How Bear Market Risks are Bad for Your Retirement

 

This is part 1 of a 2 part series.

Will your retirement plan survive the next bear market? Well it probably will be around after the next down-market but it might be dealt a fatal blow.  Let me explain. There are two main phases of our investment lives, the accumulation phase which is while we are working and the distribution phase which is while we are no longer working and are drawing income from our investments to support our needs.

During the accumulation phase the sequence of your returns, the order in which you get your investment returns does not have as much of an impact as it does once you retire. If the markets have a terrible year like 2008 it gives you an opportunity to purchase shares at a discount, as long as you are adding money each month to your retirement accounts. This is commonly known as dollar cost averaging. Most investors are familiar with the effects of dollar cost averaging and how dollar cost averaging can help you take advantage of buying more shares when prices are low and less shares when prices are high. Keeping your account fully invested through the ups and downs of the market can help you take advantage of the compounding effects of interest.* But is that how you should invest in retirement? Is retirement investing the same? NO.

During classes on retirement planning that I teach at our local community college, I’m always astounded by the number of people of retirement age who have no idea about the sequence of return risk. During the accumulation phase while you’re working and you’re contributing money to your retirement accounts if you sustain a 30% loss in your account you only need to make 43% to get your account back to where you were before. Lose 50% then you need to make 100% to recover. The smaller the loss, the less time to recover. This is why it took so many people so long for their accounts to actually recover after 2008.  Many individual’s portfolios did not get back up to the previous values until 2013. Because they had to make back a larger percentage than the percentage they had lost.

Now let’s try the same exercise during retirement.  Jim Otar, CFP® and brilliant engineer authored a white paper titled “The time value of fluctuations”. Jim did the difficult math to calculate what an investor would have to earn if they lost 30% of their account value while taking a 4% withdrawal annually. They would have to recoup a 63% return in order to get their account value back up to where it was.  And they would have to do it in three years.  In other words, if they make the 63% but they do it in four years their account still isn’t back to even because each year they have a constant 4% drain on the portfolio so as Jim points out, it’s like compounding in reverse.

This is an example of how large losses can contribute to the sequence of return risk, and a bear market can mortally wound your portfolio. Sequence of return risk adds to the other risks of retirement such as investment risk and longevity risk. Retirees have a daunting task in front of them to figure out how they’re going to manage their money in retirement.  My follow up article will look at the way many retirees are invested and whether or not those portfolios will be able to withstand a bear market.

* An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.     

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

To learn more about Chad White, view his Paladin Registry profile.

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