Retirement Income: Recovering From Market Devastation

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Terence Floyd
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Retirement Income: Recovering From Market Devastation Certainly, many investors experienced losses in the value of their retirement account balances last year.

postponing retirement is the only way to recover a high level of retirement security.

work forever to recover. In light of last year s more significant stock market losses, Christine Fahlund, a senior financial planner at T. Rowe Price Associates, Inc.

1 Retirement Income: Recovering From Market Devastation Certainly, many investors experienced losses in the value of their retirement account balances last year. Having suffered devastating losses in their retirement nest eggs, those who have recently retired or are planning to do so soon may believe that drastic action such as going back to work or postponing retirement is the only way to recover a high level of retirement security. Not to downplay the negative impact of last year s losses, but there is evidence that such drastic action may not be necessary and those who have just retired or who are planning to may not have to work forever to recover. In light of last year s more significant stock market losses, Christine Fahlund, a senior financial planner at T. Rowe Price Associates, Inc., examined the impact on new retirees chances of outliving their assets if their portfolios sustain overall losses as great as 30% in the first year of retirement, as well as the effectiveness of strategies for restoring retirement security after that degree of market misfortune. The results are based on a probability analysis simulating how the strategies performed under 10,000 potential market scenarios. (A detailed description of the study and important disclosures are provided on page 5.) T. Rowe Price Retirement Plan Services, Inc. 1

2 In short, Ms. Fahlund found that new retirees have a much higher chance of not outliving their assets over a full 30-year retirement period if they hold their withdrawals constant for the next five years. Moreover, if stock market returns in the wake of last year s crash follow the historical post-bear market pattern and are much higher than longer-term averages holding withdrawals constant for the next five years would provide retirees an even greater probability of not running out of assets during retirement. While not taking an annual 3% inflation adjustment in their withdrawals may be a hardship, it is a relatively modest one compared with substantially cutting back withdrawals after the first year (though that more aggressive action also would significantly improve retirees long-term security). With inflation expected to remain modest or even decline for much of 2009 and with Social Security benefits increasing 5.8% in 2009 as a cost-of-living adjustment, this strategy may not put retirees behind in meeting their living costs at least in the immediate term. A similar T. Rowe Price analysis last year concluded that portfolio returns for retirees in their first five years of withdrawals are particularly crucial. The study showed, specifically, if annual cumulative returns average less than 5% for the first five years of retirement, it is much more likely that retirees may not be able to sustain their projected withdrawals for the duration of a 30-year retirement. The Impact of a Market Crash on Retirement Income Prospects In the first year of retirement, portfolio losses can significantly reduce the chances of new retirees sustaining their assets over a 30-year retirement. But if retirees hold their withdrawals constant not taking annual inflation adjustments they can gain back a large degree of retirement security. And if stock market returns for the five years after a bear market are in line with prior rebounds from similar valuation levels (assume a 15% gross average annualized return for stocks), new retirees chances of not running out of money improve. This study assumes a retiree started with a $1 million portfolio invested 55% in equities and 45% in bonds, with a planned initial withdrawal amount of $40,000 increased 3% each year thereafter. This strategy provides for a 90% likelihood of not running out of assets over a 30-year retirement. The portfolio value drops 30% in the first year to $700,000. The retiree continues with the planned withdrawal amount of $40,000. Likelihood That Retiree Will Not Run Out of Money Portfolio Increasing Withdrawals 3% Annually for Inflation Holding Annual Withdrawals Constant for Next Five Years 55% Stock/45% Bond 40% 60% Same Portfolio With Greater Equity Returns Switch 100% to Bonds in Second Year 7 29 See important disclosures about market simulations on page 5. The overall odds of sustaining withdrawals represents the percentage of 10,000 simulations in which the investor does not run out of money during a 30-year retirement. For simulations, a gross return of 10% is used for stocks with annual fees of 1.211%. In the second scenario in the table, the assumed gross return for stocks in the second through sixth years is 15% and 10% thereafter. A gross return of 6.5% is used for bonds, with annual fees of 0.726%. 2

