Many people who retired in 2000 thought they were in great shape: over the last 20 years, stocks returned 17.8% on average.
More modest returns were expected for the next decade, but few would have bet stocks would actually go down—that had occurred only about 5% of the time over rolling 10-year periods since 1926. Then came two ferocious bear markets.
Retirees in 2000 who had an 89% chance of living on their retirement income for the next 30 years saw their prospects plunge.
In a new study, T. Rowe Price draws this lesson from the last dismal decade: retirees need to cut spending for about three years after bear markets.
"Our research shows that retirees who take a 'set it and forget it' approach to their retirement income strategy do so at their own peril, particularly when hit by a bear market," says Christine Fahlund, a senior financial planner with T. Rowe Price.
An investor who simply continued withdrawals as planned throughout the decade now only has a 29% chance of not running out of money, with T. Rowe’s model. "And fleeing to bonds was certainly no panacea. Those investors, who locked in their equity losses, missed the ensuing market rebounds," explains Fahlund.
The study assumed hypothetical investors who retired on Jan. 1, 2000, with a $500,000 portfolio, invested 55% in equities and 45% in bonds and withdrew 4% of portfolio assets ($20,000) the first year, with that amount increasing 3% annually for inflation.
Using normal expectations, as of Jan. 1, 2000, these investors had an 89% chance of sustaining these withdrawals over 30 years. However, less than three years later, by the end of the first bear market in September 2002, the odds of being able to keep up that withdrawal rate had fallen to just 46%.
Although those odds were largely restored by the five-year bull market, they fell to only 6% after the bear market from October 2007 to March 2009. So what would have been their best strategy over the decade?
T. Rowe Price concluded that an investor who temporarily reduced withdrawals by 25% for three years after each bear market bottom had the best chance of outliving her assets. By the end of 2010, her odds of sustaining withdrawals over the thirty years had reached 84%.
Three years is a good bet, as Fahlund explains, in the last ten recessions prior to 2007, it took about 20 months on average for the S&P 500 to recover to its pre-recession peak from its recession low.
The next best strategy: Taking no inflation increases for three years after each bear market bottom (from 2002–2005 and again from 2009–2012). That brought the odds to 69% by the end of the decade.
An investor who switched to a 100% bond portfolio at the end of the first bear market in September 2002 was left with a virtual certainty of running out of money.
"We realize that cutting withdrawals by 25% may not be realistic for many retirees on a tight budget," Fahlund explains. "The math will always work so that the less you withdraw, the more you will have in your account. So the rule of thumb is to take whatever achievable or realistic steps you can to reduce withdrawals or hold them steady until markets rebound."
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