way to preserve your nest egg is to reduce your withdrawal rate while the stock market is down. Cutting back can be difficult, but it’s not impossible especially if you just retired. Actually, there are quite a few things you can do.
- Put off large expenses until the stock market recovers. Instead of taking 3 international trips, perhaps cut back to one and visit local sites instead. Put off buying a new car and keep fixing your old car for a few more years. Once the stock market recovers, you can splurge a bit to make up for putting things off.
- Earn some income. A little earned income goes a very long way in retirement. Even $1,000 per month can make a big difference. There are many things recent retirees can do to earn a little income.
- Put off retirement until after the bear market. I hate to say this, but putting off retirement until the bear market is over is a very good option. You can keep investing while buying at a bargain price. I know this is not an option for some people, but it’s a good idea if you can put retirement off for a year or two while the stock market recovers.
- Tighten your belts. Rowe Price recommends cutting your withdrawal by 25% and raising it back after the market recovers. 25% is a pretty big cut and retirees will need to make some adjustments. The good news is that the cut back shouldn’t last too long and you only need to do this once. After 5 years, a bear market has less impact on your nest egg and you shouldn’t have to cut back as much if at all.
- Move to a cheaper location for a few years. I think this is a great option for someone who recently retired. I would love to take a few years off and go live in Thailand or Ecuador. Our cost of living would plummet in those locations. Portland is getting more and more expensive every year. Of course, if your cost of living is already low, you won’t benefit as much from moving to a more affordable location.
Lastly, you can save more for retirement. If you think you need a million dollars to retire, then save 15% extra. That cushion will help pull your nest egg through a bear market. Beefing up your nest egg by 15% seems difficult, though. I bet the bear market will be over before you can increase your retirement portfolio by 15%.
One way to keep an eye on your nest egg is to use a good retirement calculator. I like Personal Capital’s Retirement Planner and FireCalc. The Retirement Planner at Personal Capital is nice because all my portfolio information is already online. They can calculate using real-time data and give me feedback instantly. If my desired spending power drops below the projection, then I know I’ll be in trouble. FireCalc is great because it gives me a visual representation of how things could play out over the next 30 years. We’re still looking pretty good with both these calculators.
Of course, if your retirement plan is solid, you probably don’t need to check the calculator very often. Checking the stock market too often will give you an ulcer and it can make you doubt your plan.
Stay the course
The first 5 years of retirement are the most crucial years. Most of us will run into a bear market during this time so we need to plan for it. The worst thing you can do in a bear market is sell all your stocks and put it somewhere safe. You will most likely sell at the wrong time and miss out on the recovery when it happens. Once you made it over this 5 year hump, your retirement should be much smoother.
If you need help, you should find a trustworthy local fee-only financial advisor. They can help create a retirement plan for you and convince you not to sell at the worse time.
If the stock market drops 40% in 2016, could you handle it? Have you made plans for a bear market during retirement?
Image credit: Rob Hurson