A Down-Market Survival Guide for Retirees

A version of this article originally published in August 2019.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

I often cringe when I hear market commentators suggest that investors shouldn't sell stocks amid market downturns. It's true that it's rarely a good idea to panic-sell; you're more likely to let your emotions get the best of you and you could make decisions that bring short-term relief but longer-term angst. ("Is the worst over? Is it time to get back in?")

But the right response to market downdrafts really depends on you, your life stage, and what your financial priorities are. The usual prescription for younger investors amid weak markets--stand pat with your existing long-term holdings--may indeed make sense if you're retired. But it's not always wise to sit tight during market weakness, especially if you're retired and haven't taken any equity risk out of your portfolio in many years. After all, spending from an equity-heavy portfolio that's simultaneously declining means there will be fewer assets in place to recover when stocks finally do. Taking too-high withdrawals from a declining portfolio could permanently impair your portfolio's long-run sustainability, especially if those withdrawals occur early in your retirement.

Another crucial difference for retirees versus accumulators is that downdrafts may be much more harrowing from a psychological perspective for retirees. Thanks to their ongoing cash inflows from their salaries, workers can view their portfolios as a renewable resource; they may even enhance their long-term gains by adding to their portfolios on weakness. By contrast, most people in retirement are pulling from their portfolios rather than adding to them; they can't make up for the weak market by adding more to their holdings.

If you're a retiree who is concerned about what sustained market volatility could mean for your plan, here are the key items to keep on your dashboard.

Step 1: Check liquid reserves.
If you're nervous about market volatility, checking cash reserves is a logical first step to help put your mind at ease. After all, if you know that your liquid assets, combined with any income you have coming in the door through Social Security or a pension, are sufficient to meet your living expenses, you're much more likely to sit tight even as your long-term investments fluctuate. Without such a cushion, it might be tempting to switch your long-term investments into a defensive posture, which you could regret when stocks begin to recover.

The tricky part is that there's an opportunity cost to over-allocating to cash, and that often comes to the fore in equity-market shocks. If yields decline, as is often the case during the recessionary environments that can lead to stock sell-offs, bond owners are the winners because declining yields boost bond prices. By contrast, cash investors earn only income; capital appreciation isn't an option.

I like the idea of holding the equivalent of two years' worth of portfolio withdrawals in truly liquid investments, whether money market mutual funds, CDs, online savings accounts, or checking and saving accounts. That's the idea behind my model bucket portfolios for retirees. That way, even if the fairly safe portions of your portfolio (bonds) drop and stay down for two years, and equities stay down for longer than that, you'll have your living expenses queued up and won't need to tap depressed assets for them. 

For example, let's say you expect to spend $80,000 in total per year over the next two years, and you receive $35,000 per year from Social Security. In that instance, your portfolio withdrawal is $45,000, so your cash cushion would equate to $90,000. (Just make sure your planned withdrawal rate is sustainable before you take that amount and run with it--more on withdrawal rates below.)

Step 2: Re-evaluate your long-term asset allocation.
If it turns out you need to top up your cash holdings for the next few years, or even if you don't, take a closer look at your portfolio's long-term asset-allocation mix. Portfolio contents have a way of shifting around over time. That can leave you over-allocated to some market segments and underexposed to others. As a result, your portfolio could be courting more risk than you expected, even if you weren't actively steering more assets into U.S. equities amid their long-running rally.

To determine whether any repositioning is in order, start by using Morningstar's Portfolio Manager or Instant X-Ray to gauge your total in-retirement portfolio's asset allocation currently. Then compare that to your target allocations. If you don't have a target asset allocation for your long-term retirement portfolio, there are a few ways to go about getting one. Of course, a financial advisor is the gold standard, because he or she can guide you to a customized asset allocation that takes your situation and risk appetite into account. 

For a quick and dirty view of sane asset allocations for retirement, Morningstar's Lifetime Allocation Indexes, as well as the in-retirement funds from the better target-date lineups such as Vanguard, provide a decent starting point. To fine-tune your allocation, I like the idea of using your actual cash flow needs to drive how much to invest in each asset class. In so doing, you're essentially matching each spending horizon to the asset type with a high probability of earning a positive return over that horizon.

As you review your long-term holdings, be sure to check out your intra-asset class positioning. Just as U.S. stocks trumped the other main asset classes over the past decade, high-growth equities have dramatically outperformed other equity types, including smaller-cap and value-leaning names, as well as foreign stocks, over the past decade. That could leave your portfolio underexposed to areas that may perform well over the next 10 years, as well as heighten your portfolio's overall risk. In addition to checking your portfolio's baseline asset-class exposure in X-Ray, also assess your total portfolio's Morningstar Style Box exposure and sector positioning for big, inadvertent bets.

