One of the biggest concerns people have in retirement is the fear of running out of money. This fear can be exacerbated when the stock market takes a sudden drop.
That fear of outliving one’s money is certainly justified as our life expectancy continues to grow. Living longer also means living with ailments or chronic illnesses that can result in more medical costs.
There are several things retirees don’t get completely correct – factors that could help them through the tough times should the market plunge.
First off, most people do not literally run out of money. Instead, as their cash needs take a larger and larger bite out of their investments, they realize (hopefully in advance) that they can no longer maintain the same lifestyle.
Something, they acknowledge, needs to change. The sooner they come to this conclusion the better, enabling them to begin adjusting their lifestyle at a younger age.
It is important for retirees to understand the subtle difference between literally running out of money and changing one’s lifestyle.
The former is an abstract concept and hard for many people to visualize. However, having to sell one’s home, or move in with children, or take less vacation, or even look for a job, are more tangible things people can hold onto, and thus motivate them to make changes sooner.
The second item retirees get wrong is the concept of not having enough time to recover from a market downturn. The historical average of a major market decline is 18 months, not a tremendously long period of time given a possible 25- to 30-year time horizon in retirement for a 65-year-old retiree.
Older retirees in their late seventies or eighties who fear there is not enough time for the market to recover need to look at how much money they are withdrawing from their investment portfolio.
Taking too large a withdrawal from one’s investments cannot be fixed by strong stock market returns. Nor can a market decline be blamed for running out of money, which likely would have happened anyway as the amount of withdrawals cannot support the investment portfolio.
The way to protect oneself from running out of money during a market downturn once retired is to keep enough liquid assets out of the stock market available to provide for one’s cash needs.
Having three years of cash needs in an investment that is not at the whim of the market and either principal-protected (Certificate of Deposit or Individual Insured Muni bond) or nearly all principal-protected (short-term bond mutual fund) will offer protection from selling stock market investments in a declining market.
For those retirees who would not feel comfortable with only three years’ cash needs, a fourth or fifth year can be invested in those same type investments.
The third mistake is allocating too much of one’s assets to such fixed-income investments as bonds or bond funds, or even cash in a savings account. Unfortunately, these investments have been sold to retirees as “safe conservative investments,” when in reality they do not keep pace with inflation.
The unfortunate part is that the retiree is losing purchasing power while looking at their investment statements and seeing no change or very little change in the principal portion of their bonds.
For example, a $ 100,000 investment in a savings account paying 1% per year looks pretty good when the stock market drops. After all, the principal remained even while the stock mutual funds in one’s portfolio dropped.
However, the stock market investments, if given enough time, are likely to go back up. Meanwhile, the $ 100,000 in a savings account will remain the same and, over time, the investor will lose purchasing power. The $ 100,000 cannot buy as much as it would have bought five or 10 years ago.
This loss of purchasing power cannot be recouped, which is why it is important to maintain a good portion of one’s portfolio in well-diversified stock mutual funds.
If you’re a retiree or quickly approaching retirement, this is what you need to do in order to hurdle potential problems:
Step 1: Figure out now how long your portfolio is really going to last. If any changes need to be made, do them now instead of waiting.
Step 2: Set aside three years of cash needs in principal-protected investments to provide for your cash needs in the event of a market drop, and there will not be a need to sell your stock market investments into a declining market.
Step 3: Maintain a healthy allocation in stock market investments so that your portfolio over time can outpace inflation.
Howard Hook is a CPA and Certified Financial Planner with EKS Associates in Princeton, N.J.
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