Make Your Retirement Savings Last

How you can manage the risk of a big market downturn early on

Penelope Wang,

AARP

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Published July 12, 2024

Illustration of woman sitting on lounge chair

During the first few years of retirement, big losses may jeopardize your financial security much more than a downturn later.

Chris Gash

Managing your retirement finances usually means investing for the long run and not sweating short-term market movements.

But there’s one point when the short term is very important. That’s the first few years of retirement, when big losses can jeopardize your financial security much more than a downturn later on.

Imagine two 65-year-old women, Andrea and Beth, each retiring with $500,000 in investments. Each withdraws $25,000 in the first year, then increases that withdrawal annually just enough to keep up with inflation. They invest in different funds, each of which has gains in some years and losses in others, but both of which, after 25 years, have had annualized returns of 6 percent. There’s only one difference: Andrea’s fund is slammed by double-digit losses in each of the first three years of her retirement. Beth’s fund suffers those same losses but much later, when she’s in her late 80s.

The result? Despite those losses later in life, Beth ends up with $1.2 million by age 90. But Andrea runs out of money by the age of 83. That’s because her losses early on, along with her withdrawals when the markets are down, leave less money in her account that can grow when markets take off.

This phenomenon — the fact that poor investment returns early in retirement hurt you more than losses later — is something financial professionals think about a lot. “It makes sense for retirees to be prepared for series of down markets, especially early in retirement,” says Tim Steffen, director of advanced planning at Baird, a wealth management firm in Milwaukee.

No one knows when the next big downturn might happen, or whose retirement it might affect. Fortunately, there are ways to protect yourself from the threat posed by losses right before you retire or soon afterward. Consider these guidelines:

1. Focus on your budget

If you’re still in the workforce, start estimating how your costs and spending might add up in retirement. It’s important to know what portion of your spending will go toward essential costs, and what discretionary spending you might be able to cut back or eliminate, if necessary. By lowering expenses early in a downturn, you can leave more money invested for possible growth.

Granted, trimming discretionary spending may be more challenging than you think. In the run-up to retirement, and in the first few years after leaving the workforce, some people tend to splurge, especially on travel or entertainment, according to research by J.P. Morgan Asset Management. But by analyzing your budget now, you can plan for a few luxuries, even if the market drops.

2. Keep some cash

Once you’ve calculated your essential costs, set aside a cash reserve large enough to cover them for the next one to three years, if possible. By keeping that cash at the ready, you can avoid having to tap your retirement portfolio at market lows, or run up credit card bills, to meet expenses. “You will worry a lot less, while buying time for the market to recover,” says Liz Windisch, a financial planner in Denver.

If pulling together all that cash isn’t realistic, consider shifting a portion of your retirement investments to cash, says Dana Anspach, a financial planner in Scottsdale, Arizona. “If there’s a downturn in the first years of retirement, you can use that money for costs instead of selling stocks,” Anspach says. “And if the market goes up, you can sell some of your stocks to meet expenses, while leaving some cash on hand.”

Be sure to keep your cash savings safe and easily accessible, perhaps in a bank account or Treasury money market fund. Many cash accounts are still paying attractive yields. Recent online bank savings accounts were yielding 5 percent or more, according to DepositAccounts.com.

3. Be flexible on withdrawals

You may have heard the rule of thumb for retirement withdrawals: Start by taking out 4 percent of your portfolio in the first year, then increase that amount annually based on the rate of inflation. This approach has worked well over past 30-year periods, but it’s a dicey move to simply set and forget your withdrawal rate.

Jay Abolofia, a financial planner in Waltham, Massachusetts, favors a simple approach similar to the IRS’s rules for taking required minimum distributions (RMDs) from IRAs and 401(k)s: Divide your savings by your expected remaining years, then withdraw that amount. For example, if Andrea or Beth expects to live to 90, she divides $500,000 by 25 to get a withdrawal of $20,000 in the first year.

“In future years, the remaining portfolio would be divided by fewer years, which could allow you to take out more,” Abolofia says. As with RMDs, the plan will gradually reduce your account over your lifetime.

Another approach is to use a spending plan linked to market performance. A 2006 study by Jonathan Guyton, a financial planner in Edina, Minnesota, and William Klinger, a professor at Raritan Valley Community College in Branchburg, New Jersey, found that using “guardrails” — rules that specify small spending changes after big market swings — can help retirees avoid running out of money over three or more decades, despite bear markets. “By making a small adjustment right away, it can save you from having to make big adjustments later,” Guyton says.

The precise rules require some math, so this approach is best for those who are comfortable punching a calculator. You’ll also need to cope with occasional swings in income.

4. Adjust investments

Though a well-diversified portfolio won’t entirely shield you from downturns, it can help minimize market risk. In 2022, an index fund portfolio 60 percent in stocks and 40 percent in bonds — a standard balanced mix — fell 14.4 percent, according to Morningstar Direct. But that was only the second double-digit loss for the 60-40 portfolio since 1973, following a 19.5 percent drop in 2008. Last year, the portfolio gained 17.3 percent. Over the past five decades, the 60-40 portfolio registered losses in just 10 years, while delivering a 9.2 percent annualized return, Morningstar data shows.

It’s important to customize your portfolio to suit your goals and risk tolerance. If you want safety, you might consider selling some of your stocks, while increasing your bond holdings. “Markets are giving a higher return for playing it safe, so it’s reasonable to ask if the upside of taking risk through stocks is worth the possibility of having to cut back on spending,” says Michael Finke, a professor of economic security research at the American College of Financial Services.

5. Consider guaranteed income

Perhaps the best protection from market downturns is a steady stream of guaranteed income. Fortunately, most retirees get that from their Social Security benefit, which has the bonus of including an annual adjustment for inflation.

For additional guaranteed income, one strategy is to buy TIPS (Treasury Inflation-Protected Securities), which pay yields that also adjust for inflation. To get that income, you build what’s known as a bond ladder, buying issues with staggered maturities; one TIPS might mature in 2030, one in 2031, and so on. “With a TIPS ladder, you get a steady source of income that keeps pace with inflation,” Abolofia says. You can buy TIPS directly from the U.S. Treasury, at treasurydirect.gov, or through brokerage firms.

Another option is to purchase a low-cost income annuity, which will give you protection against longevity and market risk, says Wade Pfau, a retirement researcher and author of the Retirement Planning Guidebook. With a single-premium immediate annuity, one of the simplest types to buy, you put in a lump sum, and the insurer sends you a monthly check for the rest of your life. Recently, a 67-year-old man investing $50,000 could buy an immediate annuity paying $4,000 a year over his lifetime, according to ImmediateAnnuities.com.