If you determine that changes are in order, be sure to mind taxes as you go about repositioning; making adjustments in your tax-sheltered accounts is usually a good starting point. If you're subject to required minimum distributions or simply need to replenish your cash holdings that you'll use for living expenses in the next few years, considering trimming the appreciated portions of the portfolio. That allows you to raise cash, meet your tax obligations (in the case of RMDs), and reduce the risk in your long-term portfolio all in one fell swoop.

Step 3: Revisit your withdrawal rate.
Another part of your portfolio wellness check during volatile times is to take a closer look at your spending rate and consider making adjustments in very weak market environments. After all, much of the research related to sustainable withdrawal rates points to flexible withdrawal rates as greatly improving portfolios' longevity over many years. That means you can spend more in very strong markets so long as you tighten your belt in very weak ones. The basic premise behind reducing your spending in weak markets is that you'll leave more of your portfolio in place to heal when the market improves.

Sticking with a fixed withdrawal percentage, such as 4%, year in and year out has the benefit of tethering your withdrawals to your portfolio balance; you're automatically making adjustments along with your portfolio's performance. The downside, however, is that withdrawal system can lead to dramatic fluctuations in your standard of living; 4% of $1.5 million is $60,000, but 4% of $1 million is just $40,000. Most retirees don't have that kind of leeway in their budgets to whack off $20,000 in annual spending.

This T. Rowe Price research looks at spending strategies during volatile times, concluding that new retirees, especially, should be conservative in their early withdrawals if they coincide with a down market. Additional research from Jonathan Guyton and William Klinger, as well as research from Vanguard, depicts how retirees can maintain flexibility in their withdrawal rates without upending their standards of living. Research from Morningstar Investment Management's head of retirement research David Blanchett suggests that the required minimum distribution calculations nicely align retirees' withdrawals with their ages and portfolio balances. (If you're concerned that RMDs are higher than you'd like, it's valuable to understand that RMD amounts rest on some conservative assumptions about life expectancy.)

Step 4: Identify tax-saving opportunities.
If there's a small silver lining in weak markets, it's that you might find opportunities to save on taxes. Selling depressed securities from your taxable account is the most obvious tactic to consider. If you invest in individual stocks, use the specific share identification method for calculating cost basis, and/or purchased shares when the market was loftier, you may be able to find stocks that are currently trading below what you paid for them. You can sell and use the losses to offset capital gains elsewhere in your portfolio or ordinary income of up to $3,000. Any unused losses can also be carried forward into future tax years. Just remember that you can't rebuy the same or a "substantially identical" security within 30 days without disqualifying your tax loss.

Weak market environments may also provide an opportunity to consider converting all or part of your traditional IRA balance to Roth. When you convert, you owe taxes on any converted dollars that you haven't already paid taxes on, so converting when the market is low reduces your conversion-related tax bill. Get some tax advice before embarking on conversions, however, to ensure that you're not triggering unintended consequences.

Step 5: Find other ways to trim investment-related costs. 
In addition to watching for volatility-related tax-saving opportunities, another way to seize control in uncertain markets is to watch your long-term costs, tax and otherwise. Not only do you exert a level of control over these costs, but over time, reducing your total expenses can have a meaningful impact on your take-home return.

Start by taking a look at your all-in investment-related expenses, beginning with fund expense ratios: Higher-cost funds may have earned their keep during the long-running bull market, but those higher expenses can exacerbate your losses during downturns. Index funds and exchange-traded funds are the cheapest of the cheap. And if you opt for active management, remember that low expenses are one of the best predictors of superior returns. If you're paying brokerage commissions to trade, make sure that you're not trading more than you need to.

Also keep an eye on the total tax efficiency of your plan. That means paying close attention to asset location--which types assets you have stored in which types of accounts. If you're actively withdrawing from your portfolio during retirement, make sure that you're sequencing those withdrawals with an eye toward reducing the drag of taxes. Here is a spot where a tax advisor can really add a lot of value. Finally, if you have taxable accounts, and many retirees do, make sure that you're managing them with tax efficiency in mind. That means holding the most tax-efficient assets in your taxable accounts, such as equity ETFs. 

Step 6: Step away from the action.
One of the great joys of retirement--extra time to do what you really enjoy doing--can be a curse in volatile markets. Having more free time gives you more opportunities to obsess over your falling portfolio. It's one thing to turn off the financial news programs, but when the market is really bad, discussions of the terrible market can turn up in general news outlets and social conversations, too. Try to reduce your exposure to the news flow and, to the extent that you can, stay disciplined about your portfolio check-ins. Use a retirement policy statement and an investment policy statement to spell out your approach to managing your portfolio and your plan on an ongoing basis. For my money, a thorough, once-annual review is plenty, allowing you to knit together portfolio oversight, tax management (including RMDs), and charitable giving as it relates to your investments.

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