By Christine Fahlund on March 22, 2012
Investors approaching or in retirement often feel uneasy about what may happen to their investments in the future. Fortunately, if markets go south, there are steps they can take to increase their likelihood of maintaining their desired lifestyle in retirement. We believe the following planning decisions can help manage those situations and what the potential outcomes might be.
If you plan to retire in the near future, we recommend that you consider working a few extra years to replenish any losses within your retirement accounts. No single decision will improve your potential retirement security as much as continuing to work even a few more years. Working longer gives your assets more time to grow and reduces the number of years that you will need to rely on your investment portfolio for income.
In fact, assuming you delay Social Security as well as delay tapping your retirement savings, the effect in retirement can be so substantial that you even may be able to cut back on the amount of money you contribute as you continue to work, while still improving your readiness to retire. Delaying retirement can be especially disappointing because you're delaying your dreams. But would staying in the workforce really seem that bad if you knew you could spend some of those contributions after tax on travel, hobbies, or other enjoyable activities? If you stay in the workforce a little longer, you're likely to come out financially ahead in the long run.
If, however, you're delaying your retirement and the value of your holdings has fallen substantially, it may be in your best interest to continue contributing as much as you can to make up for any recent losses as quickly as possible. Continuing to work for a few more years offers another major benefit—it enables you to delay taking Social Security (up to age 70), delay withdrawals from your retirement accounts, and continue to receive salary and benefits. The following chart, shows how an average 60-year-old couple could increase their potential retirement income—from combined investments and Social Security benefits—by delaying Social Security and contributing (or not contributing) starting at age 62. Note that this chart illustrates clearly the fact that you have trade-offs you can make with respect to your strategy. For example, which would you prefer, to continue working and increase your retirement contributions from 25% each year until age 66 or to continue working and contribute nothing at all until age 67? The chart suggests that by using either approach, your retirement income will be the same.
As we begin the new year, we have no idea as investors what lies ahead for global markets in 2012. For that reason alone, a flexible planning strategy becomes especially important when deciding at what point to retire. One thing is certain: It is usually unwise to fully retire in the midst of a bear market, since taking withdrawals at the same time your investments are declining in value simply exacerbates an already negative financial situation. Ultimately, only you and your family can decide what's best.
If you have recently retired, you may feel unsettled because the future of the markets is unknown. Don't panic. In most cases, adjusting your lifestyle temporarily will be all that is needed in years when the market drops significantly while you are taking withdrawals. What you certainly don't want to do when you are worried about the markets is cash out all your investments in the stock market and go 100% into bonds. As the example below illustrates, eliminating the growth potential from your portfolio when markets are down could result in your likelihood of not running out of money in retirement dropping from 70% or 80% to under 10%. If you cannot reduce your lifestyle at times like these by reducing the amount of your withdrawals, consider withdrawing the same amount from the portfolio for a couple of years. Once you feel more financially secure, you can once again increase the amount of your withdrawals from your investments in order to keep up with inflation.
You also can take your withdrawals from whatever cash or short-term investments you hold, so you don't lock in losses on your investments in stocks and stock funds. Remember: You don't actually incur a loss until you redeem the investment. Don't forget that you may need your assets to sustain you for decades. Cash-only portfolios may seem safe, but they do a poor job of protecting your income against the long-term threat of inflation. We don't want you to have to choose down the road between living on extremely low income levels versus potentially experiencing the very real threat of running out of money.
Generally, we suggest that retirees who are age 65 to maintain 55% in equities, 35% in fixed income, and 10% in short-term investments. Even as retirees enter their 80s, T. Rowe Price Certified Financial Planner® Christine Fahlund still recommends a high allocation to equities—at least 40%. This may seem counterintuitive in light of recent highly volatile markets, but even for those who have retired recently, retirement is not a short-term goal. Every retiree should aim to save enough for a retirement that could last to age 95 or longer. Realistically, near-retirees and those who have retired in recent years would be wise to reevaluate their retirement income strategies at least annually. The good news is that you don't have to change course entirely to have a successful retirement. A few smart steps can put your strategy back on course.
Baseline assumptions: Both spouses begin taking withdrawals from investments and their Social Security benefits at age 62 (they are the same age), having saved 15% of their salaries at ages 60 and 61. All income is expressed in current dollars at age 60, using a 3% discount rate. Each case assumes both spouses are currently age 60, are making 15% contributions at ages 60 and 61, and are making 0%, 15%, or 25% contributions annually thereafter. They will retire at the same time. The examples also assume a current annual salary of $100,000, increasing 3% annually; $500,000 in retirement savings at age 60, growing at 7% annually before retirement, 6% annually after retirement; initial savings withdrawals in the first year of retirement, based on retirement age, range from 3.5% at age 62 through 4.5% at age 70, each year of delay adding 0.1%; initial withdrawal amounts increased each year thereafter for inflation (3%). The Social Security payments were calculated in "inflated (future) dollars" using the Quick Calculator on the socialsecurity.gov website and discounted 3% annually to current dollars at age 60. This chart is shown for illustrative purposes only and does not represent the performance of any specific security.
Source: T. Rowe Price.
