Rethinking Retirement in Bear Times

July 15, 2008 — -- Thinking of retiring soon? It could be time to adjust your expectations.

The current bear market is wreaking havoc on nearly every investment portfolio, but it may be inflicting its greatest pain on those about to retire or those who are recently retired.

The early years of retirement are generally the worst time for an investor to suffer through a major market decline.

A recent study by the mutual fund firm T. Rowe Price found that poor portfolio performance in the first five years of retirement significantly increases the chances a retired person outlives his or her money over a 30-year retirement period.

Should the current market turmoil persist, those looking to tap into their retirement portfolios for the first time will face a new reality requiring tough decisions.

In many cases, retirement will still be possible, but it may not be the retirement envisioned. It may be a retirement with part-time work, delayed Social Security or fewer trips to fa away destinations.

Frank Boucher, a financial planner in Reston, Va., says "cash is king" if you are retiring, and the market is headed in the wrong direction.

"If you plan to retire soon, you should be building cash reserves in your 401(k) and your taxable investments," he says. "Use this cash to fund your retirement needs while the market recovers."

If you're short of cash, Boucher says, "consider working a little longer or maybe getting a part-time job to reduce your dependence on deflated investments. If doing this doesn't fit in with your retirement plans, you can change those plans. This is your retirement. If you would rather retire now and play golf but worry about money, that's your choice. On the other hand, you may choose to retire now, play a little less golf and sleep better.

To understand why the worst time for a portfolio to sustain major declines is in the early years of retirement, consider the following scenario.

Let's assume you retire with $500,000 in an IRA from which you plan to withdraw 4 percent at the start of each year to help supplement your income. Your first-year withdrawal would be $20,000.

If you then went on to earn a 6 percent return on the remaining $480,000 in that first year of retirement, you would end the year with $508,800, ahead of where you started retirement.

Your second 4 percent withdrawal would then amount to $20,352, leaving you with $488,448. Earn another 6 percent return on that amount, and you would end year two of retirement with $517,755, again ahead of where you started. Retirement's going great.

But now let's assume something far worse.

You retire with your $500,000 IRA and make your first 4 percent withdrawal of $20,000 at the start of the year, again leaving you with $480,000. Then in that first year, your remaining portfolio loses 15 percent of its value as the stock market suffers a decline like the one we're experiencing now. In this case, you would end your first year of retirement with $408,000 -- down $92,000 from where you started.

Then it comes time to make your second annual 4 percent withdrawal and you take only $16,320 from your portfolio. Maybe you adjust for a year by lowering vacation expenses, but your portfolio now is down to $391,680.

Now, what if your portfolio declines in value again in the second year of retirement? Even if it's just a 5 percent drop, you would end year two of retirement with $372,096 in your IRA. Suddenly, retirement is not going so well.

It's time to make adjustments. The good news is that small alterations can make a major difference to preserving a dented retirement portfolio.

In the above scenario, you might consider a part-time job after the first-year portfolio decline of 15 percent, allowing you to eliminate that second-year withdrawal of $16,320. Even if portfolio loses 5 percent in that second year, you would end the year with $387,600.

Again eliminate the planned 4 percent withdrawal and assume a market recovery that means a 6 percent return in the third year of retirement, then you would end that year with $410,856. It's still not where you started, but keep it up and soon your retirement plans could be back on track.

This is a simplistic scenario that does not take into account the effects of inflation, but it underscores the need -- and the ability -- to adjust your retirement to market conditions.

Along with a part-time job, the other major adjustment to consider is a delay in when you begin collecting Social Security benefits. The majority of workers start collecting before reaching full retirement age, but most of those folks would be far better off waiting until then.

Someone turning 62 this year would receive a benefit 25 percent lower than if they had waited until their full retirement age of 66. If you'd qualify for a $20,000 annual benefit at 66, you'd get just $15,000 at 62.

An extra $5,000 a year (before cost of living adjustments) will go a long way toward making up for a market downturn.

Another option to consider to reduce the impact of market declines early in retirement is a delay in withdrawals from tax-deferred retirement savings plans like IRAs and 401(k) accounts. Unless it's a Roth IRA or 401(k), you will be required to start taking withdrawals after turning age 70½. But there's no requirement to take anything before that.

So if you have money in taxable accounts, use those funds first. The funds in a tax-deferred account will make up for lost ground more quickly than in taxable accounts.

Anything you can do to lower expenses and increase income will help you withstand a bear market early in retirement.

Just remember, markets recover. But until they do, a willingness to adjust is key to financial survival.

This work is the opinion of the columnist, and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com