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How to Protect Yourself When Retiring in a Down Market

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Market corrections happen.  Given their frequency, the chances are very high that you will live through a few of them once retired.  This can be a scary prospect for a number of people.  According to Charles Schwab Research, and reported on by Forbes, retirement accounts that cannot keep up with income needs is one of the biggest worries retirees have.  These concerns are often distant when markets are booming.  They come to the forefront when corrections happen.  When people see their account balances decline, they become increasingly worried about failing to generate the income they need in retirement.  And there’s good reason to be concerned.

Conventional retirement income planning wisdom suggests that we deduct 4% of our retirement assets each year for the purpose of creating retirement income.  Taking that number (and adjusting it when our account balance rises and/or falls) should protect us from running out of money.  The math that backs this up is pretty extensive, and there is no reason to doubt the probability of success here.  The problem, however, is that running out of money is a separate problem–one which we can easily solve if we set the withdrawal rate low enough.

In fact, I’d argue that when it comes to various problems a retiree faces, running out of money is one of the theoretically easier problems to solve.  Having enough money to cover your needs, is a substantially more important and immediate problem.  Sure it’s the case that if your assets pool isn’t sufficient to cover your income needs, you’ll eventually run out of money, but then you’ll face both the problem of running out of money and not being able to generate the income that you need to live in retirement.  In other words, the problem of running out of money is more a by-product of not being able to generate adequate income.  We can solve the former, by exacerbating the latter.

The Four Percent Dilemma, a Case Study.

Suppose you have $2 million saved for retirement.  If you implement the idea that you will simply withdraw 4% of the account balance, you will begin retirement with an income from retirement assets totaling $80,000.  Let’s assume–for simplicity’s sake–that $80,000 plus social security is adequate for your income needs.  You take your $80,000 of income and the market produces a 15% return this year.

That means your retirement asset pool grows to $2,208,000.  This means the following year, you get $8,320 raise!  Now with an income generated of $88,320, you are beginning retirement pretty happy at how this all works.

…But then a correction occurs.  Not a huge one.  Just a 10% reduction to your retirement portfolio.  No biggy, you should easily be able to overcome this with future returns.  There’s just one small potential problem.  This 10% reduction means that your account balance after taking income is now $1,907,712.  You still theoretically have plenty of money.  But your income in the coming year is going down.  Following the rule, your income is now $76,309 for the year.  Where I come from, we call that a $12,000 cut in pay.  For the math lovers, that’s a 14% reduction in income.  If the market rallies back by about 10%, you’ll be back to where you started at retirement.  The good news is you can now generate $80,000 of income.  If you want to get back to generating that ~$88,000 per year, you’re going to need a return of about 20.5%.

Now let’s discuss a few practical problems you face here.

Firstly, a risk profile that has a chance of producing 20% annual returns is quite aggressive.  It would be far beyond the allowable risk tolerance anyone with a securities license would recommend to a client–at least without catching extreme ire from the compliance department.  And for good reason.  Such a risk profile could continue to produce losses that further reduce income.

Secondly, what if this small 10% correction and 14% reduction in income occurs during a time like what we’re experiencing right now?  The market declines, and inflation is red hot.  Now you have 14% less income, but the price of the things you want and need to buy are rising at a rate near 8-10%.  That means the effective loss in income is some number far larger than 14%.

The problem with blindly following the 4% rule isn’t that it won’t work.  The problem is that the 4% rule wasn’t designed to solve the problem many people think it’s the solution to.

This rule isn’t a fancy trick to ensure you can safely cover your income needs.  It’s a guide to help protect you from running out of money.  That’s fine, but it won’t ensure you don’t starve or freeze.

Rate of Return, the Billion Dollar Boondoggle of the Retirement Planning Industry

A lot of people are fooled into believing that rate of return is the paramount consideration in retirement planning.  It gets stuck in the “if a little is good more must be better” line of thinking.  I can understand the easiness of falling into this trap.  More money should be capable of producing more income and therefore more income is the pursuit of creating more money.

But that’s not always necessarily true.

As you get older you’ll find that the importance you place on your ability to create income–especially reliable income–becomes your key concern.  Rate of return can take a hike in most cases.

This means you need a good retirement plan.  The problem is that most good retirement plans must begin several years before retirement.  Sure some people will accumulate enough wealth to retire without much of a plan and rest on their excess of resources as a way to trip and fall through a mostly successful retirement.  But it take a lot more money–or sacrifice–to pull that off than you likely think.

Another Shining Example of Life Insurance and Annuities’ Strengths

You can create reliable income with life insurance and annuities.  You can even produce a higher income with these two assets with a lower overall rate of return vs. what you’d expect from equity investments.

Now in the interest of not getting caught up in the “if a little is good more must be better” problem, I want to be clear that I am by no means advocating for a complete and total concentration of life insurance and annuities as your retirement income portfolio strategy.  This is a call to complement your market investment with these products to produce a more stable and resilient income stream in retirement.

We’ve shown in the past that life insurance can produce a higher amount of income per contributed dollar.  Annuities can produce similar results.  When to use one versus the other depends on unique circumstances.

Here’s what I do know.  People who begin using fixed life insurance products to produce income in retirement, do not need to make adjustments to their income when a market correction takes place.

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