T. Rowe Price examines how recently retired investors could offset the impact of a down market—such as the one experienced in 2008—on their retirement savings. The most effective approach is to hold withdrawals steady but to temporarily suspend the annual inflation adjustment. The hypothetical example below illustrates our findings using actual historical returns for stocks and bonds for the period from August 31, 2006, through August 31, 2011, and projections for the 25 years thereafter are based on 10,000 simulations of possible future market scenarios. This analysis demonstrates three ways an investor, Steve, could approach this situation and how these decisions could determine the likelihood his savings will last throughout retirement.
To evaluate your personal situation, visit the T. Rowe Price Retirement Income Calculator.
*Represents the percentage of total simulations in which the investor does not run out of money during a 30-year retirement period. The odds of success on August 31, 2006, reflect the initial investment and withdrawal assumptions. The odds of success at the various stages of the options reflect historical return data and any changes in the investment or withdrawal assumptions and projections thereafter. In calculating this example, we use historical market returns from August 31, 2006, through August 31, 2011, with the investor deciding between Option A, B, or C on March 1, 2009. For historical returns, the S&P 500 Stock Index is used for stocks, and the Barclays Capital U.S. Aggregate Index is used for bonds. For simulations, the compound annual return for stocks is assumed to be 4.90% in excess of 3% inflation and before fees of 0.70%, and the compound annual return for bonds is assumed to be 2.23% in excess of 3% inflation and before fees of 0.60%. Portfolios are rebalanced monthly, and withdrawals are made monthly. This example does not take into account taxes or required minimum distributions from retirement plans.
T. Rowe Price (including T. Rowe Price Group, Inc., and its affiliates) and its associates do not provide legal or tax advice. Any tax-related discussion contained in this article 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.
The following is an explanation of the Monte Carlo simulation analysis used in the article above.
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.
- Underlying long-term rates of return for the asset classes are not directly based on historical returns. Rather, they represent assumptions that take into account, among other things, historical returns. They also include our estimates for reinvested dividends and capital gains.
- These assumptions, as well as an assumed degree of fluctuation of returns around these long-term rates, are used to generate random monthly returns for each asset class over specified time periods.
- The monthly returns are then used to generate 10,000 scenarios, representing a spectrum of possible return outcomes for the modeled asset classes. Analysis results are directly based on these scenarios.
- The analysis relies on return assumptions, combined with a return model that generates a wide range of possible return scenarios from these assumptions. Despite our best efforts, there is no certainty that the assumptions and the model will accurately predict asset class return ranges going forward. As a consequence, the results of the analysis should be viewed as approximations, and users should allow a margin for error and not place too much reliance on the apparent precision of the results.
- Extreme market movements may occur more often than in the model.
- Some asset classes have relatively short histories. Actual long-term results for each asset class going forward may differ from our assumptions, with those for classes with limited histories potentially diverging more.
- Market crises can cause asset classes to perform similarly, lowering the accuracy of our projected return assumptions and diminishing the benefits of diversification (that is, of using many different asset classes) in ways not captured by the analysis. As a result, returns actually experienced by the investor may be more volatile than those projected in our analysis.
- The model assumes no month-to-month correlations among asset class returns (correlation is a measure of the degree in which returns are related or dependent upon each other). It does not reflect the average duration of bull and bear markets, which can be longer than those in the modeled scenarios.
- Inflation is assumed to be constant, so variations are not reflected in our calculations.
- The analysis assumes a diversified portfolio, which is rebalanced monthly. Not all asset classes are represented, and other asset classes may be similar or superior to those used.
- Taxes on withdrawals are not taken into account, nor are early withdrawal penalties.
- The analysis models asset classes, not investment products. As a result, the actual experience of an investor in a given investment product (e.g., a mutual fund) may differ from the range of projections generated by the simulation, even if the broad asset allocation of the investment product is similar to the one being modeled. Possible reasons for divergence include, but are not limited to, active management by the manager of the investment product, or the costs, fees, and other expenses associated with the investment product. Active management for any particular investment product—the selection of a portfolio of individual securities that differs from the broad asset classes modeled in this analysis—can lead to the investment product having higher or lower returns than the range of projections in this analysis.
- The primary asset classes used for this analysis are stocks and bonds. An effectively diversified portfolio theoretically involves all investable asset classes, including stocks, bonds, real estate, foreign investments, commodities, precious metals, currencies, and others. Since it is unlikely that investors will own all of these assets, we selected the ones we believed to be the most appropriate for long-term investors.
- Results of the analysis are driven primarily by the assumed long-term, compound rates of return of each asset class in the scenarios. Our corresponding assumptions, all presented in excess of inflation, are as follows: 4.9% for stocks and 2.23% for bonds.
- Investment expenses in the form of an expense ratio are subtracted from the return assumptions as follows: for stocks, 0.70%, and for bonds, 0.60%. These expenses represent what we believe to be a reasonable approximation of investing in these asset classes through a professionally managed mutual fund or other pooled investment product.
- The modeled asset class scenarios and withdrawal amounts may be calculated at, or result in, a simulation success rate. Simulation success rate is a probability measure and represents the number of times our outcomes succeed (i.e., has at least $1 remaining in the portfolio at the end of retirement).
The results are not projections, but they should be viewed as reasonable estimates. Source: T. Rowe Price Associates, Inc.