A Checklist for Volatile Markets: Retiree Edition

A previous version of this article appeared on April 9, 2020.

If you’re many years from retirement, coping during a down market is primarily a mental exercise; the key objectives are not to sell into the weakness and to line up enough liquid reserves to meet any preretirement goals you might have or to address unexpected job loss or other financial emergencies.

But if you’re retired, a down market is apt to feel more distressing than when you were working. Of course, you probably have more time to check out your portfolio and take the occasional peek at CNBC; seeing the major indexes fall further into the red can cause heartburn. But the main issue is that your portfolio is your paycheck--or at least part of it--in retirement. It’s only natural to feel more protective of it than you might have been when you were working.

Coping during a period of market weakness requires mental fortitude, just like when you were working, but it may also require course corrections to help ensure that your portfolio can sustain withdrawals throughout retirement.

If you're already retired or retirement is close at hand, here’s a checklist to use to make sure your plan is on track. We also have a checklist for savers.

1. Revisit Your Withdrawal Rate Your portfolio and the performance of various holdings may be grabbing your attention right now, but before delving into it, stop and consider the basic outlines of your plan, starting with your portfolio spending rate. 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 leeway in their budgets to whack off a third of their annual spending in a given year.

Recent research from John Rekenthaler, Jeff Ptak, and me took a look at strategies that can help retirees maintain flexibility in their withdrawal rates without upending their standards of living. One simple tweak is to plan to forgo inflation adjustments in withdrawals after a portfolio has incurred a loss, though that could be a tough pill to swallow given today's higher rates of inflation. Another strategy that our research demonstrated was effective is the "guardrails" approach, developed by financial planner and Jonathan Guyton. It calls for retirees to take lower withdrawals in down markets, but in exchange they can take more when their balances are elevated.

2. Check Short- and Intermediate-Term Reserves After you've checked your withdrawal rate, it's time to turn to your portfolio's allocations. Are they structured sensibly to meet your planned withdrawals?

As regular readers know, I'm a big fan of organizing your in-retirement portfolio based on your expected cash flow needs, often called a bucket approach to retirement portfolio planning. Very short-term expenditures get parked in cash, intermediate-term expenditures can go into bonds, and money for longer-term outlays can reasonably go into stocks. My model bucket portfolios provide a runway equal to 10 years' worth of portfolio withdrawals in cash and bonds. That way, if stocks fall and stay down for a long time--or we experience another lost decade in stocks like we did in the 2000s--you wouldn't likely have to dip into stocks.

There’s also a behavioral benefit to a bucket approach in herky-jerky markets like the current one. After all, if you know that your liquid assets, combined with any income you have coming in the door through Social Security, a pension, or an annuity, 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.

I like the idea of holding the equivalent of two years' worth of portfolio withdrawals in truly liquid investments, whether money market mutual funds, certificates of deposit, online savings accounts, or checking and saving accounts. Another eight years’ worth of portfolio withdrawals can go into high-quality bonds, with perhaps an additional dash of high-quality dividend-paying equity exposure in this portion of the portfolio, bucket 2. The return potential of bucket 2 is a touch higher than what cash is likely return over the next decade; the trade-off is the potential for a bit of volatility.

3. Re-evaluate Your Equity Weighting Holdings: Size and Type Once you've established that your portfolio cash flows for the short and intermediate term are parked in fairly safe assets, you can turn your attention to your portfolio's equity weightings. For a quick and dirty view of a reasonable allocation to equities for retirement, Morningstar's Lifetime Allocation Indexes, as well as the in-retirement funds from the better target-date lineups such as the one from T. Rowe Price, 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. U.S. stocks, and especially large-growth equities, have dramatically outperformed over the past five-plus years. 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.

4. Identify Tax-Saving Opportunities

You may alsobe able to turn up opportunities to save on taxes--if not this year than in the years ahead. 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 them 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.

Extended 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. Balances are still elevated, and in turn the tax implications of conversion also remain high in many cases. A series of partial conversions can make sense versus a very large conversion all in one go.