3 Coping With Big Losses This new study examines the case of a retiree with a $1 million portfolio that remains invested with 55% in equities and 45% in bonds. The retiree plans to withdraw 4% of the balance in the first year of retirement (or $40,000) and increase the annual withdrawal amount by 3% each year for inflation. That strategy would provide a 90% chance of not running out of assets over a 30-year retirement. In general, Ms. Fahlund found that if new retirees suffer first-year overall portfolio losses of 10% to 20%, they may be able to stick with their original withdrawal strategy and sustain a relatively high likelihood of not running out of money over the long run. However, she found that coping with first-year losses greater than that may require a change in the withdrawal strategy, such as holding withdrawals constant for at least five years or cutting back the initial withdrawal amount from what had been planned or taking both steps together. If this investor s portfolio dropped by as much as 30% in the first year, for example, and she stuck to her original withdrawal plan, then her overall chance of not outliving her assets could fall from 90% to as low as 40%. But if she does not take 3% inflation adjustments for years two through six, she could restore her chances of not exhausting her assets to about 60% (see chart on page 2). Banking on History No one can predict with any certainty potential market returns for 2009 and thereafter, but it may be useful to consider the possibility of higher than average stock returns in the five years immediately following last year s big losses in other words, simulating a stock return greater than 10%. return over the following five-year period has been about 15%, based on valuation and normalized earnings patterns since In that scenario, the probability of not running out of assets would rise to 56% or 74% if withdrawals are held constant for five years quite a large step back toward the level of security of 90%, at which this retiree started....retirement planning is all about tradeoffs finding the right balance between an investment allocation and an appropriate withdrawal strategy. Fleeing to Fixed Income On the other hand, if this retiree abandoned stocks altogether for bonds after suffering through the first-year decline, the chances of not exhausting her assets over the full retirement period would plummet to about 7%. Even if she takes no inflation adjustments for five years, the probability with an all-bond portfolio would rise to only about 29% more than a 70% likelihood of running out of money. After suffering a major market crash in their first year of retirement, it is understandable why new retirees may be frightened about staying committed to equities, Ms. Fahlund says. However, retirement planning is all about trade-offs finding the right balance between an investment allocation and an appropriate withdrawal strategy. Generally, we suggest that most retirees in these situations would be much better served by sticking with an allocation to equities. This analysis assumed a 15% gross average annual return over that five-year period, based on research by The Leuthold Group. That research shows that when the stock market (as measured by the S&P 500 Index) is priced as relatively cheaply as it was near the end of 2008, the average annual 3

4 Reducing Withdrawals Having suffered a 30% portfolio loss in their first year of retirement, some new retirees still may not be satisfied with only partially restoring their original 90% chance of sustaining withdrawals during a 30-year retirement or with counting on a market rebound to do that for them. In that case, they should consider reducing their annual withdrawals immediately, if feasible, to restore a 90% chance of not outliving their assets during their retirement. As shown in the chart to the right, a new retiree who suffered a 30% portfolio loss would have to drop her withdrawal in the second year from $40,000 to $27,000 (about 3.8% of the remaining $700,000 portfolio value) if she planned on taking annual inflation increases thereafter. Or the new retiree could take a slightly higher withdrawal amount in year two ($30,000 or 4.3% of the remaining $700,000) if she also were to forgo annual inflation adjustments for five years. This strategy involves essentially starting over in your retirement income planning based on a significantly lower nest egg value, Ms. Fahlund says. This simply may be unaffordable for many people and holding withdrawals constant offers a less costly and less disruptive approach that ought to be considered. Withdrawal reductions needed to restore a 90% chance of sustaining assets over a 30-year retirement After a market crash in the first year of retirement reduces a $1 million portfolio by as much as 30%, a new retiree must reduce her planned initial withdrawal from $40,000 if she wants to restore a 90% chance of not outliving her assets. As noted in the other chart, this retiree had planned on withdrawing $40,000 at the end of the first year of retirement and increasing that amount by a 3% inflation adjustment every year thereafter. Balance of $1 million Portfolio after one year Withdrawal amount needed to restore a 90% probability of sustaining assets over a 30-year retirement if: Increase withdrawals annually for inflation Hold annual withdrawals constant for next five years $900,000 $34,000 $39, ,000 31,000 35, ,000 27,000 30,000 See important disclosures about market simulations on page 5. For simulations, a gross return of 10% is used for stocks with annual fees of 1.211%. A gross return of 6.5% is used for bonds, with annual fees of 0.726%. For help in your retirement planning, we suggest you try our Retirement Income Calculator at troweprice.com/ric and request our free, comprehensive Retirement Readiness Guide by calling

