Retirement changes the anxiety of investing.
While you are working and accumulating wealth, a market decline can be uncomfortable, but you still have a paycheck. It serves as a perceived safety net beneath the trapeze.
Once you retire and begin withdrawing money, that net is gone. The market risk has not changed, but the consequences have.
You are no longer simply waiting for the market to recover. You may also be selling investments to fund your life along the way.
That changes the performance question.
The goal is not necessarily to capture every bit of the market’s upside. Another way to evaluate a retirement portfolio is by how it balances several competing objectives: providing income, managing losses during market declines, pursuing growth to help offset inflation and maintaining sufficient capital to participate in an eventual recovery.
What Is Sequence-of-Returns Risk in Retirement?
A retiree spends dollars.
That distinction matters because withdrawals continue regardless of what the market is doing. Mortgage payments, groceries, travel, healthcare and other living expenses do not stop simply because investment prices are falling.
When withdrawals occur during a decline, the retiree may have to sell more shares to generate the same amount of cash. Those shares are no longer invested when the market eventually recovers.
A significant decline early in retirement can therefore be more damaging than the same decline occurring later. This is known as sequence-of-returns risk.
Two retirees could earn similar average returns over time but experience very different outcomes depending on when their best and worst years occurred. The retiree who encounters major losses while simultaneously taking withdrawals may have less capital available to benefit from the recovery.
What Is the 4% Rule for Retirement Withdrawals?
The 4% rule is commonly associated with financial planner William Bengen’s retirement-income research.
It generally refers to withdrawing 4% of a retirement portfolio during the first year of retirement and increasing that dollar amount annually for inflation.
For a $1 million portfolio, the initial withdrawal would be $40,000. If inflation increases, the dollar withdrawal would generally increase as well.
The 4% rule is a planning convention, not a personalized retirement-income guarantee.
Its success depends on factors that cannot be reduced to a single percentage, including:
- The retiree’s time horizon
- Asset allocation
- Inflation
- Taxes
- Spending needs
- Social Security and pension income
- Market returns
- The timing of those returns
- The ability to adjust spending during difficult periods
A withdrawal rate can provide a useful starting point, but it cannot account for every circumstance a retiree will encounter.
Why Deeper Market Losses May be Harder to Recover From
Recovering from a loss requires a larger subsequent gain.
A 10% decline requires an approximately 11% gain to recover. A 20% decline requires a 25% gain. A 50% decline requires a 100% gain.
For someone who is still working and contributing to a portfolio, a decline may create an opportunity to purchase investments at lower prices.
For a retiree taking withdrawals, the same decline presents a different challenge. Money is leaving the portfolio while asset values are depressed.
This is why retirees may benefit from asking a different question during periods of market stress:
How much of the market’s decline did the portfolio experience?
That concept is commonly described as downside capture. It measures how much an investment or portfolio historically declined relative to a benchmark during periods when the benchmark was falling.
Lower downside capture does not guarantee positive returns or eliminate losses. It simply provides another way to evaluate historical risk.
Does Diversification Protect a Portfolio During Market Declines?
Diversification does not mean that one portion of a portfolio will always rise when another falls.
During a broad market event, stocks, real estate, preferred securities and other risk assets can decline together. Bonds can also decline, particularly when inflation and interest rates rise rapidly.
The 2008 financial crisis demonstrated how several risk-oriented asset classes can fall simultaneously. The 2022 bear market provided a different lesson when both stocks and bonds experienced significant pressure.
Diversification did not eliminate losses in either environment.
Its purpose is to reduce dependence on a single asset class, company, economic outcome or market narrative. Different investments have different sources of return and respond differently to changes in growth, inflation, interest rates and investor sentiment.
That does not guarantee a better result. It acknowledges that the future is uncertain.
The S&P 500 Is Not a Retirement Plan
The S&P 500 is an important measure of large-cap U.S. stock performance. It is widely followed, easily understood and useful for evaluating what is happening in the equity market.
But it is not necessarily the benchmark for a retiree’s life.
A retirement portfolio may have a different purpose, asset allocation and risk profile than an all-equity index. Its job may include generating income, maintaining liquidity, limiting the need to sell assets during a downturn and supporting spending across multiple market environments.
Comparing every retirement portfolio exclusively with the S&P 500 can therefore create the wrong performance conversation.
The better questions may be:
- How much income does the retirement plan require?
- How has the portfolio behaved during previous market declines?
- How large of a loss can the plan withstand without forcing a significant lifestyle change?
- What happens if poor returns occur during the first five years of retirement?
- How are Social Security, pensions and cash reserves integrated into the plan?
- Which expenses could be adjusted temporarily during a prolonged downturn?
These questions connect investment performance to the life the portfolio is intended to support.
Retirement Requires a Different Scorecard
A retiree does not need to win the annual performance derby.
They need a financial plan capable of funding an actual life through markets that cannot be predicted in advance.
That requires looking beyond a single index or annual return. Income, inflation, taxes, withdrawals, liquidity, downside risk and the sequence of market returns all contribute to the outcome.
No portfolio can predict or eliminate the next crisis. A retirement plan can, however, consider how a significant decline could affect future withdrawals, income needs and the life the portfolio was built to support.
How Could a Market Decline Affect Your Retirement Plan?
If this article made you think differently about market declines, that is a good instinct. Understanding downside capture, sequence-of-returns risk and the role income plays during difficult markets can help put short-term performance into the context of a long-term retirement plan.
We work with retirees and pre-retirees every day who are balancing the need for income today with the need to preserve and grow capital for the future. A single conversation can bring additional clarity.
If you have questions or would like to discuss how a significant market decline could affect your retirement plan, we would be glad to help. Schedule a complimentary conversation with our team and receive our educational whitepaper, which includes a 20-year historical illustration examining how an income-oriented asset allocation represented by market indices responded during periods of market stress.
This article is provided for general educational and informational purposes only and does not constitute individualized investment advice or a recommendation of any particular investment, allocation or withdrawal strategy. Investing involves risk, including the possible loss of principal. Diversification and asset allocation do not ensure a profit or protect against loss in declining markets. Retirement-income decisions should be evaluated in light of an investor’s financial circumstances, spending needs, tax situation, time horizon, risk tolerance and other sources of income.
