Many people who retired in 2000 thought they were in great shape: Over the previous 20 years, stocks returned 17.8% on average. Then two ferocious bear markets came rushing in.
In a new study, T. Rowe Price draws this lesson from the last dismal decade: Retirees need to cut spending for about three years after bear markets.
"Our research shows that retirees who take a 'set it and forget it' approach do so at their own peril when hit by a bear market," says Christine Fahlund, a senior financial planner with T. Rowe Price. With T. Rowe's model, people who retired in 2000 with comfortable odds of not outliving their money had poor ones by March 2009.
The study assumed hypothetical investors who retired on Jan. 1, 2000, with a $500,000 portfolio invested 55% in the S&P 500 and 45% in the Barclays Capital U.S. Aggregate index for bonds. They took monthly withdrawals adding up to 4% of all assets ($20,000) the first year, and gave themselves a yearly 3% inflation adjustment. With normal expectations, in 2000, these investors had an 89% chance of sustaining the plan over 30 years.
Less than three years later, by the end of the bear market in September 2002, those odds had fallen to just 46%. The figure went up after the five-year bull but fell to only 6% after the next bear.
So what would have been the best strategy over the decade? Temporarily reducing withdrawals by 25% for three years after each bear market bottom.
With that approach, by the end of 2010, the odds of being able to keep up your original plan for the next two decades had become comfortable again. Three years is a good bet, as Fahlund explains. In the last 10 recessions prior to 2007, it took about 20 months on average for the S&P 500 to recover to its pre-recession peak from its recession low.
The next best strategy? Take no inflation increases for three years after each bear market bottom.
Switching to bonds was the worst choice to make. "Those investors, who locked in their equity losses, missed the ensuing market rebounds," Fahlund explains.
Many retirees can't cut their budget by 25%. But it's better to adjust than simply count on the next bull. "The rule of thumb is to take whatever steps you can to reduce withdrawals or hold them steady until the market rebounds," Fahlund says.