5 Explaining Monte Carlo Analysis Used in Retirement Study Monte Carlo simulations model future uncertainty. In contrast to tools generating average outcomes, Monte Carlo analyses produce outcome ranges based on probability thus incorporating future uncertainty. Material Assumptions Include: Unless otherwise noted, underlying long-term expected annual returns for the asset classes are not based on historical returns, but estimates, including reinvested dividends and capital gains. Expected returns plus assumptions about asset class volatility and correlations with other classes are used to generate random monthly returns for each class over specified time periods. These monthly returns are then used to generate thousands of scenarios, representing a spectrum of possible performance for the asset classes. Success rates are based on these scenarios. Taxes aren t taken into account, nor are early withdrawal penalties or required minimum distributions. But fees average expense ratios for typical actively managed funds within each asset class are subtracted from the expected annual returns. Material Limitations Include: Extreme market movements may occur more often than in the model. Market crises can cause asset classes to perform similarly, lowering the accuracy of projected portfolio volatility and returns. Correlation assumptions are less reliable for short periods. The model assumes no month-to-month correlations among asset class returns. It does not reflect the average periods of bull and bear markets, which can be longer than those modeled. Model Portfolio Construction Portfolios used in the analysis were designed to illustrate certain principles not necessarily for effective diversification among asset classes. The initial withdrawal amount is the percentage of the initial value of the investments withdrawn on the first day of the year following the initial 30% drop in the portfolio s market value. In subsequent years, the amount withdrawn grows by a 3% annual rate of inflation unless otherwise noted. Success rates are based on simulating 10,000 market scenarios and various asset allocation and withdrawal strategies. A simulation success rate is defined in these analyses as the likelihood that a particular retirement income strategy will result in a portfolio with a nonzero value at the end of retirement (i.e., that will still have assets remaining in the portfolio at the end of the time horizon). The underlying long-term expected annual gross return assumptions (without fees) are 10% for stocks (except in the scenario where a 15% gross annualized return for stocks is assumed for years two through six following a bear market) and 6.5% for intermediate-term, investment-grade bonds. Net-of-fee expected returns use these expense ratios: 1.211% for stock and 0.726% for intermediate-term, investment-grade bonds. IMPORTANT: All information produced by the T. Rowe Price Investment Analysis Tool is a reasonable estimate and not reflective of actual investment results or predictive. The simulations are based on assumptions, so there is no guarantee that the projected results will be achieved or sustained; the potential for loss or gain may be greater than shown. The charts present a range of possible outcomes. Results may vary with each use over time and differ from the simulated scenarios. The results are not predictions, but they should be viewed as reasonable estimates. Inflation is assumed constant, so variations are not reflected in our calculations. The analysis does not use all asset classes. Other asset classes may be similar or superior to those used. 5

6 This article has been prepared by T. Rowe Price Retirement Plan Services, Inc. for informational purposes only. T. Rowe Price Retirement Plan Services, Inc., its affiliates, and its associates do not provide legal or tax advice. Any tax-related discussion contained in this article, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this article /

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