What should you do about the recent bout of turbulence in stocks if you're a new retiree? For many retirees, the latest debacle amounts to déjà vu all over again, evoking scary memories of the 2008 market crash that followed the housing bust. Back then, many older workers postponed their retirement, or were laid off and forced to retire after seeing their 401(k) balances shrink.
Did we forget the hard lessons we learned so quickly? Even if retirement is five to 10 years away, you should be paying close attention to what's happening now.
Suppose you're retired, have invested your savings to generate a retirement paycheck, and are counting on withdrawing more from your 401(k) and IRA than just interest and dividends to cover your living expenses. Then you're dipping into principal during a market downturn, which is one of the worst possible scenarios for recent retirees.
Analysts even have a name for that sort of behavior -- "sequence of returns risk," where you lock in investment losses with your withdrawals. If you lose too much principal this way, there might not be enough money left if and when the market recovers.
If possible, the solution is to reduce your withdrawals to just the interest and dividend cash flow. You can also either reduce your spending accordingly or go back to work to earn some extra spending money.
You could avoid this scenario if you can cover your basic living expenses with guaranteed sources of retirement income such as Social Security, a monthly pension, and/or an immediate fixed annuity. This strategy lets you breathe a little easier and ride out the market downturn, and you won't have to move in with your kids if the worst happens and the market continues to crash.
With this strategy, you're funding discretionary spending through withdrawals from your investments, so most people will be able to cut back these withdrawals without too much pain.
In either situation, conventional wisdom says that one of the worst things you can do is panic and dump stock now. And that's generally good advice that you should heed. However, you need to think long and hard about how you'll feel if the market keeps dropping. Write down "Dow Jones hits 14,000" and contemplate your gut reaction. Will you capitulate and sell then?
If not, then try "Dow hits 12,000." Would you sell at that point? How about "Dow hits 10,000?" Still have the guts -- and resources -- to stay invested? Because that's what it takes to invest in the stock market when you're retired and living on your savings.
If you decide to go with the "don't panic and sell" strategy, then you need to be ready to ride out a drop of 50 percent or more, because that could happen. So be really, really, honest with yourself: If you can't stand such a loss, then selling now isn't such a bad idea if it prevents you from selling later at an even lower level. After all, even today the Dow is above the level it was less than two years ago. How much has it dropped since the day you retired? If the answer is "not much," then are you really that much worse off compared to the day you retired?
If you're not working with a financial advisor, you may want to consider hiring someone who can talk with you during market downturns and craft appropriate stock investment strategies. An unbiased advisor who is trained in the complexities of retirement income can guide you through the emotional roller-coaster of retiring in an uncertain and volatile stock market.
Another good strategy for generating retirement income is to just live on the interest and dividends from an investment portfolio of stocks and bonds or mutual funds. In this case, you're somewhat insulated from stock market declines, because your investment cash-flow doesn't fluctuate nearly as much as the value of the underlying investments.
Companies don't reduce or eliminate their dividend payments just because the market drops -- they reduce these payments if they're making less money, which generally hasn't happened yet and may not happen if the U.s. economy holds up. A friend of mine recently summed up this philosophy in colorful way: A dairy farmer only cares about the amount of milk produced by the cows and the price of milk, not about the price of beef.
A careful strategy to generate retirement income will help you sleep better at night and enjoy your retirement. Part of this strategy is planning for the day when (not if) the market drops 50 percent, because that's an event that could happen in your lifetime. Plan for it now and you'll rest easier in the future.