Market Plunge Plus Withdrawals During Early Years of Retirement May Cause Portfolio Death Spiral

If you’re a retiree with an equity-heavy portfolio and have to make a withdrawal in a bear market during the early years of your retirement, you can dig such a hole that your 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, at the end of the year. 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 soon, the portfolio can enter a death spiral. 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.

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. But you can’t rely on luck.

What’s the answer? Completely avoiding equities isn’t a good choice for most retirees because it precludes growth.

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

The challenge is to get the best combination of yield and liquidity from the guaranteed portion of your retirement savings.

Having some cash is okay, but a large allocation isn’t wise. Yields on money market and savings accounts are running well behind the rate of inflation, even before taxes.

Certificates of deposit pay more but are largely illiquid, and yields aren’t impressive these days.

Guaranteed annuities offer a good solution for a portion of your retirement money. There are a number of types that can be deployed to meet virtually any retiree’s needs.

Various types of fixed annuities all guarantee your principal, but their characteristics are quite different.

A retiree can choose an immediate annuity that produces an immediate stream of income for either a set number of years or a lifetime. The monthly payments provide a cushion so that the owner won’t have to sell equities to raise cash in a down market. Meanwhile, the money remaining in the annuity is earning a much higher internal rate of return than cash equivalents.

Retirees can also invest in deferred fixed-rate annuities, which act much like a CD by providing a (usually higher) set rate of interest for a set period of time, plus tax deferral and some liquidity. These annuities often permit the owner to withdraw up to 10 percent annually without penalty. The accumulated interest portion of amounts withdrawn, however, is usually fully taxable.

Another good option is the fixed-indexed annuity, which is immune to stock-market downturns while offering a share of the gains when the market goes up.

It gives you an opportunity to earn more interest than you can get from a fixed-rate annuity or a bank CD. You can shelter some of your money from market risk without locking in a lower interest rate.

Fixed indexed annuities, however, are less liquid than other investment alternatives, so it wouldn’t be a wise choice to put all of your retirement money into them. But they do help buffer a portfolio from severe ups and downs while offering potentially higher earnings than fixed-rate annuities over the long run. Many also offer lifetime income riders that can further reduce income uncertainty during retirement. The surrender terms of fixed-rate and fixed-indexed annuities can be laddered so that at least one is maturing each year and can be tapped if needed.

Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities. More information is available from the Medford, Oregon, based company at https://www.annuityadvantage.com or (800) 239-0356.