Helping Clients Avoid a Bear Market ‘Portfolio Plunge’

Here’s an interesting question for investment professionals: Do you have a retiree with an equity heavy portfolio who has to make a withdrawal in a bear market during the early years of the client’s retirement?

“If so, that’s a problem,” said Ken Nuss, chief executive officer at Annuity Advantage, an online annuity marketplace. “You can dig such a hole that your retirement savings will never recover.”

Consider a retired couple with a $1 million portfolio. During their first year of retirement, the market drops 26 percent and they also make a $40,000 withdrawal, or 4 percent of their original principal, Nuss said.

Now their portfolio is down to $700,000. In year two, the market is up 4 percent, but because their second $40,000 withdrawal is at the end of the year, their portfolio will shrink to $688,000.

Unless there’s a big multi-year market rally, the portfolio can enter a “death spiral,” Nuss explained. Even several years of good returns won’t stem the decline and eventually it can vanish.

“Having to make early withdrawals during market downturns can decimate a portfolio,” Nuss said.

In contrast, if an investor enjoys strong returns during the early years, his or her portfolio will continue to grow despite withdrawals. It can withstand bear markets later on.

“It’s just a matter of luck if a down market strikes early or late in your retirement,” Nuss said. “But you can’t rely on luck.”

Protecting Assets From a Bear

There are several paths to safety in this scenario, but the idea is to get the best combination of yield and liquidity from the guaranteed portion of your client’s retirement savings.

“Achieving the right balance between volatile equities and stable investments is a calculation that’s different for every retiree,” Nuss said.

That’s where guaranteed annuities offer a good solution for a portion of a retirement fund, he added.

“There are a number of types that can be deployed to meet virtually any retiree’s needs,” he said.

Annuities aren’t the only way out of an early retirement, bear market dilemma.

“The risk of taking withdrawals during a bear market, especially within the first five years of retirement, is the possibility of depleting assets too soon considering that retirement could last 20 to 30 years,” said Judith Ward, a senior financial planner at T. Rowe Price.

Retirees see their portfolio decline in value, and then they withdraw money -- essentially locking in a loss.

“Because money is being spent from the portfolio, the portfolio balance is reduced when the market rebounds,” Ward said. “A bear market early in retirement is definitely concerning, but doesn't have to be dire.”

Understanding spending needs in retirement is a big key in weathering early bears.

“Determine which expenses are essential and where you have more discretion over spending,” Ward said. “This can help you be better prepared if you need to considering tightening the belt for a short time period.”

Matching your income sources to your spending needs is another good idea.

“Social Security benefits are a steady stream of inflation-adjusted income,” Ward said. “Ideally, consider this income as a source to cover your essential spending needs. You may have other predictable income such as pension and rental properties that can also help cover essential and some discretionary spending.”

It’s also a good idea to start with a conservative withdrawal rate in retirement.

“One of the other primary risks is overspending early in retirement, which is why we talk about the 4 percent rule,” Ward said. “When entering retirement there are many unknowns. Starting with a conservative withdrawal rate and adjusting later can help guard against market declines early in retirement.”

Time to ‘Sit Tight?’

The real problem with taking money out of an investment account early in retirement - no matter what the market condition - is the loss of tax-advantaged portfolio growth.

“The big advantage of retirement accounts is that you don't pay taxes on the accumulation,” said Ken Moraif, CFP and senior advisor at Money Matters in Plano, Texas. “The big disadvantage of retirement is that, in most cases, you pay taxes on the distributions. In addition, money taken out early loses the compounding effect of the time value of money.”

If you do find one of your clients in an early withdrawal retirement scenario during a declining market, sit tight, Moraif said.

“Since the value of your retirement account is declining in a bear market, the best strategy is to take no money out,” he said. “However, if you need money to live on, take the least amount out that you possibly can get by with on a monthly basis.”

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms. Brian may be contacted at [email protected].

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